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This means buying assets such as real estate , or other hard assets tend to be bad investments with negative rate of return. Learn more: warrants definition. If you have debt, the real value of the obligation rises over time during deflation. At the same time, your capacity to repay the debt is likely to decline as jobs become scarce, business revenues and therefore salaries decline and the value of collateral goes down. Paying down your existing debt should be of utmost priority and you should avoid taking out new debt.
This is true for consumers and it is also true for businesses. Highly leveraged businesses will have trouble servicing their debt, and should be avoided as investments. Read more: how to get into stocks. The flipside of being a debtee is being a lender.
Regular cash income becomes very attractive specially from companies or entities that are likely to be able to continue paying coupons on their bonds. The safest bonds are of course the US Treasuries. You should expect the interest rates to be low but these should stay above the interest rates you can get through bank deposits. See also: Economic Articles for Students.
Similar consideration as to buying bonds applies here. You should remember that equity is a riskier asset class, so when evaluation dividend paying companies, greater emphasis should be placed on balance sheet strength and earnings sustainability. Certain companies or industries have natural competitive advantages that protects their pricing power.
In many cases, these competitive advantages arise from their strong brand. These products and services tend to be relatively price inelastic. Also regulated industries such as utilities are safer investments. Safety in these kind of stocks tend to be maintained only to a certain level. Depending on the severity and the length of deflation, you should expect consumers to shift their buying habits to of-brand products, deciding to start forgoing some essentials.
In the longer term there will also be demographic shifts such as larger family units that would start cutting into utilities revenues. Deflation is not good for the economies and the governments and central banks will do everything in their power to prevent it from happening. If it does happen, expect large interventions in the markets to shore up the economic activity and re-inflate the market. We are more likely to see short lived depressions than a full fledged deflation. We have learned quite a bit from deflations past and the recent Japanese experience.
One of the dangers is that when the economy rebounds, there is a greater possibility of rapid inflation that will quickly make all your deflation measures counter productive. Deflation is also related to risk aversion , where investors and buyers will start hoarding money because its value is now increasing over time. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest.
In a closed economy , this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency.
A devalued currency produces higher prices for imports without necessarily stimulating exports to a like degree. Deflation is the natural condition of economies when the supply of money is fixed, or does not grow as quickly as population and the economy. When this happens, the available amount of hard currency per person falls, in effect making money more scarce, and consequently, the purchasing power of each unit of currency increases. Deflation also occurs when improvements in production efficiency lower the overall price of goods.
Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods, and consequently, deflation has occurred, since purchasing power has increased. Rising productivity and reduced transportation cost created structural deflation during the accelerated productivity era from —, but there was mild inflation for about a decade before the establishment of the Federal Reserve in Most nations abandoned the gold standard in the s so that there is less reason to expect deflation, aside from the collapse of speculative asset classes, under a fiat monetary system with low productivity growth.
In mainstream economics , deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up due to increased productivity without an increase in the supply of money, or as with the Great Depression and possibly Japan in the early s the demand for goods going down combined with a decrease in the money supply.
Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation. A structural deflation existed from the s until the cycle upswing that started in The deflation was caused by the decrease in the production and distribution costs of goods. It resulted in competitive price cuts when markets were oversupplied. The mild inflation after was attributed to the increase in gold supply that had been occurring for decades.
By contrast, under a fiat monetary system, there was high productivity growth from the end of World War II until the s, but no deflation. Historically not all episodes of deflation correspond with periods of poor economic growth. Productivity and deflation are discussed in a study by the Brookings Institution that gives productivity by major US industries from to , along with real and nominal wages.
Persistent deflation was clearly understood as being the result of the enormous gains in productivity of the period. Debt deflation is a complicated phenomenon associated with the end of long-term credit cycles. It was proposed as a theory by Irving Fisher to explain the deflation of the Great Depression. A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is a nearly equal percentage increase in money velocity.
Additionally, the velocity of the monetary base is interest-rate sensitive, the highest velocity being at the highest interest rates. In the early history of the United States, there was no national currency and an insufficient supply of coinage. During financial crises, many banks failed and their notes became worthless. Also, banknotes were discounted relative to gold and silver, the discount depended on the financial strength of the bank.
In recent years changes in the money supply have historically taken a long time to show up in the price level, with a rule of thumb lag of at least 18 months. More recently Alan Greenspan cited the time lag as taking between 12 and 13 quarters. In modern credit-based economies, deflation may be caused by the central bank initiating higher interest rates i. In a credit-based economy, a slow-down or fall in lending leads to less money in circulation, with a further sharp fall in money supply as confidence reduces and velocity weakens, with a consequent sharp fall-off in demand for employment or goods.
The fall in demand causes a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production, or repaying debt levels incurred at the prior price level. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets that have fallen dramatically in value since their mortgage loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation.
To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans as in Japan , and most recently America and Spain. This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on. In the early economic history of the United States, cycles of inflation and deflation correlated with capital flows between regions, with money being loaned from the financial center in the Northeast to the commodity producing regions of the [mid]-West and South.
In a procyclical manner, prices of commodities rose when capital was flowing in, that is, when banks were willing to lend, and fell in the depression years of and when banks called in loans. Most money circulated as banknotes, which typically sold at a discount according to distance from the issuing bank and the bank's perceived financial strength. When banks failed their notes were redeemed for bank reserves, which often did not result in payment at par value , and sometimes the notes became worthless.
Notes of weak surviving banks traded at steep discounts. Deflation occurred periodically in the U. This deflation was at times caused by technological progress that created significant economic growth, but at other times it was triggered by financial crises — notably the Panic of which caused deflation through , and the Panic of which triggered the Long Depression that lasted until Federal Reserve System and its active management of monetary matters.
Episodes of deflation have been rare and brief since the Federal Reserve was created a notable exception being the Great Depression while U. A financial crisis in England in caused banks to call in loans and curtail new lending, draining specie out of the U. Prices for cotton and tobacco fell. The price of agricultural commodities also was pressured by a return of normal harvests following , the year without a summer , that caused large scale famine and high agricultural prices.
There were several causes of the deflation of the severe depression of —, which included an oversupply of agricultural commodities importantly cotton as new cropland came into production following large federal land sales a few years earlier, banks requiring payment in gold or silver, the failure of several banks, default by several states on their bonds and British banks cutting back on specie flow to the U.
This cycle has been traced out on a broad scale during the Great Depression. Partly because of overcapacity and market saturation and partly as a result of the Smoot—Hawley Tariff Act , international trade contracted sharply, severely reducing demand for goods, thereby idling a great deal of capacity, and setting off a string of bank failures.
The United States had no national paper money until greenbacks used to fund the Civil War , but these notes were discounted to gold until There was also a shortage of U. Foreign coins, such as Mexican silver, were commonly used.
In the financial crises of —19 and —41, many banks failed, leaving their money to be redeemed below par value from reserves. Sometimes the notes became worthless, and the notes of weak surviving banks were heavily discounted. Following the finding of gold in the Sierra Nevada , enough gold came to market to devalue gold relative to silver.
To equalize the value of the two metals in coinage, the US mint slightly reduced the silver content of new coinage in When structural deflation appeared in the years following , a common explanation given by various government inquiry committees was a scarcity of gold and silver, although they usually mentioned the changes in industry and trade we now call productivity. However, David A. Wells notes that the U. Furthermore, Wells argued that the deflation only lowered the cost of goods that benefited from recent improved methods of manufacturing and transportation.
Goods produced by craftsmen did not decrease in price, nor did many services, and the cost of labor actually increased. Also, deflation did not occur in countries that did not have modern manufacturing, transportation and communications. By the end of the 19th century, deflation ended and turned to mild inflation. William Stanley Jevons predicted rising gold supply would cause inflation decades before it actually did.
Irving Fisher blamed the worldwide inflation of the pre-WWI years on rising gold supply. In economies with an unstable currency, barter and other alternate currency arrangements such as dollarization are common, and therefore when the 'official' money becomes scarce or unusually unreliable , commerce can still continue e. Since in such economies the central government is often unable, even if it were willing, to adequately control the internal economy, there is no pressing need for individuals to acquire official currency except to pay for imported goods.
In effect, barter acts as a protective tariff in such economies, encouraging local consumption of local production. Increasing competition by internal or external economic liberalisation generally has a price-cutting effect. Measures of deregulation like the abolition of e. If a country pegs its currency to the one of another country that features a higher productivity growth or a more favourable unit cost development, it must — to maintain its competitiveness — either become equally more productive or lower its factor prices e.
Cutting factor prices fosters deflation. Monetary unions have a similar effect to currency pegs. Deflation was present during most economic depressions in US history  Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency, and because confused pricing signals [ citation needed ] cause mal-investment, in the form of under-investment.
In this sense, it is the opposite of the more usual scenario of inflation, whose effect is to tax currency holders and lenders savers and use the proceeds to subsidize borrowers, including governments, and to cause mal-investment as over-investment. Thus inflation encourages short term consumption and can similarly over-stimulate investment in projects that may not be worthwhile in real terms for example the housing or Dot-com bubbles , while deflation reduces investment even when there is a real-world demand not being met.
In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with economic depression, as occurred in the Great Depression and the Long Depression. I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression.
While an increase in the purchasing power of one's money benefits some, it amplifies the sting of debt for others: after a period of deflation, the payments to service a debt represent a larger amount of purchasing power than they did when the debt was first incurred.
Consequently, deflation can be thought of as an effective increase in a loan's interest rate. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate — the overnight federal funds rate in the U. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target. With interest rates near zero, debt relief becomes an increasingly important tool in managing deflation.
In recent times, as loan terms have grown in length and loan financing or leveraging is common among many types of investments, the costs of deflation to borrowers has grown larger. Deflation can discourage private investment, because there is reduced expectations on future profits when future prices are lower. Consequently, with reduced private investments, spiraling deflation can cause a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent for institutions to hold on to money, and not to spend or invest it burying money.
They are therefore rewarded by holding money. This "hoarding" behavior is seen as undesirable by most economists, as Hayek points out:. It is agreed that hoarding money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation is in itself desirable.
Some believe that, in the absence of large amounts of debt, deflation would be a welcome effect because the lowering of prices increases purchasing power. Since deflationary periods disfavor debtors including most farmers , they are often periods of rising populist backlash. For example, in the late 19th century, populists in the US wanted debt relief or to move off the new gold standard and onto a silver standard the supply of silver was increasing relatively faster than the supply of gold, making silver less deflationary than gold , bimetal standard, or paper money like the recently ended Greenbacks.
A deflationary spiral is a situation where decreases in the price level lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in the price level. Another economic example of this situation in economics is the bank run.
The Great Depression was regarded by some as a deflationary spiral. Another related idea is Irving Fisher 's theory that excess debt can cause a continuing deflation. During severe deflation, targeting an interest rate the usual method of determining how much currency to create may be ineffective, because even lowering the short-term interest rate to zero may result in a real interest rate which is too high to attract credit-worthy borrowers. In the 21st-century negative interest rate has been tried, but it can't be too negative, since people might withdraw cash from bank accounts if they have negative interest rate.
Thus the central bank must directly set a target for the quantity of money called " quantitative easing " and may use extraordinary methods to increase the supply of money, e. Until the s, it was commonly believed by economists that deflation would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention. This view was challenged in the s during the Great Depression.
Keynesian economists argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending. Reserve requirements from the central bank were high compared to recent times. So were it not for redemption of currency for gold in accordance with the gold standard , the central bank could have effectively increased money supply by simply reducing the reserve requirements and through open market operations e.
With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates i. This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early s and in —02, respectively. Austrian economists worry about the inflationary impact of monetary policies on asset prices. Sustained low real rates can cause higher asset prices and excessive debt accumulation.
Therefore, lowering rates may prove to be only a temporary palliative, aggravating an eventual debt deflation crisis. When the central bank has lowered nominal interest rates to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires " special arrangements " to lend money at a zero nominal rate of interest which could still be a very high real rate of interest, due to the negative inflation rate in order to artificially increase the money supply.
Although the values of capital assets are often casually said to deflate when they decline, this usage is not consistent with the usual definition of deflation; a more accurate description for a decrease in the value of a capital asset is economic depreciation. Another term, the accounting conventions of depreciation are standards to determine a decrease in values of capital assets when market values are not readily available or practical.
The inflation rate of Greece was negative during three years from to The same applies to Bulgaria , Cyprus , Spain and Slovakia from to Greece, Cyprus, Spain and Slovakia are members of the European monetary union. The Bulgarian currency lev is pegged to the Euro with a fixed exchange rate. In the entire European Union and the Eurozone a disinflationary development was to be observed in the years to Table: Harmonised index of consumer prices.
Following the Asian financial crisis in late , Hong Kong experienced a long period of deflation which did not end until the 4th quarter of The Hong Kong dollar however, was pegged to the US dollar , leading to an adjustment instead by a deflation of consumer prices. The situation was worsened by the increasingly cheap exports from Mainland China , and "weak Consumer confidence " in Hong Kong.
This deflation was accompanied by an economic slump that was more severe and prolonged than those of the surrounding countries that devalued their currencies in the wake of the Asian financial crisis. In February , Ireland 's Central Statistics Office announced that during January , the country experienced deflation, with prices falling by 0. This is the first time deflation has hit the Irish economy since Overall consumer prices decreased by 1. Mr Lenihan said month-on-month there has been a 6.
This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the interview. The Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits. The alleged economic harm caused by deflation is not alluded to or mentioned by this member of government. This is a notable example of deflation in the modern era being discussed by a senior financial Minister without any mention of how it might be avoided, or whether it should be.
Deflation started in the early s. In July , the zero-rate policy was ended. Bloomberg L. As a result, it is likely that deflation will remain as a long term economic issue for Japan.
The most recent (August 8) estimate puts the 5-year probability of deflation from early to early at around 15 percent. This week's light calendar gives investors room to digest the European Central Bank's radical moves to avert deflation and look beyond U.S. There will be deflation, in fact we are most likely experiencing it already. But deflation will give way to a period of high inflation. The.