The reduction of prices seems to be an ideal economic scenario. But when the price drop becomes massive, the consequences can be devastating.
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Written by: Miodrag Šajatović
[email protected]
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In conditions of deflation, the worst part is that those who have money do not want to spend it because it is worth more day by day.
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In inflation, one hundred thousand kuna at the beginning of the year is worth five or ten percent less by the end. In conditions of deflation, for that one hundred thousand kuna at the end of the year, one can get five or ten percent more goods than at the beginning.
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Croatian writer Slavko Kolar published the story “Crisis” in 1931. The main character, farmer Mika, who takes the bull Jelena to the fair, painfully realizes that the Great Depression from America has moved to Croatia. Unsatisfied with the price offered for Jelena, he takes him back to the stable. The following week, prices at the fair are even lower. Only then does the main character refuse to sell the bull. Prices are falling week by week. In the end, the bull, ‘parked’ in front of the municipality, wanders off…
Kolar is often said to have frequently written about social themes. This story excellently describes the economic phenomenon about which the general public in today’s Croatia, including the business community, knows almost nothing. It is about deflation.
This is a state in which prices generally fall. Deflation is the opposite of inflation, and however desirable it may seem to the average person that goods and services become cheaper – the deflationary spiral is equally dangerous for the national economy as inflation. Simply put, inflation is excessive ‘fattening’ of prices, while deflation is uncontrolled, excessive ‘thinning’.
It may seem misplaced to dedicate an article to such an exotic economic phenomenon as deflation in the week when Barack Obama became the first African American president of the USA. But it could happen that one of the unexpected troubles Obama will face is precisely deflation. Consequently, such a scenario is possible in other countries around the world, and Croatia should not be excluded.
This is confirmed by the cover of the Financial Times from November 3, which states: Can deflation be the next shock for the financial system? There are enough reasons to doubt that prices could start falling so much that it eventually turns out they are generally in the negative. From the drastic drop in oil prices, raw materials like steel, food, to the prices of houses and apartments.
As a consequence of the financial crisis worldwide, demand for all types of goods and services is dramatically and rapidly decreasing. The global economy is cooling from a five percent growth to barely three percent per year. A multitude of producers reacts to the drop in demand with panic price reductions. Inflation is rapidly melting away.
At first glance, price reductions are a great thing. But when it becomes massive and turns into deflation – things become very serious. Banks, entrepreneurs, and individuals adjust their behavior. They hold cash and do not want to buy or invest. Why would they? If the price per square meter of an apartment, for example, drops from 2,200 euros to 1,900 in three months, that is a reason to buy. But if further price drops are expected, why buy at a higher price? One should wait. Such behavior from potential buyers drives builders into bankruptcy. The bank can only collect the loans it has given by taking the houses or apartments, but what good is that if it cannot sell them in a market where buyers are waiting for further deflation.
Japan, which fell into a similar deflationary spiral, struggled throughout the 1990s with escaping deflation that prevented greater GDP growth.
Deflation is also tricky for central banks. In conditions of inflation of, for example, six percent, the monetary authority can reduce interest rates on loans from four to two percent and thus stimulate investments. But if the price growth is, for example, minus three percent per year, interest incentives become impossible.
Additional money can be printed, but those who get their hands on it will not spend it. In inflation, one hundred thousand kuna at the beginning of the year is worth less by the end. In conditions of deflation, for that one hundred thousand kuna at the end of the year, one can get more goods than at the beginning.
It should be acknowledged that in the highly monopolized Croatian economy, the danger of deflation in the first phase is not so great, but if the price drop affects a larger part of the world, it is not unimaginable to foresee a meeting of the Price Monitoring Commission where the Prime Minister states: ‘Among you are irresponsible individuals who unjustifiably lower prices and thus encourage deflation.’ And the accused entrepreneurs justify themselves: ‘Mr. Prime Minister, we are not to blame for prices being lower. This is imported deflation!’
Today, this seems like a good joke, and there will be analysts who will argue that such a scenario is impossible. These will be the same ones who until recently claimed that there was no chance that the world and Croatia would fall into recession.
