What if you could get more for your money tomorrow than you did yesterday? Thanks to inflation in Switzerland and its daily rising prices, this sounds like a fairytale utopia. Falling prices, however, are neither utopian nor fairytale-like from an economic point of view. If prices are not shrinking because technological progress enables savings or because processes are becoming more efficient, this economic phenomenon is referred to as deflation. And deflation is by no means a cause for celebration.
Deflation definition
Deflation is the counterpart to inflation – an economic phenomenon in which there is a persistent increase in prices. Money therefore loses its purchasing power. In contrast to inflation, the purchasing power of money increases in a deflation. While this initially sounds like a reason to be pleased, deflation is just as undesirable as uncontrolled inflation. Price declines are only referred to as deflation if they lead to unemployment and a decline in economic output. Deflation makes it impossible for an economy to grow.
Types & causes of deflation
There are two forms of deflation: monetary deflation and price deflation.
- Monetary deflation – In monetary deflation, there is less money in the economic cycle, which leads to a long-term reduction in the prices of goods.
- Price deflation – In price deflation, the process is triggered by price reductions. Fundamentally, deflation arises from an imbalance between supply and demand. Four causes can be distinguished for this imbalance.
Economic reasons
Economic reasons for deflation can include austerity measures, negative expectations about the future and instability in the labor market. Austerity measures can affect both private households and companies. All of these reasons are closely interlinked. Negative forecasts for the future can, for example, mean that production volume is reduced and redundancies follow. This not only results in loss of wages for private households, but also a reduction in profits for the company. All these factors lead to purchases and investments being temporarily suspended and postponed to an indefinite point in the future.
Wage deflation
Wage deflation occurs when companies, due to declining demand and thus falling sales, have to cut employees’ wages or subsequently lay them off. Consumers therefore have less money available to spend. A downward spiral begins.
Credit deflation
As the value of money rises, so does debt and, consequently, the likelihood of over-indebtedness. As a consequence, banks grant fewer loans and thereby further reduce the money supply. This accelerates the deflationary process.
Political reasons
Political causes of deflation include raising the key interest rate and reducing government spending. Here too, the result is that demand falls, or in other words, that less money is invested.
Consequences of deflation
Similar to inflation, deflation also leads into a vicious circle. Demand falls, profits decline, employees receive lower wages or are laid off. A higher unemployment rate in turn leads to a further decline in demand, which in turn reduces tax revenues and leaves governments with less money to spend. If no countermeasures are taken, deflation turns into a depression and thus into a severe economic crisis.
Reflation: Counter-strategy to deflation
To avoid the worst-case scenario of a depression, economic policy countermeasures must be taken as soon as deflation looms.
Reflation is the fiscal counter-strategy to deflation. The goal is to raise the price level, which in the case of deflation is no longer sufficient to cover costs. In addition, other economic policy goals such as price stability, a balanced government budget and the interruption of a persistent deflationary spiral are to be achieved. Reflation involves an interplay of expansionary monetary and fiscal policy.
In contrast to the strategy used in inflation, the Swiss National Bank lowers interest rates in the event of deflation. This allows more loans to be taken out and monetary funds to be brought into circulation. Furthermore, the demand for products and services is stimulated by the money brought into circulation. Thanks to increased demand, the downward pressure on prices eases and companies can raise them back to a profitable level. This restores price stability. In a deflationary environment, cost-intensive construction projects can make sense. These counteract high unemployment rates, which in turn leads to an increase in demand volume. As demand increases, so do government revenues from taxes. Depending on the state of public finances, it may also make sense to lower taxes in order to further relieve companies and private households.
A final option for combating deflation is foreign exchange control. This allows the state to ensure that foreign currencies are exchanged for domestic currency. This increases the amount of money in circulation.
Inflation vs. deflation
When asking which is worse, inflation or deflation, the answer always depends on the point of view. Both phenomena bring considerable problems for the economy. In times of inflation, debtors emerge as winners, while those who have not invested their money in a way that is protected against inflation (e.g. gold as protection against inflation) or who are particularly affected by rising prices are considered losers. In deflation, consumers – albeit only in the short term – are considered winners, as they can purchase goods and services at lower prices. From a macroeconomic perspective, however, deflation is considered the greater problem, whereas inflation to a certain extent (the 2 percent mark) is actually desired. The depreciation of money in the context of inflation stimulates purchasing, which allows the economy to flourish. In contrast, deflation causes investment and demand to fall, which leads to the economy coming to a standstill.