Deflation prospects and implications

Craven, Jim jcraven at
Fri Jul 11 13:14:23 MDT 2003

Dear Dr. Dollar

I have been hearing quite a bit about the dangers of deflation to the United
States economy. I have even heard warnings that "spiraling deflation" could
cause a global depression such as occurred in the 1930s. But wasn't the
Great Depression caused by hyper-inflation, not deflation? Is deflation
really a serious concern, or is this just scare-mongering?      -Richard
Weigel, Aiea, Hawaii

Deflation-a general fall in the overall level of prices-is indeed 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%. (The hyper-inflation you mention 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

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

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

James M. Craven
Blackfoot Name: Omahkohkiaayo-i'poyi
Professor/Consultant,Economics;Business Division Chair
Clark College, 1800 E. McLoughlin Blvd.
Vancouver, WA. USA 98663
Tel: (360) 992-2283; Fax: (360) 992-2863
Employer has no association with private/protected opinion
"Who controls the past controls the future. Who controls the present
controls the past." (George Orwell)
"...every anticipation of results which are first to be proved seems
disturbing to me...(Karl Marx, "Grundrisse")

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