Admin

Five Reasons To Fear Deflation

The deflation scare is back, as Jon Hilsenrath and Brian Blackstone report on the front page of The Wall Street Journal. It’s worth taking a moment to contemplate why deflation is such a bad thing. After all, falling prices sound appealing to consumers, especially compared with the alternative of higher prices.

So why worry?

Here are five reasons:

1. Deflation is a generalized decline in prices and, sometimes, wages. Sure, if you’re lucky enough to get a raise, your paycheck goes further–but those whose wages decline or who are laid off or work fewer hours are not going to enjoy a falling price index.

2. It can be hard (though, as we’ve seen, not impossible) for employers to cut nominal wages when conditions warrant;  it’s easier to give raises that are less than the inflation rate, which is what economists call a real wage cut. And if wages are, as economists say, marked by “downward nominal rigidity,” then employers will hire fewer people.

As Paul Krugman put it in 2010: “in a deflationary economy, wages as well as prices often have to fall–and it’s a fact of life that it’s very hard to cut nominal wages. … What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines. See Estonia and Latvia, cases of.”

3. As economic textbooks teach, the prospect that things will cost less tomorrow than they do today encourages people to put off buying. If enough people do that, then businesses are less likely to hire and invest, and that makes everything worse.

4. Deflation is terrible for debtors. Prices and wages fall, but the value of your debt does not. So you’re forced to cut spending. This applies to consumers and to governments, and it is one of the biggest issues in Europe right now. As Yale University economist Irving Fisher wrote decades ago, debtors are likely to cut spending more than creditors increase it, and this can turn into a really bad downward spiral. (The experience of Japan, though, proves that an economy can have a prolonged period of moderate deflation without falling into that downward spiral.)

5. Cutting interest rates below zero is very hard. Yes, one way that central bank magic works is that the Federal Reserve and the European Central Bank cut inflation-adjusted interest rates below zero when times are bad, hoping to spur borrowing, spending and investment. But it’s almost impossible for them to cut rates below zero. (Sure, there are some examples of negative interest rates, but they’re not very negative.)

If there’s 4% inflation, a zero interest rate works out to a -4% real (or inflation-adjusted) rate. At no inflation, a zero interest rate is, well, zero. And with deflation, a zero interest rate is a positive real rate. Deflation just makes all this harder to do. When short-term rates hit zero the Fed turned to buying all those long-term bonds in what’s known as “quantitative easing,” or QE. But there is a lingering debate about how well QE works, and its side effects, and as the ECB demonstrates, there are political obstacles to launching QE that don’t apply to simply cutting interest rates.

Once upon a time,  the U.S. and other economies seemed so prone to inflation that even low rates of inflation didn’t provoke fears of deflation. “Today that belief in an inflationary bias is gone, or at least greatly attenuated,” Berkeley’s Brad DeLong observed in 1999. There are still some people fretting that, given all the money the Fed has pumped into the economy in quantitative easing, inflation is just around the corner. But today, the bigger fear–especially in Europe–is just the opposite.

Courtesy of Brookings

E-mail me when people leave their comments –

You need to be a member of StockBuz to add comments!

Join StockBuz

We welcome you to post a blog entry, oped or share your daily reading with us as long as it is relevant to the topic of investing and not an attempt to sell a product, proprietary strategy, platform or other service. Please provide links to any research data and if re-posting other articles, give credit where credit is due providing a back link to the original site.

300 words minimum per post. You may also sort by category or search by topic. Don't forget to comment and please "share" via Facebook, Twitter and Google+. If you have any questions, please contact us.

FOLLOW STOCKBUZ

__________________

This is a member-supported site. Please donate when you can to help pay the rent. Thank you!

Stay Informed. Sign up for the FREE StockBuz eNewsletter

________________

Investing involves substantial risk. All content is subject to StockBuz disclaimer.

Create Income With Option Spreads

All content on StockBuz.net is subject to disclaimer and Terms of Service