Deflation is the opposite of inflation. Unlike the latter, it is characterized by a lasting and self-sustaining fall in the general level of prices.
To measure price trends, we can indexes such as the French index of the Harmonized Consumer Price Index (HICP) published monthly by INSEE. It is calculated from the evolution of the price of a basket of products consumed by households between two periods. This index must be negative for several quarters in order to speak of deflation.
Deflation should not be confused with disinflation, which is simply a slowing down of the rate of inflation. This is currently the case in the euro zone, for example, where the general price index has been falling for several months while remaining in positive territory.
The different causes of deflation
Instances of deflation are rare. In developed countries, there are only two examples of this over the past 100 years : the deflation of the 1930s, which affected the United States and then Europe, and the more recent one which affected the economy. Japan in the late 1990s.
In both cases, deflation broke out following a financial shock (stock market crash in the United States in 1929, stock market crash and then real estate crash in Japan in 1990-1992) to which the monetary authorities provided inappropriate responses or too late which precipitated the economy into a deep crisis.
In the United States, the central bank (the FED) decided, faced with the fall of the stock market in October 1929, to increase its interest rates. The result will be a contraction in credit and activity that will plunge the economy into deflation. The lesson of this error will be learned. Thus, in 2008, the FED will in fact react very quickly to the real estate and stock market crash by injecting liquidity and lowering its key rates.
In Japan, the stock market and real estate crashes of the early 1990s weakened the banks which had granted numerous loans secured on the value of real estate assets, and which found themselves in difficulty.
To deal with this, they massively sell the financial assets they hold, stocks and bonds, and reduce the distribution of credit. Activity is contracting and economic agents are looking to deleverage rather than invest in assets whose prices are falling.
A spiral of the type of fall in asset prices followed by deleveraging causing postponement of investments to the fall in asset prices is taking place and ends up weighing on activity via the fall in investments and the absence of wage increases.
The Bank of Japan is slow to react. Indeed, the Japanese economy had already swung into deflation when the zero interest rate policy and unconventional financial asset purchase measures were adopted.
Deflation: the harmful effects
Deflation gives households a gain in purchasing power, since the prices of goods and services tend to fall. A priori, one might think that this is beneficial to consumption and therefore to economic activity and growth. However, this is not the case, quite the contrary. Deflation indeed provokes wait-and-see reactions on the part of economic agents which prove to be particularly harmful for the economy:
On the one hand, the regular fall in prices encourages households to postpone their purchasing decisions while waiting for further price falls. This behavior leads to hoarding money, lowering overall consumption and inflating the stocks of companies that can no longer sell their productions. In response, they reduce their production and their investments. Wages are falling, hiring is becoming scarce and unemployment is on the rise, which ultimately affects household income. There follows a further drop in consumption which generates the formation of a vicious circle because it is self-sustaining. Greece thus experienced a period of deflation from 2013 to 2015.
On the other hand, deflation causes a deterioration in the financial situation of individuals and institutions who resort to borrowing. Indeed, the real cost of debt (i.e. once inflation is taken into account) increases with the fall in the general price index because loan repayments are generally not indexed to the inflation. This results in a lower ability to invest for companies and a lower ability to consume for indebted households, which reinforces the vicious circle described above.