Deflation is often talked about but a very rare occurrence. Basically, deflation is a general and relentless decline in prices. Doesn’t this sound good? Well, it may sound great…as prices go down, your dollar buys more goods. Those with jobs or money see their value going up. The longer they wait the greater their potential profit.
However, while deflation might give many a short term gain, it is very damaging to the overall economy.
When declining prices are widespread and sustained, this will produce a cycle of economic contraction. Simply put…faltering consumption leads to reduced production. As demand for any product shrinks, businesses must reduce their payrolls. Then these unemployed workers have no money to spend and this further exacerbates the reduced consumption situation.
This very kind of cycle is one way that recessions turn into depressions.
During the Depression, the failure of almost a third of US banks crippled the supply of money in the economy. With far fewer dollars circulating in the economy, prices crashed. People were forced to barter for goods instead of buying. In some places local governments even tried to create their own currencies to replace scarce dollars.
Something similar to the Depression is happening now. Banks are restricting credit to financial institutions and consumers. Cars and houses that are available for sale with borrowed money are unsold.
Demand falters when consumers are afraid for future jobs and income. They postpone or eliminate consumption. This reduction can become widespread if the slowdown is severe enough. The more widespread the price declines, the more dangerous for the economy. When price declines affect almost everything, consumers will anticipate a lower future price and postpone purchases. Inflation promotes current consumption in place of future consumption because goods are bought sooner in anticipation of higher prices in the future. Likewise, deflation is focused on future consumption when prices are expected to be lower.
The anticipation of lower future prices can become general in economy. At this juncture, if consumers add anticipation of lower future prices to the current layoffs, and lost wealth in stocks and home equity, the potential affect economic growth becomes huge.
Falling consumption means fewer goods produced and this will generate cutbacks in production and employment as producers are forced to match output to sales. This is a true spiral of declining production, employment and consumption.
The only way to avoid the spiral generated by deflation is for governments and central banks to print and spend money. The Fed has created trillions of dollars in the past year in many attempts to rescuing the banking system. President-elect Obama has talked of a stimulus package of more than $500 billion.
Inflation, deficit spending, and very low interest rates are the tools the government is using to fight this deflation. It is absolutely no wonder the dollar has lost heavily in the past several weeks.
