Two Questions about Deflation

[Mike 03]

More frequently I'm hearing people discuss the possibility of deflation as opposed to inflation.

I've tried to understand the implications of deflation for a few months now, and even though I understand how it can inflict injury on an economy, I don't understand why it is "worse" than inflation. Specifically,

1. Don't falling prices actually help the economy by spurring consumer spending? In this sense, isn't Deflation a self-correcting mechanism, in a way that Inflation can't be?

2. Do wages contract in an deflationary environment? If this happens, then I can understand why it might be worse than inflation. But on the other hand, this might actually help weaker businesses survive by allowing them to retain employees during the deflationary period. And employees might temporarily accept a wage cut in an economic slump during which the price of everything is falling?

As you can see, I'm a little but confused.

Why is Deflation such a bad thing?

[AzDar]

1. " I don't know nuthin' 'bout birthin' no babies!! "...

Sorry. Too many Red Bulls.

[BootinUp]

2. not a financial expert but...

yes, wages do decrease in a deflation situation.

My belief is that there needs to be some deflation to correct for the bubble that just burst. And I am hoping that in todays market the deflation will not go into a death spiral but will catch itself. Things correct themselves much quicker today than in the past. Like oversupply and such. But I guess we shall see.

[Selatius]

3. Deflation hurts producers. Inflation hurts consumers.

That's the short-hand.

If employers had their way, they would cut worker wages quickly to keep up with deflation, but workers do not want to give up wages. They will fight tooth and nail for whatever they can gain in a deflationary environment.

This translates out into employers who will hire less workers because they cannot afford to take on new ones.

[Mike 03]

5. Hmmm. That wouldn't be very helpful, cutting wages. I'm beginning to see the conundrum.

Thank you.

[Warpy]

4. Prices fall because spending has stopped

usually for a reason completely unrelated to prices, like depressed wages, high debt burdens, and unemployment--sound familiar?

Prices fall because anyone caught with inventory wants to unload it for whatever they can get so that they can survive.

Prices fall even faster because unemployed and other economically stressed people compete with merchants by trying to sell anything they can in order to eat.

As ugly as inflation is, deflation is worse. Lower prices only spur spending when people have money to spend, something which is not the case now.

[Mike 03]

6. That's what I meant about "self-correcting." As consumers begin to consume again, wouldn't

that naturally push prices back up again (and wages, too) to where they belong? And it seems like it wouldn't take very long for this to happen. But I've never been through deflation that I can recall, so, I don't know.

[BootinUp]

8. What happens is the value of everything is dropping

and everyone jumps on the sell it now for whatever price bandwagon making it accellerate. Debts cannot be repaid because assets have lost their value.

[Mike 03]

9. Okay, I'm starting to understand this now.

Thank you, I appreciate it.

It does sound like a vicious downward spiral. It also sounds like a lot of businesses could fail if it gets to the point where they are just dumping inventory and lowering the wages of--or firing--the workers. That's not a good situation at all.

[Warpy]

12. No. Deflation turns into a vicious circle

with decreased demand leading to decreased employment leading to even more decreased demand, and so on.

The cycle can only be broken by putting unemployed people back to work and raising the wages of the employed to a liveable level.

Deflation has to be ended by reversing the cause: too few people with too little money to buy goods and services.

Don't assume people stay employed during a deflationary cycle. The jobs go first.

[BelgianMadCow]

7. Good question! I asked myself your n°1 as well. And I don't know either

:shrug:

We have an article in this weeks' Trends magazine stating exactly that : a deflationary cycle is under way. Gonna reread it now.

[BelgianMadCow]

10. well here's wikipedia on it - the answer to n°1

"While an increase in the purchasing power of one's money sounds beneficial, it can actually cause hardship when the majority of one's net worth is held in illiquid assets such as homes, land, and other forms of private property. It also amplifies the sting of debt, since-- after some period of significant deflation-- the payments one is making in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as a phantom amplification of a loan's interest rate."

http://en.wikipedia.org/wiki/Deflation#Effects_of_deflation

[backwoodsbob]

11. from an article I read today

kind of trying to go by memory so bear with me.

Deflation can't be controlled as easily as inflation.The feds can jack up rates to control inflation but can't go below zero to stop deflation.

Consumers will hold off on dropping prices waiting on an even better deal due to deflation,and..

Jobs will be cut and wages dropped,putting further pressure on prices.

[On the Road]

13. A Fall in an Individual Commodity Like Oil Can be Beneficial

What is harmful is a deflationary spiral. From Wikipedia:

Deflation should not be confused with temporarily falling prices; instead, it is a sustained fall in general prices. In the IS/LM model...deflation is caused by a shift in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity - contributing to the deflationary spiral.

Since this idles capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral. The solution to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand....

What is curious to me is that you can argue that most of the 80s and some of the 90s were deflationary due to falling costs of technology, oil, and some commodities. And it was a time of high growth.

So I agree with you that deflation can be beneficial provided that demands increases increases as a result of falling prices. Per your two questions:

1) Like inflation, deflation can be a self-reinforcing spiral or self-correcting (which appears to be happening with oil prices). I suspect part of it is whether the economy has the capital and optimism to bottom-fish and invest when things look worst. I suspect another part is lower prices caused by trade from overseas do not form part of a negative spiral domestically and actually generate more foreign demand.

2) Wages are famously known to be "sticky downwards". This is not compeletely true -- for example, benefits, hours per week, and bonuses may be cut. Unions sometimes accept concessions from employers losing money. It is more likely that wages would decrease by lower-wage competitors gaining market share.

I don't think any of us have seen the kind of infamous deflationary spiral that people like Bernanke fear. There are too many sources of stimulus to the economy -- the speed of technological development, increases in efficiency, greater government and private borrowing, freer monetary policies.

[HamdenRice]

14. Consider how it affects "TIMING" of purchases

That is the key thing. When prices keep going up, even in a bad inflationary economy, consumers tend to buy sooner rather than later. If the price of butter is going to go up next week, you might buy a pound of butter and put it in the freezer.

When prices are falling, which usually happens only in a situation where there is already severe recession or depression, consumers tend to put off making purchases. If the price of butter is going down next week, why buy it now, when it will be cheaper. But when all these decisions are put together, there tends to be a freeze on purchases, with everyone waiting for the prices to go down, even as the economy grinds to a halt.

Also there is the problem of debt. All businesses and most consumers take on debt. During inflationary times, debts tend to get easier to pay because the value of the debt decreases as the value of dollars decreases. In a deflation, debts get harder and harder to pay - like debt peonage. A debt that was one weeks salary becomes two weeks salary if the prices of things and wages decreases by half. So people become more and more trapped in debt and less able to spend.

The only industry that consistently has deflation problems is computers. Computer prices are always falling. If you've ever bought a computer you've experienced the deflation problem: you hold off buying because you know in a few months, you'll get the same processing power for less money.

In deflation, that affects the entire economy.

[CountAllVotes]

15. my opinion re: this

I believe we are not in a deflationary time. If it were, why would my property taxes, basic services, and other monthly fees continue to keep rising? People keep paying anyway as they need things like having their trash collected once a week if living in a home, apt.

I see massive inflation still in food prices. This has been blamed on the cost of gasoline. However, now the price of gasoline is lower for many reasons we will never know.

It would seem prices of food would drop if we are in a deflationary cycle. However, this isn't happening because of the effect that global warming and other environmental disasters are affecting the cost of these items. This will only worsen as this continues and that is why it is indeed the primary reason for these problems which are going basically unchecked for the most part. In the end, it will reveal our complete failure as a society to restrict itself and show an true ability to change. It is not until this aspect of the problem is addressed and correction begins that change will begin to occur along with the condition of the economy being a direct benefactor.

So what we have now is something that is deflationary to a point, but on the flip side of this same coin is massive unchecked inflation.

I'd say we need a new term to describe this phenomena.

The land itself is now the culprit.

This doesn't fit into any economic model that has ever or does exist yet the two things are interlocked intrinsically.

[backwoodsbob]

16. prices of food here ARE dropping

where do you live?

[CountAllVotes]

18. California

I was just at the store last week - pancake mix was close to $11.00 for a 5 lb.bag of it. It was a little less than $9.00 not long ago.

Other items were more so I did not buy much.

Gasoline is now $2.69 a gallon - the lowest price I've seen in quite awhile.

My taxes went up on the the house too. I just heard the phone bill will be going up 10% soon for my LAN line.

It goes on and on.

Just got home from the veterinarian. That visit that once cost $30.00 was $44.00 today.

This is inflation. The only thing less at the moment is gasoline. Everything else, including shampoo is up about 30%.

The reason is because we are in an environmental crisis. This is the reason food costs so much. No bees = no fruits/vegetables.

[Up2Late]

19. Deflation is not a big problem with "non-durable goods," which are what you listed here...

...but it's a major problem when it starts happening to "Durable Goods."

non-durable goods include cosmetics, food, cleaning products, fuel, office supplies, packaging and containers, paper and paper products, personal products, rubber, plastics, textiles, clothing and footwear, etc. Durable goods include cars, appliances, business equipment, electronic equipment, home furnishings and fixtures, housewares and accessories, photographic equipment, recreational goods, sporting goods, toys and games.

I posted a more complete answer below your question. More info about durable goods is at this link below:

<http://en.wikipedia.org/wiki/Durable_good>

For a more personal example, I have several 35mm cameras that have lost almost all their value over the last 5 years, so I can't afford a comparable new Digital camera that I need for work, so I'm holding on to them for now in the hope that their value will rise in a few years.

Plus, even if I wanted to sell my house in the next year or so, I probably couldn't find a buyer now, because of the tight credit market and the fact that their are so many houses being dumped onto the market right now.

[evlbstrd]

20. Wasn't that once called stagflation?

[CountAllVotes]

21. I almost mentioned stagflation in my post

I didn't want it to become too confusing, but yes stagflation (stagnant economy + inflation = stagflation) is a real concern. It is perhaps the worst case scenario. That is what I am seeing, yes - stagflation is one word for it.

However, still the same, the environmental aspect of this problem must be factored in. When considered, you see only one thing again - inflation.

The credit crisis - failure to lend money - another example of a stagnant economy.

Prices on homes have fallen, yes. However, the house I live in is still worth close to 3X what I paid for it in 1999.

Depending on how much it worsens, it still makes one say to themselves :wtf: .

[Up2Late]

17. Question 1, No. Question 2, Yes.

Both situation are bad, best is a very small inflation rate of .5 to 1.5% annually, because usually, in normal (good) times in the U.S. workers are given wage increases of 3-4% annually. In that situation, with an average inflation rate of 1.5% for all annual expenses, the worker is getting a little more wealthy each year.

But to answer question one, Yes and No. Falling prices do not help the economy by spurring consumer spending. Yes, they help the consumer in the very short term for very small items and non-durable goods (non-durable goods are goods that are used up when used once, or that have a lifespan of less than 3 years), but for durable goods (a good which does not quickly wear out, or more specifically, it yields services or utility over time rather than being completely used up when used once)deflation is very bad.

(from Wikipedia) <http://en.wikipedia.org/wiki/Durable_good>
Examples of consumer durable goods include cars, appliances, business equipment, electronic equipment, home furnishings and fixtures, housewares and accessories, photographic equipment, recreational goods, sporting goods, toys and games....

...Examples of non-durable goods include cosmetics, food, cleaning products, fuel, office supplies, packaging and containers, paper and paper products, personal products, rubber, plastics, textiles, clothing and footwear....

So since most non-durable goods are made my machines, which are more and more run by computer which make the need for human workers less and less every year and the fact that most of the durable goods listed above are now imported from lower wage countries, deflation quickly leads to unemployment which causes consumer spending to fall, and since unemployed people spend less on everything, but especially durable goods, it leads to more price cuts and more deflation...

To put it simply (and crudely), in a time of deflation, when the American economy is something like 70% consumer driven (or at least it was before the house of cards began to collapse), WE, the lower 97%, are F*cked.

And to answer question 2 directly, (2) Do wages contract in an deflationary environment? Yes, it's called unemployment or part-time employment.