Deflation in the Spanish Property Market
December 2nd, 2008
According to economists, the Spanish property market is experiencing “deflation” – a decline in prices, caused by a reduction in the supply of money or credit. There are four possible causes of deflation, and the Spanish property market is experiencing three of them:
- Decreased supply of money
- Increased supply of goods
- Decreased demand for goods
- Increased demand for money
How does deflation work? Let’s assume that there are ten equally desirable Spanish homes for sale and ten €1.00 notes available to purchase them with. We can safely assume that each home will sell for €1.00.
If the quantity of money increases to €20 (without increasing the number of homes) the price of each home will increase to €2.00 – that’s inflation.
If the quantity of money decreases to €5.00, house prices will fall to €0.50 each (deflation). The supply of money may reduce because it genuinely isn’t available, or because those who have it don’t want to spend it.
Instead of having ten homes, let’s build ten more. Now there are twenty homes and only €10.00 – once again each homes is now worth €0.50.
What about the demand for homes? If everyone already has a home, and no one needs another, house prices will also fall as sellers compete to find buyers.
The demand for money is measured by how much people are willing to pay to borrow it – reflected in interest rates. If inflation is high, interest rates rise to compensate for the loss of purchasing power.
If the demand for money rises, banks charge more to lend it. If the demand for money falls, interest rates also fall.
Currently, in Spain – three of the four causes of deflation are active:
- There is a decreased supply of money because banks aren’t lending as freely as they once did.
- There is an oversupply of homes thanks to excessive building.
- There is a decreased demand for homes – thanks in part to the global nature of the credit crunch.
Even though the demand for money is high (the fourth cause of deflation), people can’t afford to borrow at the current rates, because supply is still low.
Deflation itself is neither good nor bad. The cause of deflation dictates whether people will suffer or rejoice. When deflation is caused by a decreased supply of money – as is the case now, and was the case in the Great Depression – people suffer.
In 1929, the stock market crash sucked all the liquidity out of the economy. The economy contracted, people lost their jobs and banks stopped lending because people were defaulting on loans. The problem compounded as more people lost their jobs and the supply of money fell further – causing more people to lose their jobs – on and on in a vicious cycle.
What happened next? Many believe that the Great Depression of the 1930′s was relieved by the US taking part in World War II. At that time, the US government instituted massive deficit spending, and the conscription of all able bodied men created a full-employment economy.
After the war, new social programmes and a global need for goods and services to ‘rebuild’ provided sufficient movement in the economy to largely repay the war spending and fuel the economy in the 50′s to new levels of prosperity.
After the war, governments recognised that they had paid a high price for the revival of the economy. They postured that full employment and a livelier market could have been achieved without the massive war spending, destruction of property, and lost lives.
In 1951, the European Union was created at the signing of the Treaty of Paris – designed to prevent future, costly war in Europe by integrating its members economically.
This week, with news of a €200 Billion stimulus package to jolt Europe’s economy out of recession, there’s evidence that European leaders have heeded the costly lessons of the 30′s, 40′s and 50′s.
Whatever the effectiveness of this particular initiative, whatever its impact on the troubled Spanish property market, whatever its effects on deflation – this is a far better solution than the one adopted in 1939.
Sources:
- What is deflation?
- The end of the Great Depression
- The impact of WW2 on the economy
- The Treaty of Paris
- EU proposes 200Bn Euro stimulus package
Martin Dell, Kyero.com
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