Many people accept inflation as a fact of life. However, under certain economic situations, the opposite phenomenon actually takes place, and is known as deflation.

Deflation is the reduction of prices of goods, and although deflation may seem like a good thing when youre standing at the checkout counter, its not. Rather, deflation is an indication that economic conditions are deteriorating. Deflation is usually associated with significant unemployment. which is only corrected after wages drop considerably. Furthermore, businesses profits drop significantly during periods of deflation, making it more difficult to raise additional capital to expand and develop new technologies.

Deflation is often confused with disinflation. While deflation represents a decrease in the prices of goods and services throughout the economy, disinflation represents a situation where inflation increases at a slower rate. However, disinflation does not usually precede a period of deflation. In fact, deflation is a rare phenomenon that does not occur in the course of a normal economic cycle, and therefore, investors must recognize it as a sign that something is severely wrong with the state of the economy.

What Causes Deflation?

Deflation can be caused by a number of factors, all of which stem from a shift in the supply-demand curve. Remember, the prices of all goods and services are heavily affected by a change in the supply and demand, which means that if demand drops in relation to supply, prices will have to drop accordingly. Also, a change in the supply and demand of a nations currency plays an instrumental role in setting the prices of the countrys goods and services.

Although there are many reasons why deflation may take place, the following causes seem to play the largest roles:

1. Change in Structure of Capital Markets

When many different companies are selling the same goods or services, they will typically lower their prices as a means to compete. Often, the capital structure of the economy will change and companies will have easier access to debt and equity markets, which they can use to fund new businesses or improve productivity.

There are multiple reasons why companies will have an easier time raising capital, such as declining interest rates. changing banking policies, or a change in investors aversion to risk. However, after they have utilized this new capital to increase productivity, they are going to have to reduce their prices to reflect the increased supply of products, which can result in deflation.

2. Increased Productivity

Innovative solutions and new processes help increase efficiency, which ultimately leads to lower prices. Although some innovations only affect the productivity of certain industries, others may have a profound effect on the entire economy.

For example, after the Soviet Union collapsed in 1991, many of the countries that formed as a result struggled to get back on track. In order to make a living, many citizens were willing to work for very low prices, and as companies in the United States outsourced work to these countries, they were able to significantly reduce their operating expenses and bolster productivity. Inevitably, this increased the supply of goods and decreased their cost, which led to a period of deflation near the end of the 20th century.

3. Decrease in Currency Supply

As the currency supply decreases, prices will decrease so that people can afford goods. How can currency supplies decrease? One common reason is through central banking systems.

For instance, when the Federal Reserve was first created, it considerably contracted the money supply of the United States. In the process, this led to a severe case of deflation in 1913. Also, in many economies, spending is often completed on credit. Clearly, when creditors pull the plug on lending money, customers will spend less, forcing sellers to lower their prices to regain sales.

4. Austerity Measures

Deflation can be the result of decreased governmental, business, or consumer spending, which means government spending cuts can lead to periods of significant deflation. For example, when Spain initiated austerity measures in 2010, preexisting deflation began to spiral out of control.

5. Deflationary Spiral

Once deflation has shown its ugly head, it can be very difficult to get the economy under control for a number of reasons. First of all, when consumers start cutting spending, business profits decrease. Unfortunately, this means that businesses have to reduce wages and cut their own purchases. In turn, this short-circuits spending in other sectors, as other businesses and wage-earners have less money to spend. As horrible as this sounds, it continues to get worse and the cycle can be very difficult to break.

Effects of Deflation

Deflation can be compared to a terrible winter: The damage can be intense and be experienced for many seasons afterwards. Unfortunately, some nations never fully recover from the damage caused by deflation. Hong Kong, for example, never recovered from the deflationary effects that gripped the Asian economy in 2002.

Deflation may have any of the following impacts on an economy:

1. Reduced Business Revenues

Businesses must significantly reduce the prices of their products in order to stay competitive. Obviously, as they reduce their prices, their revenues start to drop. Business revenues frequently fall and recover, but deflationary cycles tend to repeat themselves multiple times.

Unfortunately, this means businesses will need to increasingly cut their prices as the period of deflation continues. Although these businesses operate with improved production efficiency, their profit margins will eventually drop, as savings from material costs are offset by reduced revenues.

2. Wage Cutbacks and Layoffs

When revenues start to drop, companies need to find ways to reduce their expenses to meet their bottom line. They can make these cuts by reducing wages and cutting positions. Understandably, this exacerbates the cycle of inflation, as more would-be consumers have less to spend.

3. Changes in Customer Spending

The relationship between deflation and consumer spending is complex and often difficult to predict. When the economy undergoes a period of deflation, customers often take advantage of the substantially lower prices. Initially, consumer spending may increase greatly; however, once businesses start looking for ways to bolster their bottom line, consumers who have lost their jobs or taken pay cuts must start reducing their spending as well. Of course, when they reduce their spending, the cycle of deflation worsens.

4. Reduced Stake in Investments

When the economy goes through a series of deflation, investors tend to view cash as one of their best possible investments. Investors will watch their money grow simply by holding onto it. Additionally, the interest rates investors earn often decrease significantly as central banks attempt to fight deflation by reducing interest rates, which in turn reduces the amount of money they have available for spending.

In the meantime, many other investments may yield a negative return or are highly volatile, since investors are scared and companies arent posting profits. As investors pull out of stocks, the stock market inevitably drops.

5. Reduced Credit

When deflation rears its head, financial lenders quickly start to pull the plugs on many of their lending operations for a variety of reasons. First of all, as assets such as houses decline in value, customers cannot back their debt with the same collateral. In the event a borrower is unable to make their debt obligations, the lenders will be unable to recover their full investment through foreclosures or property seizures.

Also, lenders realize the financial position of borrowers is more likely to change as employers start cutting their workforce. Central banks will try to reduce interest rates to encourage customers to borrow and spend more, but many of them will still not be eligible for loans.

Tools to Fix Deflation

Fortunately, it is possible to reduce the impact of deflation. However, fighting deflation requires a disciplined approach, as it will not fix itself. Prior to the Great Depression, it was commonly believed that deflation would eventually run its course. However, economists suggested government intervention was necessary to break a deflationary spiral.

During the Great Depression, the government attempted different methods to fight deflation, most of which proved ineffective. For example, President Franklin D. Roosevelt believed that deflation was caused by an oversupply of goods and services, so he attempted to reduce the supply of resources on the market. One way he tried to do this was to purchase farmland so farmers could not produce as many crops to sell in the marketplace. However, these kinds of solutions only further damaged the economy, possibly worsening the deflationary spiral.

Central banks have a considerable influence over the direction of inflation and deflation by changing the nations monetary supply. For example, the Federal Reserve has engaged in quantitative easing as a means to prevent deflation. Although increasing the nations monetary supply too much could create excessive inflation, a moderate expansion in the nations monetary base could be an effective means of fighting deflation.

The central banks efforts to fight deflation are effective in some instances, but not in others. The biggest limitation with central bank policies is that they can only decrease interest rates until they are near 0%. After reducing interest as much as possible, central banks no longer have a large bevy of solutions available to them. In fact, there still exists no clear-cut, foolproof way to address deflation.

Historical Examples of Deflation

Although deflation is a rare occurrence in the course of an economy, it is a phenomenon that has occurred a number of times throughout history. Among others, these are incidences in which deflation has occurred:

1. Expansion of Industrial Revolution

During the late 19th century, manufacturers took advantage of new technology that allowed them to increase their productivity. As a result, the supply of goods in the economy increased substantially, and consequently, the prices of those goods decreased. Although the increase in the level of productivity after the Industrial Revolution was a positive development for the economy, it also led to a period of deflation.

2. Great Depression

The Great Depression was the most financially trying time in American history. During this dark era in history, unemployment spiked, the stock market crashed, and consumers lost much of their savings. Also, employees in high production industries such as farming and mining were producing a great amount, but not getting paid accordingly. As a result, they had less money to spend and were unable to afford basic commodities, even in spite of how much vendors were forced to reduce prices.

3. Depression of 1920-1921

4. European Debt Crisis

The debt crisis in Europe is causing a number of complications for the global economy. In response to this crisis, governments have implemented austerity measures, such as cutting government assistance to needy families. However, these measures have reduced GDP considerably. Also, the banks have contracted their credit, which has reduced the money supply within the country. As a result, Europe is undergoing massive deflation.