The Real Problem With Deflation

Deflation is negative inflation: a general decrease in the average price level and an increase in the purchasing power of money. Every school of economics considers deflation negative for economies. However the standard explanation of why deflation is terrible for economies is incorrect. The correct explanation is understanding the impact of deflation on the real rate of interest, and thus the ability for private firms and individuals to manage debt repayments.

Standard economic thinking suggests that deflation negatively affects the economy because people see that prices for goods and services are decreasing, therefore they delay any purchases indefinitely until the price stabilises at some point in the future. Such delayed spending may be consumer discretion spending, corporate investments or, anything in between. Nevertheless, the subsequent impact is that when this occurs across an entire economy, all purchases are delayed indefinitely and demand collapses. An economic crisis emerges because it becomes a self-fulfilling prophesy: prices continue to spiral downwards as firms try to attract demand, but buyers continue to wait… and wait… and wait.

However, this standard logic fails to consider the more impactful influence of deflation – and how deflation can cause a more immediate collapse of economies. Because, although the standard thought is logical – it is foreseeable that the actual fall-off in firms’ revenues could be slow: because historic orders that are being completed “now” can help keep firms afloat in the short-medium term.

The correct interpretation of why deflation is negative for economies is the impact on the real rate of interest rate of debt. Although there are some exceptions – e.g. base-rate tracking mortgages, the majority of debts generally have fixed interest rates. When the deflation occurs, real interest rates on debts increases. As firms often do not have considerable fund available for sudden increases in debt repayments (especially in scenarios when deflation may occur), they begin missing repayments and either have to begin drastic cuts within the firm to produce the funds to repay or close down. In either case, the immediacy of the negative impact of firms is more apparent than the standard evaluation and the impact on the wider economy from collapsing firms is more obvious.

For example: imagine a firm with a $100,000 debt with a set interest of 15% and 10 years (121 months) to repay. This implies an approximate monthly repayment of $1613. If the rate of inflation was 8%, as it was in the UK during the 1990’s or the US during the 1980’s, the real rate of interest on the firm would be 7%. However, if the economy went into deflation or -2.2%, as Japan did in 2009, the real rate of inflation would be 17.2% This is the equivalent spread of 10% (i.e. 7% to 17.2%! Otherwise calculated as a 146% increase in the debt burden). Considering this scenario, it’s easy to see how firms can foreseeable be unable to manage their debt – and there be forced to collapse.

Therefore, it is apparent that what economists and market watchers should consider when analysing the impact of deflation on economies is the scale of private debt in economies. As this will provide a better insight into how influential the deflation will be. The greater the scale of private debt – the greater the impact on individuals and firms managing their debt burdens, and hence the more actively negative for the economy. Not the standard explanation of the slow impact on firms’ revenues – which is merely passively impactful on firms and secondary.

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