Does deflation harm the economy?

Last updated 8 min read

Deflation is a general fall in the price level. Many policymakers and economists see it as a serious threat. Former Fed Chair Ben Bernanke warned that persistent deflation “can be highly destructive for a modern economy and must be strongly resisted.” Central banks around the world try hard to prevent falling prices. Economists from the Austrian School argue, however, that the common fear of deflation is often exaggerated. In their view, the impact depends on the cause. In many cases, falling prices can be positive in principle, while aggressive central-bank countermeasures may do greater harm.

What is deflation?

In economics, deflation means a sustained decline in the price level for goods and services. With the same amount of money, you can buy more over time. Money’s purchasing power rises. In other words, it is negative inflation when the inflation rate is below 0%. Deflation is usually measured with price indices such as the consumer price index (CPI), which tracks a basket of goods. If the average prices in the basket fall over a period of time, we speak of deflation.

Note: In the past, deflation was often defined more narrowly as a contraction of the money supply (vs. inflation as an expansion). Since the mid-20th century, usage has shifted; today, deflation usually means a fall in the general price level. In practice, money supply and prices often move together, but the distinction matters across schools of thought.

Modern economies more often see mild price increases (inflation) than lasting deflation. Central banks such as the US Federal Reserve or the European Central Bank (ECB) usually target around 2% inflation and use monetary policy to avoid persistent deflation. Deflation is rare today largely because monetary policy acts against it.

What causes deflation?

Deflation can have different causes. Prices tend to fall when supply rises, demand falls, or the money/credit supply shrinks. Possible drivers include:

  • Productivity gains and growth. If an economy becomes more efficient, technology lowers production costs, or there is oversupply, prices can fall even while the economy grows. The Austrian School calls this growth deflation. A historical example: after the US Civil War, prices fell for about 30 years without stopping economic growth. They fell because growth was strong. This productivity-driven deflation lifts living standards because goods become more affordable.
  • Demand decline (recession). In a downturn, households and firms spend less (pessimism, lower incomes, higher saving). Sellers cut prices to clear inventories. During the COVID-19 shock in 2020, demand collapsed due to lockdowns and uncertainty. Consumer prices fell sharply in March 2020, the biggest drop in years. Economists warned that firms would drop prices to generate demand. Such demand-driven price drops often come with rising unemployment.
  • Monetary deflation (money/credit contraction). Prices can also fall when the money or credit supply shrinks. With less money circulating, money becomes more valuable relative to goods, so prices must fall. A classic case is the Great Depression of the 1930s, when US bank failures and panic cut the money supply by roughly 30%. In the Austrian view, such credit deflation usually follows a credit bubble. After excessive credit growth and malinvestment, the bust arrives. This form of deflation cleans out overinvested excesses. It is *painful, but it removes distortions. Austrians argue that credit deflation *appears only after an artificial boom driven by cheap money. When that boom collapses, broad price declines help bring the economy back into balance.
  • Government actions. Deflation can also be administrative, for instance enforced price controls downward or currency reforms that withdraw money. These cases are rare. From an ethical Austrian perspective, such forced deflation is “bad” because prices do not fall through natural market processes. In practice, state-ordered price cuts are uncommon today. Governments more often tolerate inflation to reduce debt rather than pulling money out of circulation. In short: Deflation can arise “naturally” from market forces (higher productivity, lower demand) or from monetary factors (money/credit contraction). For the Austrian School, the key is why prices fall. “Good” deflation (efficiency gains) is harmless and even welcome. “Bad” deflation (after a credit boom) is painful but can be a necessary correction.

Economic effects of deflation

The impact depends on the type and duration. Public debate often focuses on negative scenarios, especially the deflationary spiral, where falling prices lead to further economic weakness. A simplified logic is:

Deflation: a general drop in prices can be harmful in a downturn because households and firms delay purchases, expecting still lower prices.

These effects can occur. But Austrians argue that not all deflation is the same. The question is whether price declines come with real-economy problems or not. Productivity-driven deflation directly raises purchasing power and lowers living costs. Falling prices then create wealth effects: the same income buys more goods and services. Often, productivity and incomes rise together. Wages might be flat or fall slightly, but if costs and prices fall faster than wages, real wages rise. A well-known example is consumer electronics: prices fall (computers, TVs), quality improves, adoption spreads (without the sector collapsing). Local price deflation in single sectors (for example tech) is normal in a healthy, growing economy.

It is different with economy-wide deflation during a crisis. If it follows a burst bubble or demand shock, short-term effects often include recession: higher unemployment, lower investment, and firm failures. Austrian economists admit this credit deflation is painful, but they emphasise its cleansing role. Malinvestments are liquidated faster. Unprofitable firms shrink or exit. Overpriced assets (for example property after a bubble) fall to sustainable levels. Resources are freed from unproductive uses. This sets the stage for healthier recovery. Murray Rothbard argues that the US recession/deflation of 1920–21 was brief because the government largely stood aside. Prices, wages, and structures adjusted quickly, and recovery followed within months. By contrast, the Great Depression from 1929 became deep and long, because policy tried to avoid painful adjustment. President Hoover kept wages and prices artificially high, blocking necessary changes, and the Federal Reserve was slow to stop the money-supply collapse. From the Austrian view, this intervention to allow adjustment turned a severe but normal deflation into a crippling “deflation crisis.”

Positive effects of deflation

Outside crisis extremes, moderate deflation can have benefits. It raises consumers’ purchasing power and can even support spending in the short run. Lower prices encourage bargains and help households buy more or save more. Deflation also favours savers and creditors: cash holdings and loans made to others gain real value. Debtors lose, since their debts become heavier in real terms. Austrians say this helps explain why governments fear deflation: the state is usually the largest debtor and benefits from inflation, while deflation makes it poorer in real terms.

Austrians also challenge a common belief: that in a deflationary world no one would invest. A business owner might hesitate if selling prices keep falling. But the profit margin is what matters. If costs (wages, inputs) also fall enough, profitable projects can exist even with falling prices. Economist Philipp Bagus notes that an investor will invest under expected deflation as long as the real return is positive.

Example: if the price level falls by 2% per year but a company earns a 5% return, the real gain is still 3%. Equity financing or using existing savings can also be attractive, since the money repaid later is more valuable. The blanket claim that deflation kills investment is too simplistic.

That said, persistent, broad deflation in a stagnant economy can be harmful (weak demand, unemployment, financial stress). History and Austrian theory suggest the context matters. Mild, productivity-driven deflation is not a reason to panic - it is often a sign of progress. The biggest danger is trying to prevent any deflation at all, which can keep bad incentives alive (“zombie firms” under artificially low interest rates).

Final Thoughts

  • Deflation is a general fall in prices (money’s purchasing power rises). Opposite of inflation. In practice, intentional inflation is more common today.
  • Causes: productivity and supply growth, weak demand in recessions, shrinking money/credit - often in combination.
  • Effects: in downturns, risks include unemployment, firm failures, and a deflationary spiral: the mainstream fear of long-lasting deflation.
  • The Austrian School distinguishes “good” (productivity-driven) from “bad” (credit-bust cleansing) deflation and warns that heavy countermeasures can create zombie firms. History shows both growth-with-deflation (late 19th century) and crisis deflation (1930s).

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