dollarvigilante.com / by Robert Blumen / February 7th, 2013
What is deflation?
According to dictionary.com, it is “a fall in the general price level or a contraction of credit and available money”.
Falling prices. That sounds good, especially if you have set some cash set aside and are thinking about a major purchase.
But as some additional research with Google demonstrates, that would be a naïve and simple-minded conclusion. It quickly becomes evident that deflation is a serious economic disease. According to the St Louis Fed,
“While the idea of lower prices may sound attractive, deflation is a real concern for several reasons. Deflation discourages spending and investment because consumers, expecting prices to fall further, delay purchases, preferring instead to save and wait for even lower prices. Decreased spending, in turn, lowers company sales and profits, which eventually increases unemployment.”
The problem with deflation is that it feeds on itself, destroying an economy along the way. It is the macro equivalent of a roach motel: perilously easy to enter but impossible to leave. The problem, you see, is that deflation reduces consumption, which reduces production, eventually shutting down all economic activity.
Wikipedia explains it this way:
“Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity. Since this idles the productive capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral.”
Deflation is far worse than its doppelgänger, inflation, because the Fed can fight inflation by raising interest rates. Deflation is nearly impossible to stop once it has started because interest rates can only be cut to zero, no lower. For this reason, Ben Bernanke believes that monetary policy should be biased toward preventing deflation more than preventing inflation.
In case you’re not already scared straight, the deflationary doomsday has already happened in America when (according to the New York Times) it caused the Great Depression.
Japan, according to Bloomberg “has been battling deflation for more than a decade, with the average annual 0.3 percent decline in prices since 2000 damaging economic growth”. The New York Times reports that Japan’s new prime minister Abe “has galvanized markets by encouraging bold monetary measures to beat deflation”.
I hope that everyone is clear on this.
