Deflation
Deflation is an economic phenomenon characterized by a decrease in the supply of money or credit, leading to a decline in prices for goods and services. Although lower prices may initially seem advantageous for consumers, deflation often signals more serious underlying economic issues, such as recession or depression. Key causes of deflation include reduced investment and cuts in spending by individuals and governments, which contribute to a less stimulated economy. Historically, deflationary cycles have been documented since the early nineteenth century, notably affecting the economies of the United States and Great Britain during financial crises.
The consequences of widespread deflation can be severe, resulting in job losses, wage cuts, and increased business failures, ultimately leading to a rise in loan defaults. In response to deflation, central banks like the U.S. Federal Reserve may implement policies to increase the money supply, aiming to induce inflation and spur economic growth. The duration of deflationary periods can vary significantly; while most last only a few years, some, like Japan's experience in the 1990s, have persisted for decades. Understanding deflation is crucial for grasping the complexities of economic cycles and the measures taken to stabilize economies during such challenging times.
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Deflation
When the supply of money or credit decreases, a correlating decline in prices on particular goods or services tends to follow. While this might seem like a benefit to consumers, deflation is a negative economic force, and is usually indicative of other negative market trends, including recession or depression. Through various economic cycles over the years, a number of causes of deflation have been identified, including a decrease in investment and cuts in personal and government spending, indicating a less stimulated economy.
Deflation, in essence, is the exact opposite of inflation—the market force that causes the price of goods and services to increase, sometimes in a short period of time. There are various cycles of deflation and inflation, and most developed economies have banking systems with mechanisms in place to prevent the market from swinging too wildly in one direction or the other.
Background
As a recognized economic cycle, deflation can be traced back to the early nineteenth century, particularly in the United States and Great Britain. Both countries faced notable economic slumps in the late 1810s that saw the price of commodities decline. During pivotal moments in economic history in both countries, a contraction in lending from banks led to a deflation in prices.
With the United States in the early years of its nationhood, its economy was still taking form throughout the beginning of the nineteenth century. At the time of the first major instance of deflation, the federal banking system in the northeast served as an important lender throughout the country. In 1818, the US economy began to spiral downward, and the nation’s first official depression followed as banks began to contract their loans and notes outstanding. Currency at the time consisted of coins and banknotes. When a bank failed, its notes became worthless—one of several reasons for the depression.
Great Britain experienced a similar deflationary cycle in 1818 as the country went through its own financial crisis. Similar to what had been taking place in the United States, British banks were calling in loans and cutting back on spending, in part because of close ties to the Bank of the United States.
In both countries, the prices for important commodities, including cotton and tobacco, fell in the aftermath of the constriction of the banking systems. The origins of this particular deflationary cycle are traced to 1816, a year that was especially brutal on agriculture and resulted in spiking prices and widespread starvation. While the agricultural supply improved in the following years, the resumption of normal harvesting patterns resulted in an adverse impact on the economic cycle.
While circumstances differed in subsequent instances of deflation, the cyclical pattern has been nearly identical. The stock market crash of 1929—the prelude to the Great Depression that wounded the global economy for about a decade—resulted in a sharp reduction in international trade. This meant a decline in the demand for commodities and a resultant deflationary cycle that spurred widespread bank failures in the United States and other countries.
Overview
When the prices of goods and commodities deflate, the scenario typically causes a ripple effect of negative shockwaves from one sector to the next. If a widespread reduction in prices occurs, a series of other events typically follow, including a reduction in employment across different industries, cuts to wages, and a rise in the number of companies that go out of business. All this often leads to loan recipients defaulting on money owed with growing frequency, which further compounds the problem.
In the United States, the government’s Federal Reserve System has, at times, implemented specific monetary policies to increase the production of currency in a deliberate effort to work against the tide of deflation. A forced increase in a country’s supply of money is aimed at increasing prices, thus spurring an inflationary cycle. If the forced cycle takes hold, businesses across various sectors stand to increase profits, and the amount of bad debt is reduced. Wages across various industries also stand to increase.
The length of a deflationary cycle depends upon a number of factors, including the origins of the economic condition that caused the downturn in the first place. Since the Great Depression (1929–39), most deflationary periods in developed economies have lasted no more than several years. But there are exceptions. For instance, Japan had a deflationary cycle that lasted nearly two decades, starting in the early 1990s. With the goal of stimulating the economy, the Japanese government attempted unsuccessfully to lower interest rates, eventually taking the figure all the way down to zero. When the method proved unsuccessful in 2006, Japan’s federal lawmakers ceased the zero-interest policy.
The financial crisis that began in the US in 2007 with the housing bubble and ensuing credit crunch resulted in a deflationary cycle that lasted several years. In 2008, as deflation began setting in, consumer prices dropped sharply during finite periods of time. For example, prices dropped a full percentage point in October 2008—the largest decline since 1947. The record was broken again a month later, when prices dropped an additional 1.7 percent.
To mitigate deflationary forces, the US Federal Reserve began cutting interest rates in December 2008. Continued cuts took place on multiple occasions in the intervening years, reaching a historically low rate that was not far from zero percent. While the economy continued to struggle after the housing crisis, most economists believed the US moved outside its deflationary spiral early in 2010. By the early 2020s, the US had reversed course and entered into one of the most significant inflationary periods in the country's history, driven largely by the COVID-19 pandemic.
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