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What’s the Deal with Deflation?
By JLP | December 4, 2008
I’ve been reading more and more about the threat of deflation. What’s deflation? I can’t find a better definition for it than what’s in the Barron’s Finance and Investment Handbook
DEFLATION decline in the prices of goods and services. Deflation is the reverse of inflation; it should not be confused with disinflation, which is a slowing down in the rate of price increases. Generally, the economic effects of deflation are the opposite of those produced by inflation, with two notable exceptions: (1) prices that increase with inflation do not necessarily decrease with deflation—union wage rates, for example; (2) while inflation may or may not stimulate output and employment, marked deflation has always affected both negatively.
In other words, deflation is not a good thing even though price declines sound wonderful to the shopper!
Here’s a great little deflation tutorial if you’re interested: What is Deflation and Why is it Worrisome?
Are we headed for deflation? I have no idea. I think we’ve already seen it in housing and oil prices. Will we see it in other areas? I don’t know. I think it depends on how high unemployment goes.
Nouriel Roubini is expecting stag-deflation (stagnation/recession + deflation)…that doesn’t sound so good.
Topics: Economics | 7 Comments »
December 4th, 2008 at 12:02 pm
I would urge anyone who thinks deflations sounds great because their “stuff” costs less to ask themselves one simple question:
How would you feel if your salary went down as well?
One of the reasons home ownership is such a good financial move (provided you can afford it…) is that inflation will make that mortgage payment cost less over the years. You’ll likely be making more in 10 years than today (with inflation) but your fixed rate mortgage payment will have stayed the same, and now take less of your income. That doesn’t happen with deflation. Deflation would make your mortgage more expensive.
December 4th, 2008 at 12:18 pm
Deflation means that your dollars (cash) can buy more stuff. This leads people to the thought “why should I buy this ____ now when I know it will cost less in the future?” This causes spending to decrease, leading to less money available for salaries, then layoffs, and back to less spending.
This is the reason that (mild) inflation is more preferable. As an aside, deflation leads to the rich (people with lots of cash) getting richer (can buy more stuff); while inflation leads to the poor (people with debt) becoming richer (cash used to pay off debt is worth less). Thus inflation is a form of tax on cash while deflation is something like a poor tax.
December 4th, 2008 at 12:24 pm
Deflation is the necessary result of inflation. Banks and government having created money out of thin air (inflation) have to stop when their actions start to devalue the dollar (runaway oil and gold prices) and foreign investors threaten to divest themselves of dollars and use more stable currencies. (that would be a bad thing)
Inflation has artificially bid up some assets (more dollars chasing fewer goods). When the inflation stops demand stops and asset prices begin to fall. The money having been created out of thin air returns to thin air and there is less money. This is what causes the drop in prices.
So deflation is bad but without inflation there would be no deflation and inflation is a willful act by government and the banks.
December 4th, 2008 at 12:56 pm
I don’t see any way we will enter a deflationary period given the government is printing money around the clock to keep up with the bailouts.
Look for inflation over the next 18 months simply because of the influx of cash.
December 4th, 2008 at 1:18 pm
Adam,
I understand what you’re saying but somehow I just don’t see the general public looking at deflation like that. Maybe I have too little confidence in the mindset of Americans but I just don’t see people putting off purchases because they will be cheaper in the future.
December 4th, 2008 at 2:06 pm
The deflationary period that we are experiencing it going to be temporary, until the assets are liquidated (houses, cars, etc).
Then, we are going to see a major uptick in imflation because of the massive increase in money supply that our government is creating.
It’s not going to be a good story to tell our grandchildren. First, deflation is causing us to lose our assets (houses, cars) and jobs. Second, we are going to have major inflation as the dollar sinks.
December 7th, 2008 at 8:12 pm
JLP, while the American public may not defer purchases, in this market, it is more likely they will simply reduce spending and increase saving. This will have exactly the same effect with a reduction in production and employment leading to less money leading to less demand and lower production and employment.
While the printing of money may reduce the impact, even that is unlikely if banks are using the money to shore up their balance sheets as opposed to lending it out to customers.
I think deflation is a serious issue, especially if credit card debt blows up in the same way as the mortgage debt leading to further financial strife…
But hey, that’s just my opinion