Why Deflation Is Worse Than Inflation

It can strangle the economy for years—and it might be coming.

By + More

On the surface, it sounds appealing: Prices fall, things get cheaper, and consumers catch a break. But deflation is a pernicious problem that can strangle an economy for years—and it's a growing worry for the watchdogs minding the anemic recovery that has followed the Great Recession.

One of the Federal Reserve's primary responsibilities is to keep inflation under control, which generally means shepherding the economy along with benign inflation of 1 to 3 percent per year. But inflation has been close to 0 so far this year, and with economic growth slowing, the odds are rising that overall prices could decline. That's a rare phenomenon most Americans have never experienced.

[See 14 things that are getting cheaper.]

Poobahs at the Fed have started debating what to do, and liberal columnist Paul Krugman recently called the Fed "feckless" for talking about deflation but taking no action. John Makin of the conservative American Enterprise Institute calls deflation "a classic prolonger of crises" and predicts it will be here by the end of the year. Investors are worried too, with stock prices vacillating on fears that price declines could undermine corporate profits.

If you're confused, welcome to a club that includes most Americans. In the midst of the recession, economists warned us not about deflation, but about runaway inflation, thanks to aggressive government stimulus spending, record-low interest rates, and more than $1 trillion in new money injected into the economy by the Fed. In a normal economy, all that liquidity would ratchet up demand for assets, which in turn would drive up prices. Voila: Inflation.

As you've no doubt heard dozens of times, however, this isn't a normal economy. Consumers need way more than the traditional pick-me-ups provided by low rates and government spending. Many are out of work, with falling income—or no income. Debt loads are so high that many consumers couldn't borrow if they wanted to, so they're using unspent cash to pay down debt. After a few hopeful months earlier this year, consumer spending is slipping. That worries CEOs, who are reluctant to hire when spending is down, while shoppers worried about scarce jobs respond by shutting their wallets. Consumers and corporate chiefs have basically formed a mutual-worry society.

[See why raises are so scarce.]

Low inflation has been a blessing for consumers, with a few things getting more expensive but many things getting cheaper. The microprocessor revolution, for example, has driven down the cost of computers, televisions, and other kinds of electronics, while growing imports from low-cost countries like China has made clothing, furniture, and appliances cheaper. Economists call this "good deflation," because it makes people and companies more productive and helps improve living standards.

"Bad deflation" happens when the price of everything falls. And that can harm everybody. Economist Gary Shilling cites three factors needed for bad deflation: A financial crisis, a deep recession, and a spike in unemployment. Gulp. We've had all of those. When the economic pain gets intense enough, demand for all products falls far below supply, simply because people don't have enough money to buy all the stuff companies are geared up to produce. That has clearly happened in the market for homes, cars, many retail items, and the commodities used to make a variety of products. The danger comes when falling demand for some products creates so much slack in the economy that the demand for all products—as measured by the consumer price index, for example—tumbles.

[See 10 states where taxes are up, services down.]

If all prices fall, it's a disaster. Falling prices means lower revenue and profit margins for companies, which as we know leads to layoffs, less hiring, stagnant wages, and outright pay cuts. Consumers with lower incomes have less money to spend, which tends to lock the cycle in place: With sales down, firms have to cut prices even more to get business. The worst part comes when everybody realizes that prices are falling, because nobody wants to buy something today if it will be cheaper tomorrow. That's why our housing market is such a disaster: When prices are falling, you've already lost money on your investment the day after your big purchase. Buyers would rather sit on the sidelines and wait for prices to bottom out.

Deflation also wreaks havoc with routine borrowing and other aspects of a normally functioning economy. For people (or countries, ahem) in debt, inflation actually eases the burden because the real value of fixed debt goes down over time. If inflation is 5 percent per year, for instance, your income keeps pace with inflation, and you pay $1,000 a month toward a fixed-rate mortgage, your nominal income goes up over time but your mortgage payment doesn't. So the mortgage effectively gets cheaper over time. The opposite happens with deflation, which makes debt more expensive over time. If deflation were 5 percent per year and your income fell at the same rate, the mortgage payment would take an increasingly big bite out of your paycheck.

[See how the economy will look on election day.]

That turns the basic machinery of the economy inside out. Under deflation, cash becomes a highly valued asset, since a 0 percent return is better than a negative one. Banks have no incentive to make loans, since they'd lose money. Defaults would skyrocket, exacerbating the problems we already know about: broke consumers, money-losing banks, frozen credit markets. Everybody would hoard cash and consumers would only buy essentials.

That's been the situation in Japan since 1995, a case study that economists have been paying a lot of attention to lately. The circumstances are different in the United States, but Japan is hardly a medieval society with illiterate central bankers. In other words, if it can happen there, it can probably happen here.

There are lots of technical lessons from Japan's battle with deflation, but the most important takeaway is that deflation is the economic equivalent of an STD: Once you've got it, you're stuck with it for awhile. "Prevention of deflation remains preferable to having to cure it," said Federal Reserve Chairman Ben Bernanke, in a long-ignored 2002 speech that's found new life as an ironic prophesy.

[See 5 reasons a double-dip recession could happen.]

Bernanke and other Fed officials think they know what to do if deflation strikes, but they haven't had a lot of practice: Full-blown deflation hasn't been a problem in the United States since the early 1930s, when widespread fire sales caused overall price drops of about 10 percent per year. So they'd rather deal with inflation, which is common enough that it essentially comes with a dog-eared troubleshooting manual. The Fed, of course, doesn't get to decide what problems it has to confront, as the last few years have shown us. Maybe they'll get one more chance to show their creativity in crisis.