Deflation

Deflation is the opposite of what inflation would be. This article will try to explain what it is about, why it exists, the advantages and disadvantages of deflation. Contrary to its antonym with which we are more familiar, inflation. If inflation becomes a general rise in prices, deflation is the general decline in prices. However, why does one sometimes occur, sometimes another, and why is it taking place for example in modern times?

Is there a way to get any benefit from it? The truth is that it occurs on specific occasions, it is not a common phenomenon and does not usually anticipate a prosperous future Economically speaking. It usually comes when supply exceeds demand, that is, when consumption is dying. This excess production in goods or products is accompanied by a general drop in prices, and this is where deflation begins, especially if this drop occurs in many different sectors.

What is deflation?

Deflation is also known as well-known inflation. Usually is conditioned by an excess supply that "forces" to end up lowering the prices of goods that can be purchased. This oversupply may be conditioned by the inability to acquire the goods by people, or by a lack of incentives and / or motivations to acquire them. It is usually associated with economic crises, and good examples of this would be the Great Depression that lasted during the 1930s or the Financial Crisis of 2008. In these cases, companies, wanting to get rid of their production and not accumulate deposits, have as a way to end up lowering prices so that their profit margins are reduced.

The effects on society usually affect points such as the distribution of wealth and social inequality. This phenomenon usually comes from the fact that creditors benefit more than debtors, whose obligations have to continue to pay.

The causes, as we have seen, are usually two, an excess in supply or a lack of demand. It has very few advantages, and quite a few disadvantages, which we are going to see below.

Advantages

Austrian school economists argue that deflation has positive effects. The only advantage to be found for now is that as prices fall, the purchasing power of consumers would increase, especially that of those who have savings. However, this heterodox thinking in turn assumes that deflation poses a problem for the economy in the short term.

Disadvantages

Deflation contains an extensive series of negative effects for the economy that we will see below. However, beyond all the facts and phenomena that result from it, the danger of deflation lies in the ease of falling into a vicious circle and how difficult it is to get out of it.

• Economic activity is reduced.
• Demand is reduced, either due to excess supply or purchasing power. More products than would be healthily necessary.
• Reduction in profit margins in companies.
• It impacts on unemployment when it ends up increasing.
• Economic uncertainty reaches high levels.
• Create an increase in real interest rates.

You can see how difficult it is to stop this difficult vicious cycle. If demand is reduced, and margins fall, unemployment ends up increasing. In turn, if unemployment rises, demand can and will surely continue to fall.

Examples of deflation throughout history

We have seen how deflation hit after the hard crises that were experienced in the 1930s and the financial crisis in 2008. However, and although it has been rather an isolated and uncommon phenomenon throughout the last century we can find examples of countries that have suffered from it.

The "Japaneseization" of the economy is sometimes referred to to explain the ECB's reaction to low interest rates by emulating the behavior of the Central Bank of Japan. This period of stagnation in low interest rates has been accompanied by a deflation that began in the 90s and still lasts today. The cumulative price drop is already -25%.

With the current crisis, the specter of deflation looms even more strongly, since its appearance was already feared before. During the last years, developed countries have been lowering their interest rates, and we have seen bonds with negative rates more and more frequently, a current normality previously unthinkable. An example, a year before this serious health crisis began, in February 2019, a total of 37 developed countries were already lowering their interest rates. Deflation is a real danger that is very difficult to solve and the motivation to prevent it is very strong.

Consequences for the Spanish economy

Deflation in the case of Spain has an even more aggravating negative effect. In fact, for this month of July, the CPI was -0% so the interannual rate would remain at -0%, but August has accompanied an increase of 0% to place the interannual rate at -1%. What consequences does deflation have for the Spanish economy? A long-lasting and widespread price drop may offer greater purchasing power for consumers. However, profit margins for companies are reduced.

If personnel costs are maintained and unemployment is enormous, as is the case in Spain, the explosive cocktail is very dangerous, since they are two phenomena that feed off each other. On the one hand, companies are forced to narrow their profit margins to remain competitive. This prevents them from achieving the desired business benefits, as well as having liquidity to make investments. This can lead to freezing or reducing workers' wages, further sinking consumption due to lack of liquidity. If to this is added the lack of savings per household, it is possible that the severe contraction of the country's internal consumption could be aggravated. With exports falling and public debt rising in the wake of the crisis, the specter of deflation may have years of bonanza ahead.