1. Wages and output fall.
This is seriously hellish, for any country. Deflation fires off a tonne of things central bankers don’t want in a grown-up economy: falling wages and lower output.
Debt increases. The economy sputters. Consumers become timid and, in extreme cases, start to hoard. Currency wars can be triggered as financial technocrats devalue currencies to compete. It’s bad, bad all around.
2. Money supply contracts.
Let’s define deflation before wading in deeper. Some think deflation means falling prices. Falling prices can be a side effect. But deflation means a country’s money supply tightens. It’s hard to find credit. It’s hard to borrow.
Responding, central banks try to persuade businesses and the public to feel better. They attempt to increase economic busyness. They promise cheap money.
They snip interest rates or electronically print off more cash, known as quantitative easing (like rattling the money box till it hurts). It’s okay to borrow and the cash on offer is cheaper than yesterday, they say.
But central bankers rely on demand. They can’t force you to borrow or invest. You have to believe!
3. Investing and business planning is put on hold.
Central banks (and most sensible governments) like economies with a bit of get-up-and-go. A ‘Goldilocks economy’ – not too cold, not too hot, but just right.
A modest amount of confidence is good, which means borrowing usually. But if deflation lurks, borrowing is put off. Why load up on debt if your profits might drop tomorrow?
Why take on debt if the value of your assets slides in six months? Why ‘invest’ if credit is cheaper – possibly a lot – in a year’s time? (Heck, money might even become ‘free’.)
There’s more: if you’re a business and there’s deflation, you may struggle to make a profit. It might be because of low demand. Or you’re forced to make lay-offs.
4. The cost of long-term debt rises.
Deflation hangs about like a bad smell.
Borrowed cash is a great idea when inflation thumps the long-term value of borrowed money. But it’s not so smart when inflation, which is supposed to smooth out that longer term risk, fails to show up. Debt’s a dead weight on growth and profits. It’s hard to kill off, dammit.
5. Public confidence falls.
It’s a slight stretch but imagine a central bank as a wealthy, distant relative. An austere one many times removed. You need a good excuse for a visit – especially if you turn up smelling poor.
In 2008 there wasn’t much choice. Many commercial banks were struggling with savagely weakened balance sheets. Queues of frantic, angry savers wanted their cash back. They snaked down the high street and beyond.