Dollars and Sense magazine, July / August 2003


Deflation-a general fall in the overall level of prices-is a serious concern. Deflation is generally the consequence-not the cause-of depressed economic growth and rising unemployment. When growth slows and workers lose jobs, spending declines and firms face depressed markets. They slash prices to move merchandise and cut wages to reduce costs. Lower wages in turn translate into less income out of which to buy goods, spurring further price cuts. This occurred in the United States during the 1930s-prices fell 20% over the decade-and is now happening in Japan, where prices have declined nearly 10%. Hyper-inflation ... occurred only in Weimar Germany, from 1922 to 1923. Once a "deflationary spiral" begins, the deflation itself can become a source of economic weakness and depression.

Thanks to vigilant anti-inflation efforts by the Fed and other central banks, inflation rates throughout the world have been declining for a decade. Even at the peak of the 1990s boom, inflation in the United States was running below 4%. Today, as the economy slows, inflation hovers between 1% and 2%, close enough to zero that falling prices are an imminent possibility.

Deflation inflicts substantial harm on anyone with heavy debts-in the United States, most middle-class households and non-financial businesses. Wages and prices fall in money terms, but the nominal value of debt remains unchanged. Thus, indebted firms and households must sell more or work longer in order to obtain dollars for repaying mortgages, commercial loans or credit card bills. Consequently, deflation redistributes income upward from those who borrow heavily to those with money to lend- mostly wealthy families and financial institutions. (Inflation, or rising prices, has the opposite effect-it redistributes income from lenders to borrowers.)

Once begun, deflation can weaken an already tottering economy in three ways. First, because the wealthy save more of their incomes than the middle classes, a redistribution from borrowers to lenders in itself depresses spending. Second, deflation encourages people to postpone large purchases in anticipation of lower prices in the future. Third, when prices are falling, money grows in value even when it sits around a shoebox or a zero interest checking account. Hence, pools of saving are less likely to find their way into the financial markets where they can be borrowed and spent. All of this can exacerbate an economic downturn and, in turn, generate greater deflationary pressures.

In theory, deflation is a boon for the wealthy because it increases the purchasing power of money and thus the real wealth of those who own money. In practice, however, deflation can drive borrowers to default and push down asset prices as strapped borrowers sell stock and real estate for cash with which to service their debts. In the end, deflation can bankrupt lenders as well as borrowers-just look at Japan's banking system.

Deflation also limits the scope of economic policy. The financial industry and the upper classes in general prefer that governments address economic instability with monetary policy-raising and lowering interest rates in an effort to stimulate private borrowing and spending-rather than with government spending. Civil works or public employment programs are anathema to conservatives, so in the current U.S. political climate, fiscal policy is a political non-starter (outside of upper-income tax cuts, but that's another story). This leaves the Federal Reserve as the primary source of macroeconomic policy in the United States today. It is probably thanks to the Fed and two years of very low interest rates-with all the zero-rate auto loans, no-cost equity loans and cash-out refinancings they have inspired-that unemployment hasn't risen much above 6%.

But deflation renders monetary policy impotent. Monetary policy affects the economy through the real rate of interest, which equals the nominal (or stated) interest rate minus the inflation rate. Deflation is equivalent to a negative inflation rate, so when prices fall real interest rates rise, even if the Fed holds the nominal interest rate at zero. The Bank of Japan is now facing precisely this problem: the overnight lending rate in Japan is 0.001%, but the real cost of borrowing keeps rising. The equivalent Fed Funds rate in the United States now stands at 1.25% and inflation at around 1.0%-a combined real interest rate of 0.25%. If U.S. prices actually begin to fall, the Fed will lose what little ability it has to counteract stagnation by lowering interest rates.


Ellen Frank teaches economics at Emmanuel College and is a member of the Dollars & Sense colIective.

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