Deflation–How Is It Harmful To The Economy?

Deflation is the decrease in the general price level. This is opposite of inflation. How could lower price levels be harmful to the economy? This is not immediately intuitive to people who are not economists nor finance experts.

There are three main reasons deflation is harmful. First, consumers realizing prices are falling would then delay many of their purchases in order to pay lower prices in the future. This leads to lower profits for businesses. Business inventories would increase beyond desirable levels. Businesses then would reduce investment and decrease production which implies layoffs of workers and/or reductions in hours worked by employees. These workers would then have less money to spend, contributing to a downturn in the economy.

Second, businesses would experience a ‘profit squeeze’ from another source. Often, businesses would have incurred the costs of production before deflation takes place. Labor contracts and raw material contracts have been set. Businesses have paid for these inputs or are obliged to pay for these inputs at a cost determined in the contracts. Since prices are falling in deflation, profits would be lower than originally expected. As stated above, lower profits lead to lower investment and higher unemployment. As a result of the latter, consumer spending declines, leading to an economic dowturn. Please note, consumer spending generally amounts to two-thirds of total spending in the economy. Consumer spending is generally stable normally. So, any decline in consmer spending is alarming to economists and policy-makers.

Third and finally, the next reason deflation is harmful is a bit more difficult to understand for many people. A decline in some asset values contributes to the decline in the values of other assets.  It arises because speculators and investors are unable to meet their loan calls and, as a result, have to sell some of their assets, further driving down asset values. This phenomenon is significant. The problem is worsened by the fact that consumer debt is at historic levels as is corporate debt. Bankruptcies and defaulting on loans result. The liquidity (the ability to offer loans) of financial institutions is reduced. Consumer spending and business investment fall and unemployment rises as a result.

Further, the negative wealth effect our economy would experience from the falling stock market prices or other asset prices would seriously reduce consumer spending on durable goods. A decline in consumer spending, as previously discussed, will further hurt the profit outlook of business firms. This would contribute to a further decline in the stock market.