Wednesday, January 7, 2015

Why Is Deflation Bad?

We all know why Inflation is bad but why is Deflation bad? All growing economies have a healthy mild inflationary bias (prices slowly creep up). However the Eurozone just announced that in December 2014, prices turned negative. Japan has been in a deflationary state for decades despite several government efforts to inflate the economy. For most of this decade, governments and Central Banks (especially in Asia) have been focusing on how to contain Inflation and curb asset bubbles (stock markets, property). It looks like this year, they will be more concerned with the threat of Deflation.
We all know why Inflation is bad: $1.00 worth less than $1.00 can buy less things. Your savings worth less and less in terms of real purchasing power. Your salary fails to keep up with cost of living.
But why is deflation bad? Isn’t it good that petrol, food, clothes, transportation etc is cheaper? Here are some of the reasons why Deflation is bad:
1.      Consumers postpone spending, because they expect prices to go lower. If you expect houses and cars to cost more and more (as in ‘normal’ times) you would make a greater effort to buy them now. Opposite happens in Deflation.
2.      Companies postpone investing in production capacity and hiring people because lower consumer spending means less demand for their goods, margins fall and yet they can’t raise prices. This is probably the greatest concern because of its multiplier effects on the economy such as the mass unemployment of the 1929 U.S. Great Depression. And it took a major inflationary event like the Second World War to jump-start the economy with the industrial production of airplanes, tanks and ships. [in that sense, war and post- war or post-natural disaster reconstruction is good for the economy]
3.      Inflation benefits debtors but Deflation penalizes them. With Inflation if you borrow $100,000 from the bank and the real value in terms of purchasing power becomes $80,000 you are happy because you are paying back the bank less in real terms. The opposite happens during a deflationary period.
4.      It is easier for governments and central banks to defend against Inflation raising interest rates than to fight deflation. With the current low interest rate regime of nearly zero and U.S. 10-year Treasuries at 2%, Central Bank attempts to fight Deflation by Quantitative Easing e.g. Bond purchase programs are less effective.

5.      The stock market is affected as all sectors from Oil & Gas, Marine, Construction, Finance, Real Estate to Food & Beverage, Retail, Technology and Transportation post lower earnings.   

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