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On the surface deflation sounds wonderful. Rather than rising prices, deflation results in declining prices. In this way, purchasing power rises, effectively giving everyone a pay raise. Better yet, deflation is accompanied by near zero interest rates making borrowing cheap. What on Earth could be better! It turns out, almost anything.
When people expect falling prices, they wait as long as possible before making large purchases, such as a car or a house because the longer you wait the cheaper the item becomes. Similarly, deflation breeds a strong desire on the part of households and firms to hold cash as it continually appreciates. By contrast, inflation creates an incentive to spend since cash falls in value over time.
Deflation is not simply falling prices, which can be good, but is also characterized by falling wages, not so good.
In a deflationary environment, due to a lack of demand for goods and services, firms fight for market share by slashing prices. By doing that, total revenue falls, forcing firms to pay workers less. However, since reducing wages of existing employees is hard, companies first hire fewer workers, then lay workers off, which leads to stagnant wages and eventually rising unemployment, which forces workers to accept lower wages.
Deflation also creates a reluctance to borrow, since loans have to be repaid in future dollars that are worth more than those borrowed. Think about it – if you have a mortgage payment that is $750/month and inflation is 4%/year and your income keeps up with inflation, your mortgage payment becomes a smaller and smaller percentage of your monthly income. But if deflation is 4%/year and your income falls by that amount each year, that $750 mortgage payment can quickly loom large and dramatically crimp spending.
As a result, borrowers find that the real amount of their debts rise over time. In response they save more to compensate and in the process spend less. Of course, lenders are better off, but they do not increase their spending by as much as debtors decrease theirs. As a result, overall spending levels decline more.
Exacerbating this problem, in a deflationary economy banks have little incentive to lend, as the only way to entice borrowers is to offer negative interest rates. But in this case, the more banks lend, the more they lose. As a result, banks do little lending, firms struggle to grow and many of both fail, causing wages to fall. In the end, consumers buy little more than essentials and everyone holds on to as much cash as possible. Not a pretty picture.
Lastly, deflation makes it essentially impossible for central banks to set interest rates low enough to stimulate demand. While central banks can set rates at 0%, it’s hard to get below zero. With inflation of 3%, a zero interest rate is a -3% real interest rate. But with -1% deflation, a central bank would have to offer an interest rate of -2% to achieve the same -3% real interest rate. While theoretically possible it’s impossible in practice.
Because of chronic falling wages, reduced spending and limited lending, deflation is something to be avoided. Once it takes hold, it’s inordinately difficult to get rid of. Japan has been struggling with deflation for decades and is now employing desperate measures to eliminate it, with limited success and high costs. We don’t want to wind up like Japan.