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Good Deflation and Bad Deflation

Is deflation a good or a bad thing for industrial countries' economies?

July 2, 2003

Is deflation a good or a bad thing for industrial countries' economies?

Believe it or not, but “good” deflation is not such an unreal thing. After all, there are some sectors which grow — even though prices have been falling for a long time. Computer and cell phone manufacturers, for example. Television sets, refrigerators and cars are getting cheaper from year to year, if we factor in the improvements in quality.

As a matter of fact, there have been entire economies which have lived extremely well with sinking price levels over extended periods. One example is the United States in the period of industrialization in the second half of the 19th century.

Even Japan on the whole seems to be coping fairly well with deflation, even though it encountered initial difficulties. Prices there have been falling for six consecutive years.

And nonetheless, discount dealers and luxury chains, for example, report rising sales. Japan accounts for over half of the worldwide sales of luxury goods.

Buildings are going up in Tokyo and the general impression one gains there is that people are not worse off than anywhere else.

The companies suffering most from sinking prices are banks, mainly because collateral for loans is gradually becoming worth less and less. In addition, unemployment and public debt levels have been increasing.

How does good deflation work? The theoretical model is very simple: Corporate productivity gains are not distributed to employees through wage increases. Instead, price decreases are passed on to consumers. Everyone profits from this, even those not actively involved in production.

For good deflation to work, what counts is that people have confidence in the future. In short, that they consume and invest according to their needs — and not according to their price expectations. People buy computers because they need them, despite the fact that they will be less expensive in the future.

A second prerequisite is that there are no strong unions insisting on productivity gains for employees.

And finally, debtors must hedge against falling prices, for instance through lower interest rates — just as creditors ask for higher interest rates in an inflationary environment.

As an example of bad deflation, we all remember the world economic crisis at the beginning of the 1930s.

At that time, prices fell not because of productivity improvements — but because of lack of demand, triggered by the stock market crash.

The consequence of lower prices was not that more money was spent, but that people were concerned about the future — and thus were reluctant to consume and invest.

This, in turn, led to further falling prices, which made the general economic situation worse yet. Recession turned into depression. What is "bad" about bad deflation is therefore not the decline in prices as such — but its consequences.

What people fear is a cumulative process of too little demand, falling prices and again even less demand. To diagnose bad deflation, we must look not just at prices — but take economic conditions in their entirety.

We have bad deflation when people are uncertain about the future, are afraid of losing their jobs, when government becomes over-indebted — and when people fear higher taxes. Then, they drive their cars one year longer and postpone a holiday because they have to save (saving out of fear) and/or hope prices will fall.

Deflation began in Japan at the end of the 1990s when the government raised the value added tax (VAT) to counter huge increases in the country’s public debt. Japanese taxpayers in turn reacted by reducing consumption.

So what to make of all of this?
1. Do not fear deflation as such. It is only a symptom. Let us do something about the depressed mood, so that if price levels sink this will not lead to a downward spiral. In short, the specter of deflation is one more argument in favor of reform.

2. If we should happen to live in a world without inflation in future (and there are indications that this is possible), there will always be a year here and there with lower prices. It is then all the more important that investors and consumers remain positive and do not give way to a pessimistic view. In a world without inflation — as positive as it would be per se — the danger of recession would increase.

3. When prices fall, creditors mostly profit — and debtors mostly suffer. Banks must take steps in good times to hedge against falling prices.

In the case of Germany, inflation has fallen below 1%— coming very close to the technical definition of deflation.

But at present, it is still the good form of deflation — because there are no signs that Germans are holding back demand because of price expectations. Price expectations on the contrary still point upwards.

For Germany, the danger is not whether it may fall into deflation — but that it will be a good deflation and not a bad one.