We have already seen that commercial banks expand their balance sheets when they create loans and mortgages to people and firms. Then, this money can be further multiplied according to the fractional reserve mechanism.
The money that a bank makes available to the people, is money that people can spend on houses, goods and services, so, unless it is saved, it concurs to inflation of assets, goods and services. If there is contraction of the money that is lent out, then what happens next is simple: since the money of the interest has not been created yet, credit contracts, and the values of assets like houses decreases because people have not money to buy things. This is a very simple yet effective explanations.
Let's make it clear: this is not the only cause of deflation. Deflation, ie negative inflation, is caused by many drivers, like:
- Globalization, so well-paid manufacturing jobs moves to Asia or to developing countries: unemployment in Europe and USA raises, people have less money, and they cannot afford the same standard of living they used to have years before.
- Previous excess of credit: thanks to government and central banks policies, banks used to give credit to people who would hardly pay the debt back. Thanks to this kind of stimulus, people made debt over debt, until the values of the assets (houses, mainly) was so high that people could not pay the principal back with the interest. This is what happened in 2008.
- Credit has been mainly confined within the financial domain since 2008, ie too little money for long-term investment, Research and Development, real jobs. Thanks to financial deregulation, for banks it has been much more profitable and less risky to invest money into financial products for many many years in a row than to give credit to firms and enterprises, that could default. This has caused a huge disparity between the richness of finance, ie the banking system, and the people. A rich guy, who earns 1000 times an normal family, does not need 1000 mobile phones, 1000 houses, 1000 cars and so on. So, the shrinking of the middle class is one of the most important drivers to deflation.
- Robotics: this point is still not so known, but if in a factory you can replace 1000 workers with a few robots, you can understand that, unless the demand of products skyrocket because people with a decent salary are increasing in number, or the jobs created by the use of robots compensate for the loss of manufacturing labor, then things are going to cost less and less. Since there is overcapacity everywhere, a further excess of supply will only decrease the cost of the product. Unless China, India and others start consuming like developed countries and become net importers, no more net exporters. This will not be the case for many, many years to come.
- Shale oil and shale gas: this is part of technology innovation, again. There is a gut of oil supply thanks to new technologies and this situation may not reverse for some years.
The main reasons why we do not see inflation in USA and Europe, even now when Central Banks have put trillions of dollars, yens and euros into the banking system, is because this money has been confined to the bank reserves, invested in financial products, while at the same time globalization has kept salaries low and there is no more room for families to get extra debt: it is difficult to get a 40 years mortgage if you are 35. There is limit to the duration and entity of a debt, since an average family father cannot work for 50 years to repay a mortgage.
Can inflation raise again? yes, if:
1. Protectionism raises: if the USA start imposing tariffs on imported goods, inflation will raise, since the USA are dependent on China for many goods.
2. Central banks start putting money into people's bank accounts. People will start spending, and inflation will raise. Of course, they will buy China stuff, so China will be super happy of such a silly decision.
3. the USA decide to invest trillions in R&D, so in fields with a high added value, on repairing also bridges, roads, etc. So, if the USA starts to run important deficits. People, again, will spend more and will buy Chinese.
In any case, I decided to fix my variable mortgage rate for the house I have in Italy, and take a fixed mortgage rate. I think it is time to move from a Euribor indexed mortgage to a fixed one: even if interests should go down further, I think it is a wise move now to block the monthly payment to a known sum, which is now very low. I succeeded in getting 1.5% for a fixed rate mortgage, 13 years duration. It was 2,2 six months ago, so I think it is time to go for it.
And it is time to buy a house in the Netherlands: of course, at a discounted price, since there are many people who may go to retirement and need cash to provide for their pensions. Whether or not I can get a house at a 20%+ discount, that's another story.
It is also possible that between 2017 and 2019 another collapse may come, due to another eurocrisis, or to the students' and corporate debts in the USA. I don't have the crystal ball. So to get a 20% discount on the price of the house may also be a buffer for another real estate crisis.