Deflation is scary for leveraged entities, whether they be individuals or businesses or nations. Owing a debt based on a falling asset value is uncomfortable. Anyone who bought a car should be used to that, but when it happens globally, it’s tough.

As I pointed out in the post, deflation can be good in some cases. ‘…In other words, deflation is not all bad. Computer prices have been falling for many years and consumers have really benefited. We have seen sharp declines in the cost of telephone calls and cell phones and many other electronic goods. Now, the slumping economy has weakened demand enough that, at least, most goods and services are under some pricing pressure.

The first type of deflation is pretty beneficial and it stems from pricing pressure on companies such that they figure out how to add more value for a lower price. And, that means they have to be more productive. However, deflation from slumping demand is less beneficial because the impact of that ripples through the economy and causes job losses.

In the real estate market, buyers are simply waiting because they wonder if prices will fall further. We also see the same in stocks and bonds. There is about $4 trillion in money market funds earning very low returns, but because of uncertainty, investors are staying put.

Deflation is an increase in the value of a currency which causes prices to adjust to reflect the greater value of the unit of account , in the case of the US it’s the dollar.

Several real scares were overlooked: As the real price of goods, services, and ultimately, incomes fall, the real cost for repayment of debt will start to rise, making it ever more difficult for debtors to pay off their obligations. This will lead to increased debt resignation, where borrowers decide to give up the struggle of maintaining debt service, and the number of debtors who throw in the towel and declare bankruptcy will increase drastically.

These factors will cause the economy to continue to shrinking, and real personal suffering will become evident.

I am a bankruptcy lawyer, and I have to strongly disagree with your perspective on deflation.

Falling prices are a good thing if the reduction is brought about by advances in productivity. Prices that drop due to deflation will not mean that consumers have more money to spend. They will have less money, because real incomes are also falling. Even if the average worker suffers no salary reduction, the numbers of the unemployed are rising. On an enlarged scale, the economy is suffering a drop in real earings, and that is where the economic crisis lies.

Consider World War II from an economic viewpoint. It was a huge public works operation financed by unprecedented deficit spending. It commandeered the productive capacity of this country and then destroyed this production in the battlefield. Why didn’t this bankrupt the country? Theoretically, an operation like that should have bankrupted the country like a “closed system” business operation would have been bankrupted. (Fortunately, free-market capitalism at the macroeconomic level is “open system”)

One can only imagine the derision and criticism had anyone of stature, in the 30s, proposed such a program to end the depression economy. But there’s no denying that World War II deficit spending did do it. Until one has a theoretical framework that can satisfactorily explain why World War II, not only did not bankrupt the country, but was the key factor in economic recovery — all one can do is bewail the problem without offering any solutions that will work.
“Open system” perspective: http://economics102.blogspot.com/

The most dangerous variable is if foreign nations stop lending the US money (Japan, China), because they need the money to save there own economies.

When this happens, the dollar will sink in value and America will suffer from a major spike in inflation, while the rest of the world will see an decrease in prices of good related to their currencies.

Another potential issue is that those who have borrowed money would have to repay it with more expensive dollars in the future. That is, if prices fell 5% by January 1, 2009, then a dollar would be worth more in January then it is worth today, in terms of purchasing power. Therefore, repaying debt costs more. Conversely, in an inflationary environment, repaying a fixed debt incurred today generally entails doing so with dollars that are worth less (not worthless) in the future.

I always enjoy your posts, this is another good one.

Deflation scares me some. We are in the midst of a retail crisis — Americans just aren’t shopping like they used to (obvious reasons aside). Yet, yesterday we saw the PPI drop, and today the CPI. If you follow the trends, which I know you do, CPI should continue to dip in the coming months as it catches up with the last three months of decline reported in the PPI (natural lag between producer and consumer pricing).

Back to my main point, deflation scares me a little. What if the current home-buying philosophy — since prices are steadily dropping, just wait for them to fall further before you buy — makes its way to retail shopping, perhaps it already has. Consumers will wait on the sideline to purchase that new laptop or TV until the price falls a little further, then maybe a little further.

While I agree the easing of inflation is very welcome news, deflation could become a reality if we’re not careful. Lower food and energy prices have allowed consumers to have a portion of their earnings available to spend on other items they hadn’t had before. They just hope they do.

Another great post,

Tim Manni

I’m emailing you in regards to an email I sent to you last month about a partnership, have you had a chance to think about it?

If you have any questions or would more information, please advise me and we can go from there.

Kind Regards,
Andrew Knight