Thursday, July 23, 2009
Deflation is Depressing
Is deflation always bad? Some industries exhibit falling prices which are beneficial to consumers, so if deflation leads to most falling that should be good as well, right? No. Deflation leads to a riskless real return on money. This is bad for the economy as any investment that returns less than that, or even more than that but carries some risk is not made, and growth slows to reduce that return to zero. Falling prices lead to delayed sales and raises real debt burdens slowing the economy further and leading to more deflation. The economy has difficulty adjusting to deflation due to the lack of expectations and sticky prices, creating a vicious cycle. In a perfect world with known expectations and all planning, contracts, and prices adjusted seamlessly, deflation would not present a problem, but in such a world neither would it be necessary, and as prices must respond to supply and demand rather than uniformly, resistance and stickiness would remain. In the end, deflation is depressing.