OK, here's why deflation is also a very bad thing


November 02, 2008|By JAY HANCOCK | JAY HANCOCK,jay.hancock@baltsun.com

A reader asks: Could you explain what is bad about deflation? I understand why inflation is bad, and I presume that deflation is the opposite of inflation. If so, why is it bad if my money is increasing in value rather than decreasing?

The short answer is that deflation, like inflation, can kill demand and productive economic growth.

Deflation is a persistent and broad decrease in prices. It arrives when there is too much supply, especially of capital goods, and too little demand. (The real estate market, with 11 months' supply of empty homes trying to get sold, is the primo example.)

When supply or productive capacity is too great, companies cut prices. Lower prices mean lower profits. Lower profits cause debt defaults and layoffs, which reduce demand even more. Perhaps the most damaging deflationary outcome is when consumers stop spending because they see prices falling and figure what they want will be cheaper in six months. So they wait. Then they may wait another six months, especially if they just got laid off. This puts new pressure on companies, and it becomes a vicious cycle.

There is no macro deflation yet in the U.S. economy. True, car and house prices are falling. But it's not deflation until there is a persistent fall in the overall Consumer Price Index.

Last week's interest-rate cut by the Federal Reserve was intended to flood the economy with money, spur borrowing and demand, and forestall deflation. Eventually it will work.

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