Deflation is always bad for the economy

deflation

Causes of Deflation

The monetary policy of the central banks is based on the optimization of the so-called magic square. This regulates the interaction between:

  • Full employment,
  • Price stability,
  • balanced foreign trade and
  • steady economic growth.

It is the development and mutual influence of these factors that lead to deflation. If economic growth falls, the employment rate usually falls too. Rising unemployment leads to a decrease in the demand for goods. Since companies have to sell, however, they are initially forced not to raise prices, which, together with increasing unemployment, leads to falling wage costs. If the demand continues to fall, stockpiles form. In order to reduce this, a price reduction must take place. The downward spiral has thus begun.

Deflation and economic growth

Inflation results from increasing demand and drives economic growth through higher production figures. During deflation, productivity falls and economic growth does not take place. Foreign trade is the only solution in this situation. Since prices in one economic zone drop significantly in times of deflation, companies may be able to deliver cheaper than competitors to other economic zones with higher price levels.

Approaches to Combat Deflation

When there is deflation, there is a lack of demand, which mostly results from high unemployment. So the first step would be to create new jobs. These arise when companies have funds to make investments. To this end, the banks must issue loans on more favorable terms.

To this end, the central banks can take the step of increasing the banks' liquidity (free cash reserves). In theory, banks can make loans available on more favorable terms as soon as they receive sufficient cash reserves from the central banks. This gives companies the opportunity to create new jobs through investments. More jobs increase the purchasing power of the population and lead to increased domestic demand, which in turn means an increase in the production of consumer goods due to increased demand. This will stimulate economic growth again.

The key role in this situation falls to the banks, as the central banks themselves are not allowed to grant loans to the economy. However, if private credit institutions remain reluctant to lend money, this cycle cannot be broken.

Is Inflation Better Than Deflation?

The central banks consider an inflation rate of two percent per year to be a healthy figure. A moderate price increase signals that there is also steady economic growth. Rising personnel costs as one of the driving forces behind rising prices are evidence of a certain level of employment, which in turn means demand. Japan suffered from the aftermath of deflation in the 1990s and is now confirming that this was the most difficult period in the Japanese economy. The recovery lasted longer than the deflation period itself.

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