What you need to know about deflation
At first hearing, you may be happy about this, because then you will get products and services cheaper and cheaper. But the economic experts are not accidentally fighting to avoid deflation if possible. This can put the economy at a complete halt, so we need to take active steps to keep the economy in balance.
What does deflation mean?
Deflation is nothing but a level of inflation below 0%, we can say its opposite. We talk about deflation when the general price level falls permanently.
Since 2020 was about falling prices in a lot of places, I brought you the inflation rate of 2019, which still shows how the world works normally. As you can see, there is basically a moderate inflation observed globally, with deflation present in only a few countries.
Deflation and disinflation
Deflation and disinflation are two separate concepts. In order to avoid deflation, it is necessary to stimulate the economy, but too much stimulus may exceed the target. Look at this chart and you will see the optimal level of inflation.
We talk about disinflation when the inflation rate of, say, 18% has fallen to, say, 3%. I mean, it’s just smaller. I could also say that the pointer went from the right edge of the image to the center.
We are not talking about inflation in deflation, as its value here is below 0%. Then the value of money does not deteriorate, but improves. That is, without any investment, it is worth more and more. In such a situation, however, buyers (quite rightly) postpone their non-essential purchases. No wonder you’re not buying anything that isn’t necessary for your livelihood and that you know for sure will be discounted soon. This is not a problem for 1-1 products, the problems start with the mass phenomenon.
The impact of deflation on the economy
Impact on investment
Because companies are unable to sell their products, investors tend to look for a place for their money where greater profits are expected. When it’s massive, the price of stocks and bonds as well as mutual funds falls.
Interestingly, gold, silver, and precious metals in general can perform well even then. Because of the increased demand their prices are rising. This means a value-preserving function even at a declining price level.
Impact on business
Maybe I don’t have to say that if you fail to sell your product to customers, no matter how you advertise, what the direct consequences are. What you can do with the situation there depends on where you started, what reserves you have. If your liquidity is in order completely (not just roughly), you have the opportunity to make a more relaxed decision and, if necessary, flee in advance. That is, to start some kind of development or (also) move to some other area.
After all, you need to balance your own business for your own livelihood and your employees, even if the whole economy is not affected by the downturn, just the sector where you work.
However, a development always requires a lot of capital. It’s usually twice as much as you first guessed, and it doesn’t even start producing right away. That is, it only takes the already dwindling stock of money in the hopes of bringing it later.
In the absence of these, however, you can pull down the blinds.
The cause of deflation
In very short: a general and significant drop in demand.
In the economy, the price of a product and the quantity offered for sale are determined by supply and demand. If I want to present this, I can do it like this:
You can see that the higher the price of a product, the higher the quantity offered for sale by the manufacturers, but the less customers are willing to buy from it. The intersection of the two is the equilibrium price for which you can get that product at that point in time.
If demand declines, supply will adjust accordingly. There will be manufacturers who will no longer make profit on production, so they will stop production. They’re either making something else or just nothing. At the same time, supply will decline.
If that happens, manufacturers still on the market will try to lure buyers with promotions. So they may have lower quantities and lower prices, but they are able to sell and stay alive with it.
The self-inducing cycle of deflation
During a fall in prices, companies first give up only a portion of their profits in order to continue operating. If this does not lead to a new balance, prices will have to be further reduced.
Once they reach a certain point, they can no longer lower their own costs either, so they try to save on something. As the labor is one of the most costly items, so many companies are downsizing. At first less, then if that doesn’t help, then more.
A worker left without a job doesn’t buy anything even if companies make promotion. This further reduces demand. And since it doesn’t even produce anything, so does supply even in other market segments.
Falling demand will lead to a further fall in prices, which will encourage manufacturers to take further “Black Friday” promotions.
As this process spills over to others, the investments postponed, which further lowers prices.
If I want to show very briefly the self-stimulating circle of deflation, I can do it like this:
What is the solution to avoid deflation?
Increasing the money supply
Well not blindly, it never leads to good. The ’30s were the worst crisis ever, with professionals experiencing the effects of deflation. To solve this, a lot of road construction, railway development, and many very large-scale investments have started, the end result of which does not have to be bought, but which gives people jobs and thus a disposable income.
The workers working here were thus able to spend this income somewhere else, so that company was already worth producing and was able to employ workers. And the people who worked there also showed up as buyers somewhere.
Change in taxation
In addition to increasing the money supply, there is also an opportunity to help businesses through taxes. This could be targeted support or a moratorium.
The aim here is not to avoid paying taxes, but merely to give businesses time.
Following the logic of this, it was introduced in the ’30s that interest on loans reduces the rate of corporate tax. If you think about it, it’s natural for you, but it was a huge innovation.
Until then, the tax authority was at the beginning of the line on all sorts of issues, but then it was at the end of the line, leaving the banks in front of itself. Before you sniff a bank lobby behind it, I’ll tell you that banks have very little to do with this. The tax authority receives revenue anyway. If this small part is missing for your survival or development, they will get you to pay them taxes in the long run. Plus, we hope more and more as you evolve. If the plan does not come in, the business will go bankrupt and no creditors will be let in front of the tax authorities.
Reduction of the base rate
By lowering the base rate, both the deposit rate and the loan rate will be reduced.
Impact of savings side
Reducing the base rate on the deposit side reduces the incentive to save (what would you put in the bank if you don’t get anything for it). This money has to be spent somewhere, so head to the mall. Then one either live off this money or invests it. He spends his money in the same way with the investment, only buying something useful from it in the long run in the hope of making a profit later.
Impact of investment side
The amount you already have is not necessarily enough for a larger investment. However, lowering the base rate also reduces interest rates on loans. This will make it cheaper on the one hand and easier on the other. After all, the bank’s risk is also reduced, so they’d rather give.
A lower borrowing rate will also allow you to increase your available profits, further boosting your investment, even if you’re not thinking about starting your own business. By purchasing a share e.g. you are joining someone else’s company as an owner, so by then the important question is what kind of profit you can make with it.
- What other steps could you take to avoid deflation?
- What do you think (even as an entrepreneur) what is the limit at which you finish the discount and prefer to switch to producing something else?
- How do you see the boundary between the end of the life cycle of a given product range (i.e., declining demand because it is outdated) and the general decline in demand for deflation?
You can ask your questions in the contact menu or in the social media comments.