The perils of a deflationary shock

Deflation means that the pound in your pocket is worth more each year. In an earlier age, deflation was regarded as benign at worst.

For a couple of hundred years before 1946, moderate deflation would occur over long periods of improving productivity. It was often associated with the good times.

It is easy to see why. The purchasing power of people’s incomes increased; people could take out life insurance policies knowing that if the sum assured paid for a funeral at today’s prices, it would pay for their funeral when they died; and businesses and individuals could sign contracts spanning the generations knowing that inflation would not lead to either party losing out.

Indeed, the economy can work better in a period of gentle deflation. If the price of housing rises for example, when prices in general are falling, we get an unambiguous signal that housing costs are increasing relative to other costs and that we should think about economising on housing. At a time when all prices are going up, it is difficult to work out what is going on in the marketplace.

Sadly, those days are past and we now have an economy that has adapted to inflation. The pound has had 97 per cent shaved off its purchasing power since 1946 and the Bank of England has a statutory mandate to target positive inflation, year after year.

A severe and unexpected deflation at any time can have serious consequences, but the consequences will be worse for an economy that has adapted to inflation…

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The problem with deflation is largely the result of government intervention and union action. It is extremely hard to reduce nominal wages even if real wages remain the same or even rise.As an aside, your Great Depression example misses the point that the vogue was for RAISING wages in a depression to “increase the purchasing power of the worker”. This is what led to mass unemployment.Deflation also encourages saving and discourages borrowing, which is hugely beneficial economically.

Partly example with deflation was 2000-2008 trend of Russia’s ruble before current non-liquiduity of its financial market. Things really got better for people, as well as trade. Inflated currency does not have trust, and thus stops (to some degree) economic development.

The problem with deflation is largely the result of government intervention and union action. It is extremely hard to reduce nominal wages even if real wages remain the same or even rise.As an aside, your Great Depression example misses the point that the vogue was for RAISING wages in a depression to “increase the purchasing power of the worker”. This is what led to mass unemployment.Deflation also encourages saving and discourages borrowing, which is hugely beneficial economically.

Partly example with deflation was 2000-2008 trend of Russia’s ruble before current non-liquiduity of its financial market. Things really got better for people, as well as trade. Inflated currency does not have trust, and thus stops (to some degree) economic development.

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