For something supposed to have been made impossible in the modern world, deflation has been doing pretty well recently. This economic ‘disease’, which many economists regard as more dangerous than inflation, has been endemic in Japan for some fifteen years, but now it seems to be spreading round the world, especially to Europe.
In order to understand what deflation is — as usual, there is a machloikes between the mumchim as to the exact definition — it’s easier to start from inflation, since that is much better known. To most people, inflation means rising prices in the shops. A more precise economic definition would be ‘a general rise in the price level’ that affects all sectors of the economy. Thus, if prices are rising only on goods in the shops, or only in the housing market, or only in the financial markets, that is not real inflation.
That’s why the claim that America, at least until recently, was suffering from inflation — because prices of food and energy were rising strongly (in 2013) — was simply wrong. True, food and energy prices were indeed rising then — and so were housing prices, somewhat, while prices of financial assets were rising a lot. But wages — the price of people’s labor — were not rising at all, and without rising wages, the ability of ordinary people to pay higher prices on the goods and services they buy is very limited.
In a real inflation, as people who lived through the ‘60s and ‘70s remember very well, the prices of almost everything rise. Some prices rise more and some less, but the phenomenon carries right across the board. Critically, the price of money –i.e. interest rates — also rise in an inflation, because otherwise money loses its value relative to real goods and services. In other words, people will not put money on deposit in the bank if they are not offered a rate of interest that compensates them for the rate of inflation in the economy.
Now let’s turn all that on its head — which would be deflation. A true deflation would be ‘a general fall in the price level’, and, we should add, this trend has to be sustained. In other words, if prices fall for a month or a quarter, that doesn’t mean the economy is in a state of deflation. Only if the trend of falling prices carries on for a year or two, and encompasses all sectors of the economy, is it legitimate to speak of deflation.
In America, these conditions do not exist, at least currently. In Israel, although the Consumer Price Index (CPI) was negative for the whole of 2014, that was due to a few key sectors, notably energy prices. Other prices — especially housing, but also wages — were and still are rising. The prices of financial assets are rising, but the price of money — interest rates — has been falling and is now almost zero. Overall, it is fair to say, Israel is not in a deflationary state, but it is clearly moving in that direction.
The European Union, on the other hand, seems to have arrived. In almost every country in the EU, prices of goods and services, as measured by the CPI, are falling steadily. In many countries, especially those where austerity programs are in force, wages have fallen. Interest rates on the euro are being pushed down and, in many countries, are already negative not just for bank deposits, but for government bonds with durations of two, five and even seven years. The only important markets in which prices are still generally rising in Europe are housing — although by no means everywhere — and equities.
The great danger of a deflationary state is that it can become entrenched. If people think prices are going to fall, they will defer buying — which will reduce demand and force firms to shrink inventories and cut prices to shift stock and, eventually cut production and fire employees. That can become a spiral which drives an economy into a depression from which it is very difficult to emerge.
That danger is why deflation is so feared by governments and why central banks are making such great efforts to prevent it taking root.