Unravelling the complexity of Deflation

Ever since recession hit economies, the word deflation has come to the forefront, and off late discussion on the subject has gathered steam because Japan’s official measure of price patterns recorded a sharpest rate of decline in half a century. Speculation is rife on whether Japan will enter yet another deflationary spiral.

Coincidently, in history, the word deflation is often linked to Japan; the country that witnessed a painful decade in the 1990’s, popularly known as the 'lost decade' on account of a deflationary spiral. Economic expansion came to a complete halt.

What is so damaging about deflation? According to most of the learned, deflation means fall in prices and that’s what I too learned when I was in college. Fall in prices- Isn’t it good? It should spur consumption and that’s what is required to pep up an economy. Then why is it feared? Out of curiosity, I happened to look up for some write ups and I came across something that caught my attention and took me by surprise. It said, the definition of deflation that I have known, ever since I was introduced to the word, is incorrect. Fall in prices is the impact of deflation and not deflation per se.

So here is an attempt to unravel this deceptively simple word.

Since most of us understand inflation, let me start from there. Inflation, as we all know, is too much money chasing too few goods. The cause is an increase in money supply. The effect of inflation is general rise in prices of goods. Deflation on the other hand, as is understood, has the opposite impact of inflation– fall in prices is the effect caused by a contraction in money supply. Simply put, deflation is fall in money supply.

Fall in money supply normally occurs is an economic downturn because of caution exercised by consumers fearing loss of job in the light of deteriorating economic conditions. The preference to save and hoard cash, results in fall in demand for goods, forcing corporates to reduce prices. Reduction in prices means coporates will rationalise resources to remain profitable which will lead to loss of jobs. The fear of losing jobs and the fact that prices could fall further, results in consumers holding back spending creating a vicious circle- a deflationary spiral. Thus, deflation is feared not because prices are constantly falling but because of a reduction in money supply which negatively impacts economic activity.

Governments world over dread a deflationary like situation because it is tough to uplift an economy from this downward spiral. Japan took a decade to get rid of this phenomenon and pep up economic activity. The only way to fight off deflation is, by recapitalising financial institutions, injecting liquidity in the economy and increasing public spending till the time negative sentiment turns around.

If deflation is dreadful, it seems inflation is the lesser of the evil and more preferred. The question then is, how much is acceptable? Spare a thought!