When I was a college student in economics, I remember what a big focus inflation was in my classes. Inflation was generally considered bad, because it eroded away the value of one’s savings who could not invest at a rate equal to or greater than the inflation rate. In other words, inflation penalizes people who hold on to cash, because that cash will continue to afford less and less.
However, it was always generally accepted that a little inflation was better than deflation. Deflation occurs when prices fall, making goods and services cheaper. Why is that such a bad thing?
Deflation poses two significant risks to the way our economy works. First, deflation puts downward pressure on wages. If cost of living goes down, your employer may argue there is no need to provide you with a wage increase. Or, new workers will be hired on at lower wages, because they arguably need less to live. This is especially tough on people who have debt or loans, because their wages may effectively decline, but the amount of debt they owe does not decline with deflation. All of a sudden, it becomes much harder to repay loans.
The second big issue with deflation is it restricts credit. If you are a lender, you need collateral to secure your loan. Take home mortgages for example. If you know the home prices are declining, and you aren’t sure how much the price will continue to decline, you will be scared to make a loan. A home that may adequately collateralize you loan today may not be worth enough tomorrow to collateralize that same loan. What is a lender likely to do? Nothing! The lender is scared and will not make loans, so the flow of money in the economy slows due to less credit being available.
My economics professors knew deflation was bad, but said it would never be a concern, because the Federal Reserve Bank could always print money to spur inflation. This was put to the test with “quantitative easing” orchestrated by the Federal Reserve Bank. The central bank created more money for banks to lend, so they would turn around and lend that money out to consumers and businesses. Of course, the deflationary environment meant banks didn’t want to lend the money out. And worse, with so many people losing their jobs, there were less creditworthy people to lend money to. While the central bank created more money to fight deflation, that money never reached ordinary people to actually cause inflation.
Deflation is in the news again as the economies of Europe limp along, and real estate values are declining in China. Much like our central bankers, they are concerned with how to combat deflation. This brings us back to classroom economics. Our professors focused greatly on how to combat inflation, and it appears we are well equipped to control inflation in the 21st century. They never assumed deflation could ever become a problem, and now it is becoming a persistent problem worldwide for which we lack a good solution!