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Central Banks around the world are busy printing money (not exactly like what you saw in Money Heist but by clicking a button on the computer) to fight the economic catastrophe brought by the CoronaVirus, from this stems the widely debated fear of inflation. But, we are not going to talk about inflation. We will discuss what happens when inflation turns negative,i.e, Deflation, and why it is hated.

What is deflation? It is a decrease in the price of goods and services. So you have a Consumer Price Index which is a basket of goods and services like prices of vegetables, mobile phones, transportation cost, some proxy for entertainment, and so on with weights assigned to them. This basket is valued at ₹100 at the end of 2019 and is worth only ₹95. We will call it a  deflation of 5%.

Why is it Bad?

 Published in Journal of Money, Credit, and Banking (Naked Money-Charles Wheelan), about a babysitting co-operative in which couples babysit for one another in exchange for coupons, which could, in turn, buy time from other couples when you needed to say go out for a movie. For some reason those fancy paper coupons began to shrink in the group may be lost or damaged. What this did is that couples started to conserve their coupons in anticipation of emergency future needs. So the velocity of coupon exchange fell in the group which further increased the problem. Now when all couples started to hoard and increase the reserves, everyone found it more and more difficult for everyone to earn coupons because a couple going out for a movie was a chance for another couple to babysit and earn a coupon which was lost.  

The same thing happens when you magnify this over the whole economy.

We know that employment will drive overall demand in the economy which in turn will be driving the price and supply in the economy. Price and Supply (Production) will, in turn, drive the profits and growth of businesses which in turn will mean that more jobs would be needed to support the increasing demand.

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Now, when the economy goes through a rough patch, there will be lower profits, which in turn would mean decreased demand for employment and will lead to increased unemployment. With fewer people left with jobs, the demand in the economy too would drop which would mean a drop in prices which would lead to a further drop in profits. To support its profit margins, businesses would have to cut production and let go of some of its employees and the circle will go on and on. This vicious downward spiral is called the Deflationary Spiral.

Similar to the Babysitting Co-op, if the general public in the economy is not confident of their future earnings, it would hoard money and preserve their savings reserves. Deflation increases the purchasing power of the currency, so naturally, people would postpone their purchase because they know that they can buy more if they wait. You can buy 5 ₹200 shirts with ₹1000 at the beginning of the year, but if you wait till the year-end you can get 6 shirts with the same ₹1000 because the price would fall. Unlike in the case of Inflation, where people hoard goods, here the people shy away from hoarding goods and rather hoard cash. 

It does not end here, because you still need to pay the EMI for your mortgages. Imagine a situation where you need to make fixed EMI payments while your salary reduces. Also, the real debt would increase because the ₹ you will have to pay back is worth more than what you borrowed and has increased purchasing power. Naturally, households and businesses would start defaulting on their mortgages. Rising NPAs (Non-Performing Assets) will put pressure on the banks and in turn, they would stop giving out loans to businesses and households in dire need of capital. Everyone would start selling their assets to make ends meet. This increased supply of assets will decrease their price. In the end, you have your fixed EMIs to pay, your income has decreased and the value of your assets has fallen. Sounds scary.

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Where are the Central Banks and its 2-barrel shotgun of Interest rate and Money Supply?

First, why increasing the money supply is not as effective: As people tend to spend less in a deflationary economy for the reasons stated above, the velocity of money in the economy falls drastically. Velocity is an important link connecting the money supply and prices of goods and services. Economic uncertainty prompts all the stakeholders of the economy, households, businesses, banks to hoard cash, and liquidate assets because they fearless access to the credit in the future. If salaries fall, demand falls, profits fall, default increases, and savings fall. If you are a bank, you face losses at one end due to defaults and at the other end, you lose the deposits made by the customers. Being a bank you need to adhere to regulatory requirements of capital adequacy while you are hit from 2-sides and the only option left with you is preserving capital you already have and not dole out loans any further. As we know banks create credit and expand money supply when it lends because it creates a deposit against each loan given out. This process when stopped, further reduces the velocity of money in the economy. It can also cause a run on the bank during bad times increasing the risk of contagion across the financial sector. So once the velocity of money reduces,i.e people spend less and hoard more money even increasing the money supply will not increase the prices of goods because most of the supply would be out of circulation.

Even if the Government throws currency notes at people, they would rather save than spend it because they are scared and very uncertain of the future, rendering the expansion of money supply ineffective. 

Now the Interest Rate: In a weak economy, the interest rates fall because there is less demand for credit because a salaried guy does not expect his salary to rise this year or businesses do not see an opportunity that would generate a return on capital employed more than the cost of capital. Lower demand for credit leads to lower interest rates. This works like a pendulum swinging from one end to another and back,i.e, between high-interest rates and a heated economy with high credit demand and a weak economy with lower credit demand and interest rates. Lower interest rates induce households to purchase more items because they will have to pay lower interest rates and businesses will soon have viable opportunities generating returns above the cost of capital.

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Deflation locks the pendulum so to say and stops the automatic healing process because while the banks would be quoting interest rates of say 1% nominal rate, the real interest rate would be negative 6% after adding the 5% deflation. Due to deflation, money paid back would have more purchasing power than the money loaned out. So in nominal terms even if the interest rate is 0% and deflation is 5% which is a heavy cost to pay during severe economic distress.

So to summarise, deflation is hated by Economists and the Central bank because it gets difficult to control and steer the economy once it hits the deflationary patch. If managing inflation is hard, managing deflation is even harder. It is for the precise reason that central banks target 2-4% inflation depending on the state of the economy.

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Sneh Kagrana

Sneh Kagrana

Sneh loves to write about the things that surround the financial system of the world. He shares his wisdom on a daily basis through his new venture - Daily Shots.
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