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The Effects of Deflation

Today, I will explain the effects of deflation in the small, medium and long term. To summarise, deflation is seen by economists and governments as dangerous insofar as it can lead to a depression or to a "deflationary crisis".

The Effects of Deflation

Deflation is a prolonged fall in prices (or negative inflation). It can be the consequence of a supply, a demand shock or a financial crisis. It can be general or specific to certain industries.

A period of economic prosperity can indeed, through a sharp increase in productivity gains, cause prices to fall. However, we will focus on the financial crisis and its effects since 2007-2008 with a cumulative process of falling financial and real estate asset prices, coupled with a fall in economic activity which also causes a fall in goods prices. The case of Japan in the late 1990s, the United States with the subprime crisis and Europe since 2009 shed light on this scenario.

Deflation is seen by economists and governments as dangerous insofar as it can lead to a depression or to a "deflationary crisis". The consequences of deflation combine short, medium and long term effects, from both micro and macro perspectives and involving many agents and institutional sectors such as households, non-financial and financial companies and public administrations.

From a microeconomic perspective, when the prices of consumer goods fall, households seem to be satisfied with a relative increase in their purchasing power, which favours their consumption and, consequently, increases the expectations of companies, which can increase their production volume by increasing their outlets. This double positive impulse for the economy is short-term because in the medium and long term, if the fall in prices continues, it radically modifies the expectations of agents and it is from this moment that the vicious mechanisms are put in place insofar as they trigger the depressive spiral.

- Households will postpone certain types of consumption in the hope that the fall in prices will be prolonged and will in fact participate in the contraction of demand for companies, which will see their stocks increase and their profit margins shrink. From a macroeconomic perspective, rational individual interests, once aggregated, lead to global counter-effects that block economic activity.

- Companies can no longer look to the future with confidence and change their investment programmes, which may appear too risky. Two components of aggregate demand are then slowed down.

- Public administrations see their tax revenues decrease due to the contraction (or decrease) of revenue sources. We then enter a deflationary crisis.

During a financial shock, the correction in asset prices causes them to fall, which leads to a fall in the wealth of households (a fall in the value of their assets) or of the companies that hold these assets.
For the United States, households in particular see the cost of their real estate loans (or their debt) increase due to the increase in real interest rates and their wealth decrease due to the bursting of the real estate bubble which depreciates the value of their real estate.

Financial and non-financial corporations, which have been particularly active in supplying the global economy with financial products including bank loans to US households with poor credit ratings, also perceive a decrease of their activity.

Risk aversion is on the rise, reducing credit activity, investment and consumption.
The deflationary vicious circle seems to have been set in motion, causing a series of bankruptcies (Lehman Brothers in the US in September 2008), the inexorable rise in massive unemployment, again reducing consumption, investment and, in fact, growth.

Debt ratios are rising in a worrying manner insofar as they compromise the positive reversal of expectations. The household debt ratio rose by more than 20 points in Europe between 2000 and 2008, reaching 93% in 2008, and 130% in the United States in 2008 (compared to 94% in 2000).

The debt is becoming unsustainable.

The panic resulting from the negative wealth effect accentuates the deflationary crisis because, on the one hand, households, forced to sell their property out of distress in order to avoid having to record greater losses, participate in accentuating the fall in property prices on the real estate markets (bursting of a real estate bubble), and on the other hand, companies and banks selling their financial assets cause their prices to fall (bursting of the financial bubble), which again feeds the deflation.These aggregate behaviours form a system (systemic crisis described by R. Boyer and M. Aglietta). The causes are partly endogenous, because in a period of strong growth, agents abused by an excess of confidence have taken enormous risks that are far removed from the rationality of homo oeconomicus, as described by H. Minsky's paradox of tranquillity.

The possible solutions to this deflationary crisis lie in the implementation of proactive monetary and fiscal policies, both conventional and unconventional.

Even before the deflationary process is set in motion to stop it, the monetary authorities (central banks) must lower nominal interest rates (conventional policies) in order to reduce the debt burden and allow the markets to hold sufficient liquidity to finance economic activity.Once the interest rate floor is reached (close to zero), central banks can no longer use this instrument and must switch to unconventional policies (using an instrument other than the interest rate or other than adjustments in the quantities of currency offered or demanded).

In particular, this involves buying up public debt through Treasury bills (rescue policies), which is what central banks have been doing in the United States (since 2009) and Japan (since the beginning of the 2000s and supported in particular by the Japanese minister Shinzō Abe), the aim being to counteract the negative expectations that are fuelling the crisis and the depression and to put an end to this vicious circle.
These are "quantitative easing" policies that the ECB is also using today in the euro zone, buying up public debt on the financial markets to the tune of 60 billion euros per month.

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