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What is Deflation? – Everything You Need to Know

We are often told that inflation is much better than deflation. But what exactly is deflation? We analyze this below, and we see why there is a type of deflation that is very positive for society.


What is Deflation?

Deflation is generally referred to as a situation in which prices fall. This is the opposite of what we are used to and even understand as normal: that prices continually rise over time.

However, there are actually two different definitions for the word deflation. Let us discuss them in more detail:

Original Definition of Deflation

Originally, deflation was used to refer to a decrease in the money supply. This means a reduction in the amount of money circulating in the economy. This is the opposite of what we commonly refer to as printing money.

By the same logic, inflation was traditionally used to speak about an increase in the amount of money existing in the economy.

Although it may be difficult to imagine that the amount of money in the economy can ever decrease, this is something that could happen if central banks decided to implement restrictive monetary policies. This would be done to achieve price stability.

Similarly, a reduction in the money supply could occur if commercial banks stopped issuing new loans to individuals and businesses and demanded the repayment of existing debts. Such practice would lead to a reduction in the amount of money available in the economy.

Current Definition of Deflation

Nowadays, the term deflation is used to refer to a drop in consumer prices. That is, when the cost of living decreases and we have to pay less to buy goods and services.

From a logical point of view, falling prices can be the natural consequence of monetary deflation. Since there is less money in the economy, prices must adjust down.

Thus, we have certainly experienced price deflation in certain goods and services over the last few decades: televisions, computers, mobile phones, communication services, internet, movies and series, and even plane tickets.

The prices of all these products and services have been falling for decades, while their features have improved dramatically. If you think about it, a computer today is much cheaper, and more powerful, than one from a few decades ago.

This phenomenon of falling prices in many important products has been very positive for society, since it has made it possible for the masses to buy them and increase their standard of living.

The question then is why inflation tends to get such a bad press when spoken about by officials and central bankers.

Types of Deflation

Deflation can be a great thing for the economy and society in general. But it can also be a destructive force for wealth and financial stability. This is because there really are two types of deflation: good and bad.

Good Deflation

Good deflation, which we could also call natural deflation, is when the economic and technological progress of society makes the production of goods and services cheaper and more efficient.

If we are able to produce more economic value with the same amount of resources (labor, capital, machinery, etc.), this will lead to a decline in the cost of production. The consequence of that will be that whatever we produce will be more affordable, thereby increasing the standard of living for society.

This is the good type of deflation, and we should certainly encourage that. It is what has happened with personal computers, mobile phones and flat televisions. Up until a couple of decades ago, these were luxury items that only the rich could afford.

In fact, in the movie Wall Street, where Michael Douglas plays a billionaire tycoon in the 1980s, we can see one of the first mobile phones and even a small portable television. If we compare those items to our current iPhones and iPads, we will realize how much better our cheaper products are.

This kind of deflation is natural whenever there is economic growth. An increase in economic growth and productivity means being able to produce more per unit of input, making things cheaper.

For example, if the size of the economy grows by 2% every year, the amount of goods and services produced, as well as their quality, should also increase by 2%. Therefore, if the amount of money in the economy has not changed, prices should go down by about 2%.

If prices rise in times of economic growth, it is simply because the quantity of money has increased by an even higher rate. Economic growth does not lead to an increase in the cost of living, unpopular belief. Economic growth makes the cost of living more affordable. An increase in the cost of living is either the result of an increase in the amount of money or a decrease in economic production.

What we have experimented with many technological products and airline tickets over the last few decades, which have become accessible to a lot more people, is what we should expect from a growing economy: lower prices and a higher material standard of living.

In fact, there have been periods of continued deflation, economic growth, and improving living standards throughout the 19th and early 20th centuries. This is because, at that time, the amount of money in the economy was relatively stable. Economic growth and the industrial revolution made prices go down.

Bad Deflation

A different type of deflation, which we can call far deflation, is far more detrimental for the economy. This usually occurs after a housing or stock market bubble. If banks have been lending too much money into the economy and credit stops, many individuals and businesses will be unable to repay their loans.

Such situation will lead to bankruptcies, an increase in unemployment, falling standards of living, consumption contraction, and even bank failures.

This type of deflation particularly affects asset prices: real estate, stocks, commodities, etc. It will rarely lead to a significant reduction in the prices of goods and services that we consume on a daily basis: food, electricity, public transport, etc.

As you can see, this type of deflation is not natural. It is the consequence of bad actions being unwound, such as a credit bubble.

Why Central Banks Say Deflation is Bad

In the previous section we have talked about the differences between good and bad deflation. They are caused by different variables and lead to very different outcomes. Therefore, whenever we hear people speak about deflation, they should clarify what they are referring to.

No one could oppose good deflation. It is the natural result of a healthy and growing economy, that is becoming more efficient and capable of producing more goods and services with the same amount of resources. This leads to a better standard of living for a large part of the population.

So why do the press and central banks always say that deflation is something to be avoided? Simply because we live in a highly indebted world. They are afraid that a burst of the credit bubble will lead to bad deflation and an economic recession.

And who would be most negatively affected by this bad deflation? Governments. Consequently, whenever you hear a central banker mention the risk of deflation, remember that central banks are just government agencies and they are most likely referring to bad deflation.

For this reason, it is important to distinguish between deflation in the things we consume daily, which is indeed positive, and collapsing asset prices that could lead to an economic depression and societal unrest.

The Great Myth About Deflation

Finally, and before concluding this post, I wanted to address something that the monetary authorities, unable to be honest with the public, continually repeat when the word deflation comes up.

In their words, deflation is bad because it makes people stop consuming. They claim people would simply wait for prices to fall further. While such argument may sound logical, it does not correspond to reality.

Good deflation would drive down the price of things at a rate of about 2% a year. I cannot imagine anyone deciding not to buy a pair of jeans or a mobile phone today, hoping to pay 2% less next in a year’s time.

There are plenty of examples for this. Those products that have enjoyed good deflation over the last few decades (mobile phones, personal computers, televisions, travel, etc.) are also the ones that have seen consumption grow the most. This shows that deflation does not destroy consume, but actually increase it. The cheaper something is, the more consumption there will be.

The only purchases that a person would postpone in case of deflation would be assets (real estate, stocks, etc.) This has to do, as we have previously discussed, with bad deflation.

I hope you found this analysis of what deflation is informative, and encourage you to subscribe to my newsletter:
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And if you want to read about the winners and losers of inflation, check out this link:
Winners and Losers from Inflation

Published in Economy

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