Deflation problems

The five argument why deflation is bad

There are five main arguments made over why deflation is a bad thing:

  1. It is bad for the economy
  2. It is bad for debtors
  3. It is bad for companies
  4. It stops people spending
  5. It makes it difficult for central bankers to control the economy.

Argument 1: Deflation is bad for the economy

The main argument is that deflationary periods are associated with bad times economically. This is because deflation is a typical side effect of financial and banking crises. However what is usually missing from such arguments is the causality. In the Great Depression, it was the financial crisis that caused the problems. The results of this then included problems for the economy and resulted in deflation.

Bank run

A bank run in Berlin in 1931
Source: Reproduced with permission from Bundesarchiv (Bild 102-12023/Georg Pahl/CC-BY-SA)

In addition to the 1930s, another example often quoted is that of the Great Deflation of the 1870s – 1890s. During this time prices in many countries around the world declined due to improvements in productivity and trade. For example in the UK, prices declined 15 per cent over the two decades from 1868. Many traditional businesses suffered due to the effects of technological changes and improvements in transport and communications; hence many historians regard it as another great depression.

However the consumer did not suffer. Analysis has shown that average incomes in the UK increased not only in actual terms but significantly also in inflation-adjusted ones. This increased purchasing power was so great that there was a marked shift in consumption from necessities to luxury goods.

The last example usually quoted in the context of the problems of deflation is that of Japan. Here the financial crisis struck in 1990. It has been argued that the country then suffered two “lost decades” of deflation and poor economic growth. However as noted elsewhere on this site, the reality is slightly different. It is debatable how badly the economy has suffered. It has been pointed out that standards of living, the strength of the yen and trade surpluses have all increased. Moreover GDP, when looked at on a per worker basis, has increased at a higher rate than in most developed European economies over the same period.

A more recent example is Spain. In 2014, Spain was the only major EU economy to have deflation (albeit at a low level). However it also topped the economic growth table that year in the EU with around 2 per cent. Deflation does not have to lead to problems for the economy.

CONCLUSION: Financial crises create asset price reductions which then can create reductions in consumer prices. Deflation of goods and service prices per se, does not have negative effects on the economy. They are a symptom but the not the cause of the problem.

Argument 2: Deflation is bad for debtors

The argument here is simpler. If deflation occurs, the real cost of servicing debts increases. This is because income declines (be it wages, company profits or taxation), yet the repayment costs remain the same. This also increases the risk of the debtor defaulting and being unable to repay the loan.

Effects on debtors

The effects of this depends on the debtor. For individuals it potentially means being made bankrupt or losing the security for the loan (e.g. a house). For companies, it means either cutting back on other business expenditure, reducing costs (e.g. laying off staff) or in the worst case, closing down.  Both of these have implications for the banking sector, which then suffers losses on the loans that are defaulted on.

The impact on government debts is somewhat different though. It should mean that reductions in expenditure are required to balance the budget. However in practice nowadays, governments do not normally cut back expenditure. They run a bigger deficit during crises/deflationary periods and add to their total debt pile.

The knock-on effects of all the above directly impact GDP. If individual debtors have to use more money to service debts, they spend less money elsewhere in the economy. Reductions in spending by companies and governments also have the potential to reduce GDP.

However this theory does not match up with the facts, as evidenced by the 1980s and 1990s. This was a period of falling inflation rates. They dropped in most highly developed economies from about 20 per cent to nearly zero by the year 2000. During this time, there was no marked increase in the number of defaults amongst individuals or companies. In other words the higher debt burden of near-zero inflation rates at the end of this time in many economies did not appear to harm GDP growth.

Another issue with the argument that deflation increases the burden for debtors is that deflation causes an equal and opposite gain for savers and creditors. They see the real value of their purchasing power increase in deflationary periods. Those that acknowledge this counter that the spending habits of debtors are greater than those of savers, so it is better for the economy to have more inflation. Even if this is true, the economy has many more savers than debtors i.e. just over a third of UK households have a mortgage, whilst three quarters have savings and a similar number have additional pension wealth*.

Linked to this is another factor that during all periods of inflation, there is a slow but incessant transfer of wealth taking place from savers to debtors. In periods of near-zero inflation it stops. During periods of deflation this flow is reversed. The argument against deflation might therefore be better framed as a moral one over whether creditors should be allowed to stop subsidising loans to borrowers and speculators.

CONCLUSION: Deflation makes debts harder to pay and in theory this can have a knock-on impact on economic growth. However near-zero inflation rates appear not to have this effect.

Argument 3: Deflation is bad for companies

Deflation is bad for companies as virtually all corporates nowadays are financed with significant amounts of debt. The sheer size of these debts is enormous.

Take Tesco, a retailer and FTSE 100 company, as an example. The company was in trouble in 2014 and its revenues were declining. This was mainly due to the lower prices it was charging, brought about by competition and decreased commodity prices. Deflation was sometimes blamed for its problems.


However the main problem for Tesco, like most listed companies, was actually debt. In late 2014, its market capitalisation was around £14bn but its total debts were also about £14bn. When deflation happens revenues decline, but the size of the debt repayments remain the same. The free subsidy provided by creditors during periods of inflation is effectively removed when deflation happens. Therefore company profits suffer. The amount of money for investment also declines and this has a knock-on effect on other businesses’ turnover and the whole economy.

In addition, in order to remain competitive during deflation, companies might seek to decrease wages in periods of deflation (just as they offer cost of living rises in periods of inflation). However reducing wages is difficult to do. It is far easier for a company to regain competitiveness by not offering a cost of living rise in a period of 2 per cent inflation than it is to cut wages by 2 per cent when there is zero inflation. It is therefore argued that company profits suffer during periods of deflation.

The impact of the inability to cut real wages is undoubtedly less than it used it to be in times of greater trade union power. In the recent recession, some companies cut back on wages effectively by reducing working hours.  Moreover markets are now much more competitive in many areas. Contract workers are easier to replace with lower-paid ones. Despite this, there is still some evidence that companies are less likely to reduce wages than they are to award a zero pay rise in the current economic environment.

CONCLUSION: Deflation decreases company profits primarily because modern business is founded on debt-based finance. That finance relies on inflation to help reduce its cost by transferring wealth from savers. Again there is a moral question on whether this hidden subsidy should exist for business.

Argument 4: Deflation stops people spending

The argument goes something like this. If people realise that prices are gradually going down they behave logically and decide that it would be more efficient to delay their spending until items have become cheaper. This therefore slows down consumer expenditure and GDP declines as the velocity of money declines.

This is a nice economic theory, but evidence does not always support it. Indeed as some analysis by an M&G Investments analyst recently concluded: “The argument that deflation stops purchases does not hold up in the real world.” Moreover, it is also contrary to another very established economic theory that suggests that for every 10 per cent drop in prices, unit sales go up by approximately 10 per cent.

During the first decade of this millennium, the west was flooded with cheaper goods from China and discount retailers such as Poundland sprung up. Those retailers have been remarkably successful in encouraging impulse purchasing of cheaper stuff that arguably people do not need. There is no evidence from them that offering lower prices causes a decrease in unit sales.


Another example is electrical goods. As technological improvements have been made over the last 50 years, the prices of everything from TVs to phones have declined. There is no indication that people have cut back their purchasing in the hope that prices will become cheaper. Indeed sales of most electronics are increasing as their prices decline.

It is possible that the economists who proposed this theory were not fully factoring in declines in the velocity of money i.e. when people decide to save more and spend less. The uncertainty brought on by a financial crisis affects people’s psyche. The fear it brings causes people to save more of what they have as they don’t know what the future might hold and whether they still might have a source of income in the future. Seen this way it is not the lower prices in the shops that causes a slow-down in consumer spending but the impact of greater uncertainty brought on by a banking crisis.

CONCLUSION: The evidence does not support the theory that decreased prices stop people spending. In fact, the opposite often happens and sales can increase. Decreased spending only occurs when accompanied by a banking crisis which affects consumer confidence.

Argument 5: Deflation makes it difficult to control the economy

Central banks are primarily tasked with controlling monetary policy to aid the economy growing at a consistent and positive rate. The main lever they have for doing this is by controlling interest rates. The logic of this is as follows. If inflation takes off (above say the 2 per cent target in the UK), the central bank increases interest rates, so private banks tend to lend less money and reduce the money supply. As less money is chasing the same amount of goods being sold, prices should decline. When they do, interest rates can then be reduced.

The system also works the other way and when an economy is in recession, reducing interest rates helps stimulate the economy. This is carried on until demand picks up and prices start to rise.

BoE model

Source: “The Monetary Policy Balloon Game” – Bank of England

Therefore, in general, interest rates are usually highly correlated with inflation rates. However should deflation happen in an economy, central banks cannot easily decrease interest rates and make them negative. They therefore lose one of their most important tools to control monetary policy and it is argued that downturns in the economy become more prolonged because of it.

The counter argument to this is that the model of the way the economy works which central banks are using is a bit simplistic and that things often do not quite work the way they proclaim. Monetary policy often has an impact on asset price inflation (e.g. share prices) but the link with consumer prices is much less clear in the short-term. For example, when the Bank of England drastically reduced base rates from 5 to 0.5 per cent in the second half of 2008, CPI inflation remained high over the following several years.

Finally it should be remembered that central bankers have become powerful and influential and any scenario of inflation in which this power is reduced is not going to be welcomed by them. Perhaps it is not surprising we often used to see headlines about Ben Bernanke fighting against the threat of deflation[xi].

CONCLUSION: In periods of deflation, traditional monetary policy implemented by central banks will not work. However it is debateable how much this matters for society as those interest rate policies have a limited direct impact on consumer inflation anyway.

* Source: Save Our Savers.