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What Is Deflation? What Causes Deflation and Can It Be Prevented?

Updated on March 14, 2015
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Deflation is falling prices.

When prices fall at your local Walmart, it seems like a good thing.

But when it happens to your economy as a whole, it's trouble.

The problem is that economy-wide deflation takes no prisoners. Not only does the price of groceries go down, so does the value of most other assets including stock portfolios and home values.

Deflation results in growth plans being put on the shelf, a rise in unemployment and many businesses closing their doors.

So what causes deflation?

There could be any number of triggers that start the process.

But it simply boils down to one thing: a change of mindset that causes people to buy less.

In good times, most of us feel good. We take what we're paid and we go out and spend it. We buy food, homes, TV's , etc.

The people building the homes, in turn, might buy something from the company we work for. And that helps create our next paycheck.

So it's a nice circular system where everyone benefits.

But say that we as a society have a change of mind. Maybe collectively we think we've recently bought too much, we've undergone some sort of shock, or we're uncertain about our future.

What do we do? We decide to buy less.

And that makes sense. Unless, that is, you make food, homes, TV's, etc. The folks who make those things, in turn, might start buying less from the company you work for. "Oops," you say, and that's where the problem starts.

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The "Glass Is Half Empty" Economy

When people decide to hold on to their money more, and buy things less, the only way companies can keep selling is to lower their prices.

Lower prices -- deflation -- is a sign that demand is decreasing and that the economy is weakening.

The big problem is that this takes us all on a downward slide. As we see prices go down each month, we decide to hold off buying things, or investing in new ideas, because it would be cheaper to buy it later.

It's just a matter of time before groceries, stocks and homes, oh -- and incomes -- are 1/3 of their original value.

That's deflation. And that's what happened to the world economy in the 1930s.

It's inflation -- the rising prices we've experienced for years -- in reverse.

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Can We Prevent or Cure Deflation?

It could be that we as a society are susceptible to the same mood swings as we are as individuals. And if that's the case, there isn't really too much that can be done to stop the pendulum from swinging back and forth between inflation and deflation.

Even if you believe, as some economists, that deflation can be cured by printing more currency and handing it out at every street corner, be ready for a realty check: you can't make people go out and spend or invest. The grateful cash recipients could simply take the money and stuff it in the mattress, waiting for prices to fall further.

You could induce people to spend and invest by incentivizing purchases, and guaranteeing loans and investments. But these machinations could simply be putting off the inevitable downturn, and exacerbate the downward outcome.

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What Ends Deflation?

As every winter is followed by a spring, so deflation is followed by recovery.

As values sink, the weakest owners of assets (homes, stocks, business, etc) can no longer afford to keep them, so they sell them. Then one day, after the last weak owner has sold, prices stop dropping.

And gradually, people start changing their mindset. They decide to buy something now, rather than wait until next year.

They have a sense of certainty that an investment today will reap a future reward.

And so, the economy switches to the "Glass is Half Full" variety. There is no economic stimulus other than a change of mind.

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How to Survive Deflation

Full blown economic deflation is a Depression. A technical definition of a Depression is when the value of economic output (GDP) shrinks by 10% in a given year.

There's no guaranteed way to survive this kind of deflation unscathed. It's like going through a natural disaster-- there's an element of being lucky (or unlucky) -- although being prepared could help your outcome.

If you believe that deflation is in the future, here's what you should do:

  • stop buying items that aren't necessary; save your cash
  • if you own assets, sell them before prices drop, unless you're prepared to hold on to them through a rough ride
  • rent rather than own
  • save your money as currency; be aware that even a bank IOU is not the same as cash
  • some businesses or trades are less prone to economic downturns: get a job there now
  • if you count on the government for assistance or security, realize they will have their hands full
  • if you depend on such things as financial institutions, power grids, highway infrastructures, school systems, consider alternatives
  • keep your family close; you'll need each other's support

To survive deflation, businesses should:

  • minimize their liabilities, especially long-term liabilities
  • minimize their inventory
  • locate customers in areas less susceptible to downturns
  • create a niche in a market with few competitors
  • focus on customer loyalty
  • think targeted marketing rather than mass advertising
  • be ready to own your niche when the market bottoms and grow your position while the economy recovers

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What Currency To Keep?

Not every country will fare well equally in a deflationary downturn. You should pick a currency from a relatively strong country with a respectable track record during past downturns. US Dollars meet this criteria; although Swiss Francs, Singapore Dollars, and Australian Dollars may prove more durable.

Of course, governments will try, as we've noted, to print more money and hand it out on street corners. So if you're holding currency, this will mean your old currency will be worth a little less since there's more in circulation. But you may experience less of a loss than holding your money through stock ownership or in real estate investments.

There are plenty of good reasons to expect the value of currency to rise during deflation:

  1. with the value of everything else falling, cash will become more in demand
  2. with banks making less loans there will be less money circulated

And think about Lehman Brothers and Bear Stearns. When the values of those organizations simply vanished, the dollars they represented abruptly disappeared from the economy. With less money in the system, the value of each remaining dollar goes up. The value of currency goes up in deflation.


How's Your Magic 8 Ball?
How's Your Magic 8 Ball? | Source

Can Deflation Be Predicted?

If deflation is based on the mood swings of our society, it probably isn't easy to predict.

There is no canary-in-a coal-mine indicator: looking at the number of bank closings seem un-useful since it's too late when that happens.

It used to be that major deflation happened every 55 years or so -- close to 1764, 1819, 1874, 1929 -- just long enough for people to forget the last one.

The last downturn was 1929 and 55 years later was 1984. But deflation didn't happen in 1984, and although the financial market had an unwelcome jolt in 1987, we've been growing our economy for another 23 years beyond 1984. Of course, introducing Russia, India and China into the world economy probably didn't hurt growth.

Maybe there's a more dominant 77-year cycle. There were big downturns around 1776, 1853, 1930, and yes 2007.

Using cycles to forecast economic trends is highly speculative. I mention it here to make the point that we've had major economic downturns throughout our history. And so we should expect them again in our future.

Maybe forecasting deflation is a matter of listening. When we hear ourselves saying "it doesn't get better than this!" that's when we know.

Can Government Fix Deflation?

Deflation is like a wildfire. It burns far and wide, and it can be devastating. It removes the weakest growth, and some of the stronger growth as well.

Government policy makers should heed this analogy when tinkering with the economy -- we've learned about wildfires in recent years. Unfortunately, our current policy tools could be adding fuel for a future fire. They include: artificial incentives and guarantees, government subsidies, price supports, government-backed insurance, unfunded liabilities, monetary easing and deficit spending. Each of these policy instruments seems to make a positive short-term impact, and may help delay a downturn. But the act of preventing a downturn could actually be providing more fuel to the fire when the downturn eventually arrives.

Is Deflation Good?

The answer here is from the "if you can survive it, it will make you stronger" category. But this isn't too helpful for those experiencing bankruptcy.

Deflation forces us to re-evaluate the value of our possessions and our own skills, of the importance of family and friends, and to come to terms with our personal priorities.

Deflation, as a part of the process of economic growth, helps ensure that the next phase of growth is on solid footing.

It helps remind us that risk has a downside.


What's your view on deflation? Please post a comment below. Also, please check out my other article/ hub on the economics of deflation: How to Fix the Economy


Comments

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  • Clarke Stevens profile image
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    Will Mays 6 years ago from North Kingstown, RI, United States

    Thanks for your supportive vote and kind feedback. I appreciate it!

    -Will

  • alanlsg profile image

    Alan Bowman 6 years ago from The World

    Great Blog, well put together and thanks and have voted up as it deserves to be.

    Kind regards

    Alanlsg

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