Deflation

8 Economics Lessons #7

Inflation is bad; deflation, or steadily falling prices is much worse.

- Charles Wheelan in Naked Economics

Deflation begets a dangerous cycle. Falling prices cause consumers to postpone purchases, waiting for big ticket items to get even cheaper. Of course, asset prices fall as well which leaves consumers feeling poorer and makes them less willing to spend their money. (The book's example is imagine if the value of your home is falling, but your mortgage payment stays the same. Do you think this would affect your purchasing decisions?) This will lead to a deflationary spiral which will cause severe damage to the economy.

The biggest problem with deflation is that monetary policy does not appear to help. Starting in the early 1990s, Japan began a long battle with deflation. The central bank in Japan would eventually cut interest rates to zero, and yet the problem persisted. (This is the dreaded liquidity trap.) Still, the rental rates (the rates on real consumer lending) didn't fall as much. Why? Well, when prices are falling, the money you pay back in the future will have more purchasing power than the amount you pay back initially. In effect, as prices fall, the cost of borrowing increases. 

How do you fix the problem? Most economists believe that Japan needs a good, steady dose of inflation. In other words, money should be put into the economy as fast as possible. (If you choose to read that as government spending, I won't argue with you.) We had our own battle with deflation from 1929 to 1933 and an inactive Fed allowed the money supply to decrease. We should have been spending more from the start. Of course, starting with the New Deal, we would spend more and things would start to get better.

Previous Entries in This Series (Globalization, Deficits and Surpluses, Fiscal Policy, Supply-Side Economics, Externalities, Regulation)