For centuries maintaining a nation’s or even a community’s financial stability was the aim of economists. Granted, in the past, the economics was greatly different, yet the fundamentals were similar, i.e., to retain the value of the financial sector. Although it stands true for the majority of the cases, there are times when a deliberate reduction in its value is needed. Despite it being controversial, it is a necessary aspect of economics to stabilize the economy.
What is Deflation?
Inflation is a common phenomenon in the economy, it causes the prices of goods and services to increase. On the contrary, deflation is a situation of negative inflation or when all sectors of an economy experience a drop in the prices of their products and services, it is considered deflation. This drop in prices is often linked with a contraction in the money and credit supply; however, factors like increased productivity and technological advancements can also cause a reduction in prices. Although it may appear deflation is good because people can afford more with the same amount of income, true negatives of deflation are only experienced in the long run. Unemployment and a significant cut in wages are the common drawbacks of deflation because the profits of firms are dropped significantly. Interestingly, one of the worst downsides of deflation is debt, because the interest rate is increased significantly, therefore, individuals or companies with a loan, end up paying more.
Deflation Examples in History
1. Hong Kong Deflation
During the 1980s and 1990s, Southeast Asia countries were seeing significant growth in the economy. This was largely due to the foreign exports. Since countries like Hong Kong, Thailand, Indonesia, and South Korea were doing exceptionally well economically, they attracted investors. Before this, the United States was the go-to country for investors; however, the recession of 1991, forced the Federal Bank to lower interest rates. Interestingly, the interest rates were lowered well below the rates offered in Asian countries, therefore, banks and companies were investing in these countries. With so much money coming in, the governments of each country decided to invest in projects that were not even used after their completion. The turning point in this growth came once the United States recovered from the economic crisis. The interest rates were increased again by the Federal Bank, and this increased the value of the American dollar. As the currencies of the mentioned countries were pegged to the American dollar, the flow of money was immediately stopped. This overburdened the exporting division of these countries, as it was necessary to maintain their money flow, while at the same time their debt was increased to foreign countries because the infrastructure was built on loans, which they had no means to pay back. It is estimated that the debt of these countries was 165% of their GDP. While other countries suffered an economic crisis, Hong Kong decided to adjust its dollar’s value by deflating the economy. This deflation lasted until 2004, during which thousands of jobs were lost, and a reduction in wages was every day’s news.
2. Ireland Deflation
In the 20th century, the financial scene of Ireland was drastically different from the modern times. The government decided to not participate in international trade, which is one of the main ways to strengthen a country’s economy. Finally, after years of struggling, Ireland opened its doors for international trade and soon it became one of the richest countries in the world. Although Ireland’s economy was booming, inflation was speeding up as well. To combat this, the finance minister of Ireland, Brian Lenihan, decided to implement an emergency budget in 2009. This meant trimming €3.25 billion from its budget to combat its economic deficit. Interestingly, it was an intentional deflation, and the government even announced that they were expecting a deflation rate of 4 percent. Moreover, this was the first deflation faced by Ireland in 5 decades. The prices of goods and services were decreasing at the rate of 1.7 percent each month. While deflation is seen as an overall negative thing, this deflation allowed the government to adjust its economy per the Eurozone. Businesses, on the other hand, were not pleased with this intentional deflation, as they claimed their profits were dropped significantly.
3. The Great Depression
Following the First World War, the United States was experiencing unmatched prosperity. More people were joining the workforce, wages were increasing, and new products such as vacuum cleaners were being purchased at a rapid pace. The economy of the United States was booming, and this era is also known as ‘The Roaring 20s’. As an economy is experiencing expansion, the organizations become lenient with money, and the same happened in the United States. The banks decided to give loans to everyone, it didn’t matter how bad their credit score was or if the person was earning enough to pay it back. This caused people to take out loans and invest them in the stock market. As the economy was climbing, people were making easy money, and investors were gaining immense profits. Too much of a good thing can be bad as well, and that was what happened in the United States. Since everyone was investing in stocks, it was becoming impossible for the companies to adjust their stock price. Additionally, after a gradual increase in supply and demand, people stopped purchasing more items, resulting in lower productivity and a reduction in wages. Finally, in October 1929, the stock market crashed, and people started selling stocks at an abysmal rate. It is estimated that $14 billion were simply lost in a single day. Unsurprisingly, numerous companies and even banks shut down, which led to an all-time high rate of unemployment. To curb this economic crisis, deflation was implemented. The value of the dollar fell by 7 percent each year until 1933. Ironically, it was the beginning of the Second World War that created jobs in the US and stabilized its economy.
4. The Great Recession
While the great depression is considered one of the worst economic crises in the history of the United States, the great recession was something that is still affecting the citizens of America today. Experts even claim that the true impact of the great recession will only be known after another decade. During the early 2000s, the housing market in the United States was booming, and investors were extremely interested in this market because the price of housing was increasing each year. Once again, similar to the great depression, banks decided to give subprime mortgages to people with bad credit scores and no means of paying back the loan. A subprime mortgage is a type of banking loan that is designed specifically for people with bad credit scores, and they are charged an expensive interest rate. This delicate balance of lending money for housing became abruptly off-balance in 2007 when the demand for housing suddenly dropped. With demands dwindling, investors found no profit to be gained in the housing market, and they decided to bail out. Suddenly, the pricing for houses plummeted, and this was the great recession. The banking system collapsed, and with such a massive shock to the economy, millions of people lost their jobs. While the severity of this recession is debated among economists, it certainly brought misery to millions of lives. Prices of commodities were reduced significantly, causing deflation in the economy. Some experts debate whether deflation was required or not.
5. Japanese Deflation
To say that Japan was in tatters following the Second World War would be an understatement. As the atomic bomb was dropped on two of its major cities, Japan was struggling with its economy. Slowly Japan strengthened its economy with the help of the international trade of electronics. Japan was churning out electronic devices like no other, and ironically, the United States became its largest buyer. During this time, the value of the American dollar increased by 50 percent to the Japanese yen. Japanese economic crisis occurred because of this, along with similar poor financial choices that led to the great depression and the great recession in the United States. Each sector felt its impact, from the stock market to local businesses. The banks that had lent loans to companies were shutting down, and the firms that had taken loans were declaring bankruptcy. The government was faced with two options; deflate the economy or print more money. Fortunately, Japan decided to opt for the former and deflated its economy for over a decade. Interestingly, Japan benefitted from this deflation so much that they continued to implement such practices to ensure that they don’t experience inflation.
6. Eurozone Deflation
While the previous examples of deflation were extreme, the deflation that was experienced by five nations of the European Union: Greece, Bulgaria, Cyprus, Spain, and Slovakia was not to the same extent. Although the true causes of deflation in these countries are unclear, experts believe that it occurred because of debt. This was the particular case for Greece, as it experienced hyperinflation throughout its history, drastic measures resulted in negative inflation from 2013 to 2015. As for Bulgaria, its currency was pegged to the Euro, which meant that the country was unable to maintain the value of its assets to the Euro, resulting in deflation.