Deflation is a general decline in prices. There are two different types of deflation and they define a "good" and a "bad" deflation. “Good” deflation originates from a positive supply shock, caused by an increase in productivity due to the use of new technologies, or simply by a good agricultural harvest, which reduces production costs and increases the quantity . Given the increased supply, quantities sold increase and prices decrease. The fall in prices is usually temporary.
Supply deflation is associated with GDP growth, higher profits for companies, increases in asset prices and better financial sector performance. A prime example of the "good" deflation is the "Roaring Twenties" (1921-1929), characterized by several technological innovations that revolutionized our way of life, such as the introduction of the automobile, the telephone and the radio, and which marked a period of rapid economic growth, accompanied in several countries by slight deflation.
“Bad” deflation is instead characterized by a protracted fall in prices, due to the contraction in aggregate demand. The demand for goods and services decreases and consequently producers sell less and at reduced prices, and the GDP contracts. This scenario is that of Japan, which has been struggling for years against the fall in prices that began at the end of the 90s.
Deflation per se is therefore neither good nor bad, but simply the symptom of a change in supply and demand, which can lead to GDP growth in the case of a positive supply shock, while leading to a contraction of GDP in the event of a negative demand shock. The problem with “bad” deflation is that if it continues over time it can further aggravate the economic contraction and lead to a deep recession, as happened in the United States and Europe during the Great Depression in the 30s.
THE COSTS OF “BAD” DEFLATION
The main problem with deflation is the impact it has on financial markets and consequently on the economy, and on the effectiveness of monetary policies. A fall in price raises the real interest rate, or the cost of borrowing money. Consumers and investors are therefore dissuaded from using credit, and consequently reduce their spending, exacerbating the fall in GDP. Spending may contract further if deflation persists, thus affecting expectations where consumers and investors prefer to postpone spending, expecting lower prices.
A second factor further aggravating economic conditions is that debts increase in real terms, as the value of money increases when prices fall. This makes it more difficult to pay off debts, and increases the likelihood of bankruptcy. In a climate of uncertainty and widespread risk of default, the cost of credit increases further and creditors are dissuaded from lending. Deflation therefore has the effect of reducing both the demand and supply of credit, severely contracting the financial market.
Deflation therefore constitutes an aggravating element in countries where financial markets are already very weak or where there are high debts. This is the case of the countries of the European periphery, above all Greece, Portugal and Spain, and in part also of Italy, characterized by a high public debt and a practically static credit market.
The worst consequence of deflation, as well as inflation, is that it feeds itself, creating a spiral of falling prices and expectations. While in the case of inflation monetary policies can intervene through an increase in interest rates that reduce aggregate demand and reduce inflationary tensions, central banks can do little with conventional monetary policies to counter deflation. The ineffectiveness of monetary policy is due to the "zero bound" of interest rates: once a zero interest rate is reached, central banks can no longer use interest rates to boost the economy because they cannot become negatives. If they were negative, it would simply be more convenient to keep your money in cash.
This is how various central banks in recent years have resorted to "unconventional" monetary policies to increase the supply of credit more or less directly (i.e. without the intermediation of short-term interest rates) and guarantee the stability of the financial markets. Among the most used measures we find quantitative easing, or the purchase by central banks of securities, both private and public, to increase liquidity in the private and public sector. However, these monetary policies have uncertain outcomes.
CAN WE TALK ABOUT ITALIAN DEFLATION?
In Italy, as in the rest of the industrialized countries, a sharp slowdown in price growth has been recorded in recent months. In particular, during this summer, inflation measured by the CPI went below 1%. In any case, the change remains positive and therefore cannot be classified as deflation. What is worrying, however, is not the current level, but its trend. The change in the CPI is now lower than in the last four years and is at its lowest in post-war economic history.
A large part of the fall in prices is attributable to the collapse in aggregate demand, corresponding primarily to the reduction in household disposable income and a consequent collapse in consumption. It therefore appears that price reductions may have the characteristics of “bad” deflation. On the other hand, when breaking down the various elements of inflation, it is reassuring to see that the fall in prices that occurred over the summer is partly explained by supply-side factors. The prices of food raw materials are down, thanks to the good climatic conditions in North America and Eastern Europe, and the prices of energy raw materials are down, after years and years on the rise, thanks to the easing of geopolitical tensions in the Middle East, and the increase in the oil supply in the North Seas and in particular in the USA, due to new extraction technologies (fracking).
If the fears of a prolonged deflationary phase appear exaggerated in this phase, it must however be recognized that the dynamics of prices in Italy have come as a surprise, considering that significant increases in administered prices have been observed in recent months, in addition to the increase in VAT from last October first. It is also true that, starting from such low price dynamics, the risks of deflation have increased in Italy, as well as in the other countries of the European periphery (in some of which the reduction of wages and prices serves to recover competitiveness). We understand the attention of the economic policy authorities, and in particular of the ECB which has shown its willingness to counter this eventuality with the decision to further reduce interest rates taken last week.
