“Black Thursday”, the world’s largest stock market crash in 1929. The US was forced to immediately initiate debt repayment by the German Reich. This eradication took place mainly in gold.
All of these factors ultimately led to deflation, which led to lower prices and wages, while unemployment rose to more than 20 percent. Ultimately, deflation has been exacerbated by austerity measures in factories and in the state.
A recovery did not take place until the late 1930s. To this day, the “Great Depression” is repeatedly recalled when it comes to illustrating the dangers of deflation.
Deflation: A simple explanation
Deflation is a continuous lowering of the general price level. The price level is falling because less and less money is in circulation.
The decline also occurs because the supply of the entire economy of a country is greater than the actual demand. One possible consequence is a sales crisis that causes a so-called economic downturn.
In this case, an economy no longer grows, but shrinks. This phenomenon is preceded by a so-called “demand gap”. The overall demand for goods and merchandise declines, but the supply remains the same.
Deflation raises the money. Theoretically, consumers can, therefore, buy more goods with their money.
Disadvantages for debtors
In deflation, debtors are at a disadvantage. As the monetary value continues to increase, so do the debt. The state as a debtor is also at a disadvantage in terms of deflation, as its debt also increases with increasing deflation.
Benefits for investments
Owners of capital have the advantage through the rising value of money. Not only do they benefit from the higher value of capital, but also more from the interest they receive. Thus, the return can develop even more positive.
However, deflation can also have a negative impact on investments. This is the case when the central bank cuts interest rates to stimulate the economy. In this case, fixed income securities will generally pay less interest. The money is worth more in the short term, but the return drops due to falling interest rates.
A simple example of deflation
The central bank gives 1,000 euros in circulation. At the same time, one kilo of apples costs two euros. With an hourly wage of 20 euros, an employee could buy ten kilograms of apples.
Now the central bank lowers the money supply and brings only 900 euros in circulation. To sell the same amount of apples as before, the dealer lowers the price to 1.80 euros. If the wage level of the employee remains the same, he could now buy more than eleven kilograms of apples for 20 euros.
However, during deflation, employers also adjust their wages so that workers have less money to spend. Thus, a spiral is set in motion, which continues to lower the price level.
The deflation theoretically describes exactly the opposite of inflation. This table compares the central features of deflation and inflation.
|goods traffic||the First oversupply, then it sinks||Sinks because buyers cannot pay any more|
|demand||Go back||Go back|
|consumer behavior||Increases first, then sinks||Increases first, then sinks|
Although deflation and inflation have different causes and evolve differently, both can have similar long-term effects on the economic development of a state.
The situation in Germany
At the beginning of 2016, the inflation rate in Germany was still 0.3 percent. This low percentage attracted economists and politicians who warned against deflation.
Among the factors responsible for the low level declined in investments, a slower growth economy and a very low oil price.
For a stable economy, however, the European Central Bank (ECB) assumes an inflation rate of two percent. That’s why the ECB started getting more money into circulation.
By March 2017, the ECB intends to buy bonds and securities worth € 1.5 trillion.
The last big inflation in Germany
In Germany, inflation is still feared today, because of the memory of the great German inflation between 1914 and 1923 lags behind. At that time a massive monetary devaluation took place.
It was a consequence of the First World War. Everyday products cost millions or even billions during this hyperinflation.
Inflation rate as a guideline for the macroeconomic state
To measure the strength of inflation, the so-called “inflation rate” is used. The inflation rate is the quotient of the difference between the current price and previous price and the previous price multiplied by 100.
The formula is: Inflation rate = (current price – previous price) ÷ (previous price) × 100
For the determination of the current prices similar to the consumer price index, an “imaginary shopping cart” is used in Germany. This includes the current prices for the most important products and services.
The Deflationary Spiral: An almost unstoppable process
The danger of deflation is a spiral set in motion by the appreciation of the currency. Consumers are pleased that they can initially afford more for their money.
But then the following process starts:
- Demand is falling as consumers and businesses are more cautious about investing. They are waiting for them to buy more for their money later.
- This reduces the sales and there is an oversupply. Companies lose sales.
- Because companies have overcapacity and sales losses, they have to lay off employees.
- Rising unemployment means fewer goods are purchased and services are used. Thus, companies have to save even more. At the same time, the tax revenues of the state are falling. He can invest less in the economy and social services. Moreover, banks rarely lend because they are unlikely to receive interest income and deficit causes the mountain of debt to grow.
- The process is repeating and a vicious circle is emerging from which it is very difficult for states to escape. It is also spoken of a “recession”. The economy is weakening. For example, a recession is detected when the quarterly results are negative two consecutive times. If the economic downturn continues over a longer period, the recession will turn into a depression. Such a major depression occurred last in the early 1930s in the United States.
Causes of deflation
Deflation can have different causes. Both political and economic aspects can trigger and sometimes accelerate the process. Ultimately, different forces work together and lead to the already mentioned deflation spiral.
Economic aspects: The decline in consumption and investment
- Private household austerity measures: Deflation can be promoted by austerity measures by households. In this case, households will be more reluctant to invest and buy. If supply remains the same, demand will fall and a sales crisis can result.
- Corporate austerity: companies can accelerate deflation if they invest less. For example, the fall in demand from one automaker may lead to a decline in demand from the automotive supplier. This then returns investment in new employees or machines.
- Existential fears and negative expectations for the future: These emotional reasons can also increase deflation. This reduces purchasing power as well as demand. Consumers are increasingly reluctant to buy and less willing to invest in new acquisitions.
- Layoffs and production throttling: In response to falling deflationary demand, companies can respond with redundancies or a reduction in production. These processes, in turn, enhance the effect of deflation.
When prices for services or goods decline, wages will be worth more. However, this relationship creates an unfavorable wage-price spiral. As companies lose less due to falling prices, they have to lower labor costs.
Workers thus receive less money and can consequently spend less again. Falling demand is causing companies to lose revenue and keep their wages down.
The consequences for the job market are great. It can, therefore, be assumed that unemployment will rise as wage deflation increases.
Asset and credit deflation
Asset deflation can be caused by the bursting of investment or speculative bubbles, such as stocks or real estate. The negative process is favored by the fact that the investments are often made with loans. That’s why people talk about “credit deflation”.
As the value of money rises, the credit debt increases. In this case, households can become over-indebted. As a result, banks lend less money, which in turn reduces the money stock in the market.
As a consequence, the deflation process is accelerated or a “real” deflation can be triggered because consumers can spend even less money or borrow new money due to their over-indebtedness.
Political aspects of deflation
If states reduce their spending and thus invest less in the markets, demand drops while supplies remain the same. In turn, this can lead to a gap in demand, which reduces the amount of money in circulation and thus favors deflation.
It is also possible for central banks to favor deflation if they raise policy rates. In this way, lending becomes more expensive and companies and households invest less.
For this reason, the European Central Bank (ECB) is obliged to stabilize the market. To prevent deflation, the ECB can increase its money supply by buying government bonds.
When is there a risk of deflation?
There is a danger of deflation whenever the economy barely grows and as a result investments decline and consumption collapses.
First, deflation is not bad, as consumers can afford more for their money. In the medium term, however, deflation leads to oversupply and thus to a decline in production and sales, which in turn starts the deflationary spiral.
Possible countermeasures against deflation
Every state has to react to deflation. If no countermeasures were taken, deflation could lead to the state ruin. After all, a state can no longer be managed without tax revenue.
- construction projects
States can stimulate the economy without a corresponding monetary policy. For example, the state has the opportunity to support new construction projects. In this way, there is higher employment and thus higher consumption and tax revenues. Possible construction projects include, for example, roads or highways.
- fiscal policy
States have the opportunity to make more investments through tax relief. As citizens or businesses have more money available, they can spend more and generate tax revenues for the state.
- monetary policy
Central banks can fight deflation by lowering key rates. Cheap loans should drive companies and consumers to invest- global regulatory. However, such monetary policy also has disadvantages. Because at low-interest rates savers and investors receive fewer capital gains. This also affects large investors such as insurance companies. For example, it could then generate less money for retirement provision. Low-interest rates can also increase inflation because there is too much money in circulation.
- exchange controls
Through foreign exchange controls, governments can ensure that foreign exchange must be exchanged into their own currency. In this way, the money supply increases and deflation can go down.
Excursus deflation in Japan
In the mid-1990s, consumer prices in Japan fell rapidly. Amongst others, the stock markets were responsible for this development.
For example, at the end of the 1980s, they caused the leading index Nikkei 225 to rise to over 38,000 points. As a result, real estate prices and asset prices rose to dizzying heights.
Finally, the leading index fell below 16,000 points between 1990 and 1992. The falling stock market power led to falling monetary values. As a result, the Japanese held back in consumption, which in turn led to overproduction.
The deflationary spiral had started. The trend was further reinforced by Japan’s strict monetary and fiscal policies.
It was not until 2003 and 2004 that deflation was partially stopped. Since then, Japan has been considered the world’s most heavily indebted country.
The ten years of deflation are also referred to as the “lost decade”. Japan recovered only partially. In the wake of the financial crisis in 2008, the deflation rate of the state rose sharply again.
What are the consequences for supply and demand?
In the case of deflation, a decline in demand initially creates an oversupply. Due to production adjustments, supply is falling again, but at the same time demand is also falling. The result can be an economic downturn, which leads to production bottlenecks.
What consequences does deflation have for the labor market?
A deflation can lead to rising unemployment, as companies have to generate less revenue due to falling demand and therefore have to lay off employees.
What consequences does deflation have on government tax revenues?
Falling incomes also reduce the tax revenues of the state. In addition, this process will be intensified because even lower taxes will be taken by falling consumption.
How is the level of employment changing?
The level of employment is steadily decreasing because companies can no longer afford employees.
What is the so-called “deflationary gap”?
The deflator gap is a demand gap. There is less demand for goods than the offer.
What other negative consequences does deflation have?
Deflation can, for example, increase public debt or lead to depression in the long run.
Who are the losers?
The losers of deflation are those who have credit debt. In addition, shareholders or real estate investors are among the losers of deflation.
Who benefits from deflation? Are there positive aspects?
The profiteers of deflation are general creditors. Positive aspects of deflation are usually short-term. Because consumers can initially afford more.