Saturday, February 19, 2011

Dangers of Deflation

Note this video was filmed in December 11, 2008 - just 5 days before the U.S. Fed lowered the target for the Fed Funds rate (the rate banks charge each other for overnight loans) to [0,.25%].  The Bank of England followed suit shortly thereafter. It lowered rates to .5% (essentially zero) in March, 2009. 

In addition to lowering their target interest rate to near zero, the Fed employed new tools to inject money into the economy to bring up prices. These tools were primarily called "facilities" and involved buying assets with newly created money. 

Fortunately, our economy did not go "Sayounara" (good-bye in Japanese) and the U.S. appears to have escaped deflation (falling prices). By 2010, worry in the U.S. has shifted back to inflation. How will the Fed unwind all its purchases now?

As shown in the video, Japan has been struggling with deflation for decades. To read about deflation in Japan see:

Economist (2-10-2011) "An Old Problem" (deflation in Japan)

NYT (10-17-2010) "Japan goes from Dynamic to Disheartened"

The basic list of dangers of deflation (falling prices) include:

1. Consumers postpone consumption - buying slows. Hence the economy slows further.

2. Borrowers face a bigger burden - they must pay same amount of dollars each month, but those dollars are now worth more. They may cut back on other spending to meet their debt obligations. Hence the economy slows further.

3. Wages are "sticky" downward, meaning wages typically don't fall even if their real value has risen (the same dollar amount buys more with lower prices). When prices fall and wages are sticky downward, firms layoff more workers and/or hire fewer workers. This leads to rising unemployment. The unemployed, and those fearful of becoming unemployed, spend less. Hence the economy slows further.

Note that the problems associated with deflation feed on themselves and make the problem worse. This is often called the "downward spiral of deflation".

One of the reasons most central banks set their target for inflation at 2% and not 0%, is to make sure they don't have to deal with deflation.

For more information about deflation see:
NYT (8-2-2010) "Why is Deflation Bad" by Paul Krugman

No comments:

Post a Comment