Inflation, the fall in the value of money, is the motivation for many to invest. And there is a good motive! Indeed, inflation reduces the purchasing power of money and strikes particularly hard on savers who focus solely on increasing the amount of savings in their bank account.
If you want to refresh your memory about inflation, read our article on the subject.
Inflation is indeed a nasty thing. Why can’t the value of money be preserved so that we don’t have to see the extra effort of preserving it?
The importance of inflation to economic well-being is easiest to understand through its opposite, i.e. deflation. If we did not have inflation, the value of money would increase in the long run. And when the value of money increases, we talk about deflation.
Deflation is due to fact of there is less money in circulation as a whole, and thus also less available to the individual. This paper addresses the fundamentals of deflation.
Deflation sounds like a brilliant deal: I’ll be practically wealthier doing nothing, because I’ll be able to spend even more of the same amount of money in the future, as long as I save now and use my savings only later.
However, for a housing or other debtor, deflation is a bad thing because as the value of money rises, you have to pay off debt rated for less valuable money with more valuable money.
In 2021, you will take out a EUR 100,000 mortgage and buy an apartment with it. In 2021, you will get about one cucumber from the vegetable department of the store for one euro. If you bought cucumbers with all the money instead of an apartment, you would get a whopping 100,000 cucumbers.
You gradually repay your mortgage, and deflation prevails throughout the repayment of the loan. In other words, the value of money goes up.
After years of loan repayment, you will find that one euro already gets two cucumbers. If you now sold your apartment for the original hundred thousand and bought cucumbers with all the money, you would get up to 200,000 cucumbers, or double the amount!
While the monthly loan repayment has remained the same for years of deflation, your loan has become much more expensive than anything else. In the end, you will pay much more for your apartment than what it is worth at the moment.
Deflation can start a negative spiral
Central banks know their economic area and set different inflation targets for their area. In the euro area, the inflation target is around 2%.
The euro area target is set by the European Central Bank (ECB). This slightly below 2% is the level that the ECB sees as inflation that maintains economic stability and prosperity. Exceptions in either direction from this level are destabilizing the economy.
The impact of below-target inflation on employment is, in principle, declining. Bearing in mind that deflation is negative inflation, it is noticed that deflation also lowers the employment rate.
This is because deflation is negative inflation: we move on the same scale all the time. Deflation begins an economic spiral that puts the macroeconomy under control.
In a national economy, everything affects everything, and deflation is no exception to the rule. In addition to deflecting debtors, deflation has other far-reaching economic implications. One of the most important is its relationship to the employment rate, which also affects the business environment.
It is important for the business of companies that the development of products and operations is continuous so that they can compete with other companies. These investments in research and development often require loan money. Especially when it comes to a young company.
With deflation, it is becoming increasingly difficult for a company to be sure that the results of development work will repay the loan money. In this case, taking a loan involves a higher risk than before.
The direct consequence is that not as much is borrowed and innovations that increase employment are reduced. This will further reduce productivity and employment.
As employment declines, people have less money at their disposal, so they also spend less.
When companies that produce products and services lose customers, there are no longer enough jobs for all the employees of the companies. Then employment will continue to fall – and a vicious circle has emerged.
Government spending increases as the number of recipients of unemployment and other benefits increases. At the same time, government revenue is declining as tax money from work is declining.
So, at worst, deflation can lead to a recession.
The cruel history of deflation
In addition to the recession, the unemployment brought about by deflation increases people’s frustration with the economy and political decisions. If the situation develops bad enough, despair can get people to grab straw that they would not otherwise grab.
This was the case in 1930s Germany when Adolf Hitler gained popularity with his promises of a better world.
The Germans had been afraid of explosive inflation in the 1920s – a time when banknotes were being used as a lighter – and wanted to avoid another inflationary catastrophe at any cost.
This led to economic deflation. With deflation, companies went bankrupt, many became unemployed.
Poverty and unemployment were fertile ground for promises of new jobs and a sound economy. Indeed, Hitler took advantage of the despair of the people in pursuing political goals.
While deflation was, of course, not the only reason for Hitler to rise to power, one thing is clear. There are compelling reasons to avoid deflation.
Once we have accepted inflation as a mandatory evil (because deflation would be even worse, as we have just learned), we can focus on protecting our savings from it.