Wednesday, June 9, 2010

Why Deflation is Bad

I know the UK has inflation of 3.7%, but deflation is a potential problem around the world. In April of this year:
  • US core consumer prices rose by a mere 0.9% - lowest rate for many years
  • In the euro area they rose by 0.7%.
  • And in Japan, which has battled falling prices for more than a decade, they fell by 1.5%.
- Japan now has the same Nominal GDP now as in 1992. see: Deflation in Japan

It may seem good if prices fall, but generally falling prices is bad for the economy. The only real exception is when falling prices are due to rising productivity and technological innovation.
This is why deflation is considered harmful to the economy.
  1. When general prices are falling, consumers tend to delay purchasing. For example, rather than buy a flatscreen today, they wait a year when they will be cheaper. The effect of falling prices is to depress consumer spending leading to lower economic growth.
  2. Increasing real value of debt. When people take on debt like mortgages, they expect the value of the debt to be steadily eroded by inflation. (A mortgage becomes easier to repay as your wage increases). When there is deflation, the real value of debts increases. You owe the same, but, your wage is falling. Therefore, you have to spend a higher % of your income on servicing the debt
  3. Increasing Government Debt to GDP ratio. Deflation also increases the real value of government debt. It makes it much more difficult to reduce the debt to GDP ratio. Thus countries can start spending a higher % of income on debt repayment. Furthermore, as deflation tend to reduce economic growth, the cyclical deficit increases. This lack of nominal GDP growth is a key factor in why markets dislike the Greek situation.
  4. Real Wage Unemployment. Wages are often sticky downwards. (Unions resist nominal wage cuts). Therefore, falling prices are often not met by falling wages, leading to a rise in real wages. This creates real wage unemployment. It also makes a countries exports less competitive (particularly a problem in the Eurozone where countries can't devalue the exchange rate)
  5. Monetary Policy Becomes ineffective. With deflation, zero interest rates may be too high. Even quantitative easing may be insufficient to get people spending. (deflation and monetary policy)
Further Reading

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