What is Deflation?
Deflation, as defined within the study of economics, is a general decrease in the price level of goods and services below zero percent. The below zero percent qualifier is important because it indicates that prices are actually decreasing as opposed to increasing to a lower degree than in previous periods. In other words, a decrease in price levels from +5% to +4% from one period to the next is not considered to be deflation -- it's called disinflation, and it still signifies an increase in prices.
Deflation is a decrease in price levels; it essentially means that money is more valuable from one period to the next. If the price of a pair of shoes was $100 in one period and $80 in the next, the price level of those shoes decreased by 20% and the purchasing power of one dollar increased by 20%.
The consumer price index, or CPI, decreased by the largest margin on record in October -- 1%. This is important because it signals the onset of what could turn into a deflationary price environment. The CPI tracks a basket of consumer goods across the the country and measures monthly aggregate changes.
A 1% decrease means that the prices of consumer goods dropped by 1% month to month -- or, alternatively, that the purchasing power of a dollar increased by 1% from month to month. The number of houses that entered construction -- or "housing starts" -- also decreased by 12%. Compared to the same time last year, work was begun on 38% fewer homes.
Why are Falling Prices Bad?
Falling prices and increased purchasing power sound like good things -- they mean that the average consumer can buy more for less. But consumer spending represents nearly 2/3rds of the American economy; the shopping mall is the cornerstone of American commerce. Consumers buying more for less also means that retailers sell less for more, and retailers are the ones employing Americans.
It's the interrelationship between consumer spending and employment that renders deflation dangerous: when prices drop, employers cut wages and lay people off. When wages are cut and people are laid off, consumer spending decreases and prices drop.
This is called a Deflationary Spiral, and it can be devastating to an economy. A deflationary spiral contributed to the Great Depression, during which unemployment peaked at 25%.
One participatory effect in a deflationary spiral is the increasing value of debt. When the
purchasing power of a dollar increases, so does the value of the balance on a mortgage, a car loan, a student loan, etc. If prices drop 10% month-over-month but an individuals wage remains constant, it means that the payments on his debts increase by 10%.
This is especially relevant in the current economic crisis as it will accelerate
home foreclosures and further destabilize the banking industry, which made highly-leveraged bets on foreclosure rates staying relatively calm. If the US does enter a period of deflation, it could have dire effects on the already tight credit markets, with corporate banks refusing to lend money.
Related Blogs
