Deflation: why is it so dangerous?

Deflation: why is it so dangerous?
With the economic news seemingly becoming worse by the day, there has been much talk about the possibility of deflation – a prolonged period of falling general prices.

By George Buckley
Last Updated: 11:35AM GMT 17 Mar 2009

But why would this be so bad? After all, surely deflation is good for households if it means that the cost of the goods and services is becoming cheaper?

There are a few reasons it's not that simple. First, prices tend to be influenced by the state of the economy. If demand is greater than the supply of goods and services then prices rise. If demand is weaker –as is the case at the moment – then prices can drop. So falling prices tell us something about the fragile shape of the economy.

A fall in prices is bad news for companies that make or sell the products we buy. Imagine a retailer having to cut prices to shift stock, but at the same time paying more for imported goods because of the fall in pound’s value. This causes profits to turn to losses, meaning some retailers will go to the wall, and many will cut staff.

Deflation, therefore, doesn’t just mean lower prices – it also means higher unemployment and lower wages. It will become much more difficult for those people who’ve lost their job or had to take a pay cut to continue repaying their debt.

Some might be forced to sell their house to pay off the mortgage – but the more people who do this, the more house prices may fall (causing negative equity). And if house prices fall that can be a blow to confidence leading to a weaker economy which in turn might perpetuate deflation. It is easy to see how a vicious cycle can develop.

Consider the situation in which we have deflation, and more importantly we think it is going to continue. There is, then, little incentive to spend money today – we may as well wait until tomorrow when prices will be lower. And tomorrow we might think the same again, deferring our purchase indefinitely.

This is what happened in Japan in the 1990s - deflation came, and shoppers disappeared. Economic growth turned to economic contraction, and we witnessed what became known as Japan's "lost decade". Following a brief interlude where growth returned, a second lost decade seems to be in the making.

Even worse was the Great Depression. In the 1930s share prices tumbled leading to an economic slump of epic proportions – and, of course, deflation and falling wages. The crash that led to that depression was caused by investors buying shares with borrowed money, pushing their prices up to ever unsustainable levels. This time round it was excesses in the housing market and the financial sector.

Governments are now trying to spend their way out of recession, attempting to fill in the gap left by households and firms. The Bank of England is helping too by bringing interest rates down to exceptionally low levels – making it less desirable to save and thereby encouraging spending.

It is still very uncertain as to how all of this stimulus will affect the economy. The pressing need is to avert a period of deflation, but the risk is that too much policy easing could cause exactly the opposite

George Buckley is chief UK economist at Deutsche Bank

http://www.telegraph.co.uk/finance/financetopics/recession/5005277/Deflation-why-is-it-so-dangerous.html

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