eirmoney | Deflation Simplified

Deflation Simplified

Posted by Emil Okanovic | 08 July 2009

What is deflation and how will it affect you

For much of the past decade, inflation has been viewed as a potential threat to economic growth and profits. Booming asset values, rising wages, and surging oil prices suggested that the economy was expanding robustly and that inflationary pressures were the only risk to sustained growth. This was the prevailing view of most economists and analysts, who, nevertheless, ignored fundamental problems of the developed economies that laid in the swollen balance sheets of both corporate and household sectors. The recent collapse of bad credit exposed those problems of excess and unsustainably high financial leverage, causing one of the largest financial crises in modern history. Now, the tables have turned — inflationary concerns have disappeared and deflation has emerged as a major problem for policy makers, investors, and households.

Deflation is the general and sustained decline in the prices of goods and services. It is an economic process in which the level of prices of goods and services declines relative to the price levels recorded in the earlier year. You may have already witnessed this process in the dropping values of your homes and investments. Now, this malaise has spread to general goods and services - think Tesco 'border' price cuts, as consumer behaviour forces the supermarket giant to actively attempt to retain business south of the border. It is evident at various retailers and merchants who offer sharp discounts to eliminate rising inventories. Some would assume that falling prices are good because one can afford more goods than before for the same amount of money. However, while this may hold true, deflation negatively affects all. It is a process that can spiral the economy into a vicious cycle that causes extended economic stagnation and damages your financial interests.

Asset prices have already declined substantially. Personal spending on goods and services has also dropped. Companies have been reducing prices to entice customers to spend. However, customers have been delaying their purchases in anticipation of even lower prices. In response, companies have lowered prices further. This reduces their earnings and forces them to slash costs though production, which causes end consumer-driven drop in demand throughout the value chain. Reduced demand leads to job cuts, which additionally reduces household incomes and makes buyers less likely to spend. Even when cost cutting does not lead to job losses, it puts pressures on wage growth, as salaries stop rising. If sales continue to fall, pressures on merchants and manufacturers increase, and the process repeats. As a result, the economy becomes trapped in a vicious cycle out of which it may be difficult to escape.

Deflation also negatively affects borrowers, individuals and businesses alike. In deflation, the value of fixed monthly installments for loan repayments increases while business revenues used to service loan repayments drop and the value of assets financed by the loan declines. This means that financial leverage increases, which negatively affects borrowers creditworthiness and therefore limits their access to credit or capital. A deteriorated credit standing and higher leverage cause lending standards to tighten and money to become costlier.

All this could make it difficult for companies to repay loans, which leads to an increase in delinquencies and defaults, making lenders less likely to extend loans. Stifled credit growth reduces demand for goods, services, and assets. Declining corporate earnings cause share prices to drop. Continued declines of prices of assets, such as properties, and more stringent lending requirements reduce demand for those assets, making it difficult to stabilize the market and return to price growth.

As described above, economic pitfalls of deflation significantly outweigh its benefits. As deflation discourages spending and investment, it hurts the economy more than it benefits consumers via cuts in prices of goods and services. This suggests that the economy and the markets will have a tough road to travel in the year ahead. What remains unknown, however, is how long deflation will last and how severe will be its impact on household wealth, corporate profits, and economic output.