Deflation - Effects

Effects

The effects of deflation are:

1. Decreasing nominal prices for goods and services
2. Increasing buying power of cash money and all assets denominated in cash terms
3. May decrease investment and lending if cash holdings are seen as preferable (aka hoarding)
4. Benefits recipients of fixed incomes

Deflation was present during most economic depressions in US history Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency, and because confused pricing signals cause malinvestment, in the form of under-investment.

In this sense it is the opposite of the more usual scenario of inflation, whose effect is to tax currency holders and lenders (savers) and use the proceeds to subsidize borrowers, including governments, and to cause malinvestment as overinvestment. Thus inflation encourages short term consumption and can similarly over-stimulate investment in projects that may not be worthwhile in real terms (for example the housing or dot.com bubbles), while deflation retards investment even when there is a real-world demand not being met. In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with economic depression, as occurred in the Great Depression and the Long Depression.

Nobel laureate Friedrich Hayek, an Austrian Economist, stated of deflation during the Great Depression:

I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression.

Interview with Diego Pizano (1979)

While an increase in the purchasing power of one's money benefits some, it amplifies the sting of debt for others: after a period of deflation, the payments to service a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as an effective increase in a loan's interest rate. If, as during the Great Depression in the United States, deflation averages 10% per year, even an interest-free loan is unattractive as it must be repaid with money worth 10% more each year. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate — the overnight federal funds rate in the US — and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target. With interest rates near zero, debt relief becomes an increasingly important tool in managing deflation.

In recent times, as loan terms have grown in length and loan financing (or leveraging) is common among many types of investments, the costs of deflation to lenders has grown larger. Deflation can discourage private investment, because there is reduced expectations on future profits when future prices are lower. Consequently with reduced private investments, spiraling deflation can cause a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent for institutions to hold on to money, and not to spend or invest it (burying money). They are therefore rewarded by holding money. This "hoarding" behavior is seen as undesirable by most economists, as Hayek points out:

It is agreed that hoarding money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation is in itself desirable.

Some believe that, in the absence of large amounts of debt, deflation would be a welcome effect because the lowering of prices increases purchasing power.

Since deflationary periods disfavor debtors (including most farmers), they are often periods of rising populist backlash. For example, in the late 19th century, populists in the US wanted debt relief or to move off the new gold standard, and onto: a silver standard (the supply of silver was increasing relatively faster than the supply of gold making silver less deflationary than gold), bimetal standard, or paper money like the recently-ended Greenbacks.