Deflation 101

How Declining Costs Hurt the Economy

Deflation 101
August 18, 2014

If given the choice of paying more or less money for an item you are considering purchasing, you will naturally choose to pay less. Most of us go to extraordinary lengths to pay less money for the things we buy, especially big-ticket items like cars, furniture and home entertainment systems.

Given these facts, it would seem to follow that lower prices are better than higher prices — right? While this might be true for the purchases made by each individual consumer, it is not true when applied to the U.S. economy as a whole. In reality, falling prices are one of the most dangerous conditions that can befall any economy.

Why Deflation is Bad

When the general price level of goods and services in an economy is decreasing, this is referred to as deflation. It is the exact opposite of inflation, which is defined as a sustained increase in the general level of prices for goods and services. Deflation occurs when the rate of inflation — which is measured in the U.S. economy by changes in the Consumer Price Index (CPI) — falls below zero percent. This is also referred to as negative inflation.

So, what’s so bad about deflation, anyway? After all, isn’t it a good thing if people can buy stuff for less money? On a micro level, yes it is. If you can buy a new flat-screen TV and surround sound stereo system on sale for $2,000 instead of $2,500, you will benefit by keeping an extra $500 in your pocket.

However, what is true at the micro level does not always translate to the macro level. When the general prices of all goods and services in an economy are falling, instead of rising, this is usually a sign that the economy is weak. Moreover, it can lead to a number of unwelcome economic scenarios, ultimately resulting in economic stagnation and a deflationary spiral if it goes unchecked for too long. Here is how this deflationary spiral often looks:

In a weak economy, the unemployment rate is higher than normal, forcing many people to work for lower wages than they would like. Since they are earning less money, people are not able to buy as many goods and services as they could when the economy was healthy, so businesses cut their prices to try to stimulate sales. From here, human psychology starts to take over and the deflationary spiral deepens.

As they see prices falling, many people hold off on buying things (especially big-ticket items) because they realize that they will probably be cheaper tomorrow than they are today. So consumer spending slows down, which weakens overall consumer demand and lowers economic growth, which is what caused the deflation in the first place. In the meantime, business profits become stagnant or fall, so companies stop hiring workers, exacerbating the unemployment problem. In effect, the deflationary spiral becomes self-perpetuating.

What Deflation Looks Like

The recent economic history of Japan offers a real-world look at the long-term effects of deflation on a nation’s economy, as the island nation has been in a deflationary spiral for about twenty years. A string of events led to Japan’s long-term battle with deflation — they include the bursting of an asset (primarily equities and real estate) price bubble in the early 1990s, the failure of many Japanese businesses in the wake of this burst bubble, and the failure of many Japanese banks that lent to these businesses.

Unfortunately, there are fewer tools available to central governments to try to combat deflation than there are to fight inflation. The best way to ward off inflation is to raise interest rates, which helps to cool down the economy when it heats up too much and prices start rising too fast.

However, taking the opposite approach and lowering interest rates does not necessarily help eliminate deflation. Japan lowered interest rates to near zero in 2001 and kept them low for about five years, with no discernable effect on deflation. In 2013, the Bank of Japan began aggressively pumping money into the economy to try to reverse its stubborn deflationary spiral. In addition, in April, Japan increased the national sales tax for the first time in 17 years from 5 percent to 8 percent in order to lift prices overall.

So far, these steps appear to be working: Core consumer prices in Japan rose in April at the fastest level in 23 years (3.2 percent), leading some economists to declare that deflation in Japan may finally be dead.

A Counterintuitive Concept

While the concept of deflation and its potentially damaging effects on the economy is counterintuitive for many people, its impact can be devastating. The key to understanding it is to think about lower prices at the individual and national levels separately.

At the individual level, it is good to pay lower prices for most of the things you buy. This saves you money and increases your overall buying power. However, when the overall level of prices on all the goods and services produced in a nation is falling, this can lead to a wide range of unwelcome economic scenarios — the worst of which is a long and painful deflationary spiral.

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