Five Reasons to Worry about Deflation

[The following article will go some way to demonstrate how interference in the market economy can go either way to worsen an existing situation. In fact, the Prophet Muhammad (saws)had refused to interfere in the market economy, letting it flow on, following political, economic, social, and natural forces, which themselves are beyond human control: YMD]


The deflation scare is back. It’s worth taking a moment to contemplate why deflation is such a bad thing. After all, falling prices sound appealing to consumers, especially compared with the alternative of higher prices. So why worry?

Here are five reasons:

1.Deflation is a generalized decline in prices and, sometimes, wages. Sure, if you’re lucky enough to get a raise, your paycheck goes further – but those whose wages decline or who are laid off or work fewer hours are not going to enjoy a falling price index.

2. It can be hard (though, as we’ve seen, not impossible) for employers to cut nominal wages when conditions warrant; it’s easier to give raises that are less than the inflation rate, which is what economists call a real wage cut. And if wages are, as economists say, marked by “downward nominal rigidity,” then employers will hire fewer people.

As Paul Krugman put it in 2010: “In a deflationary economy, wages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages… What this means is that, in general, economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines.”

3. As economic textbooks teach, the prospect that things will cost less tomorrow than they do today encourages people to put off buying.If enough people do that, then businesses are less likely to hire and invest, and that makes everything worse.

4. Deflation is terrible for debtors.Prices and wages fall, but the value of your debt does not. So you’re forced to cut spending. This applies to consumers and to governments, and it is one of the biggest issues in Europe right now. As Yale University economist, Irving Fisher, wrote decades ago, debtors are likely to cut spending more than creditors increase it, and this can turn into a really bad downward spiral. (The experience of Japan, though, proves that an economy can have a prolonged period of moderate deflation without falling into that downward spiral.)

5. Cutting interest rates below zero is very hard.Yes, one way that central bank magic works is that the Federal Reserve and the European Central Bank cut inflation-adjusted interest rates below zero when times are bad, hoping to spur borrowing, spending and investment. But it’s almost impossible for them to cut rates below zero. (Sure, there are some examples of negative interest rates, but they’re not very negative.)

If there’s 4% inflation, a zero interest rate works out to a -4% real (or inflation-adjusted) rate. At no inflation, a zero interest rate is, well, zero. And with deflation, a zero interest rate is a positive real rate. Deflation just makes all this harder to do. When short-term rates hit zero, the Fed turned to buying all those long-term bonds in what’s known as “quantitative easing,” or QE. But there is a lingering debate about how well QE works, and its side effects, and as the ECB demonstrates, there are political obstacles to launching QE that don’t apply to simply cutting interest rates.

Once upon a time, the U.S. and other economies seemed so prone to inflation that even low rates of inflation didn’t provoke fears of deflation. “Today that belief in an inflationary bias is gone, or at least greatly attenuated,” Berkeley’s Brad DeLong observed in 1999. There are still some people fretting that, given all the money the Fed has pumped into the economy in quantitative easing, inflation is just around the corner. But today, the bigger fear – especially in Europe – is just the opposite.


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