What's so bad about deflation?

Discussion in 'Economics' started by The Kin, Nov 10, 2005.

  1. :confused:
  2. The real purchasing power of cash is worth more tomorrow than today. Why invest if you can buy the same products for less tomorrow! This creates demand for the dollar which makes our products more expensive to foreigners, they buy less of our products...flip-side, their products are cheaper to us. Deficit widens, debts increase to service the deficits...the cycle goes on!
  3. deflation is death for anybody with hi debt loads. example: you buy a million dollar house in california. you borrow the full amount. after 5 years of deflation the house is worth $500,000 but you still owe almost a million on it. extrapolate that out to the whole economy and you can see why a debt laden nation can not allow deflation to happen.
  4. Two real problems with deflation that I can see.

    1. The government has lots of debt. Inflation decreases the value of that debt every year. So our government wants inflation.

    2. If real interest rates are 1% and deflation is 2%, what is the nominal interest rate? -1%. If they went negative, people would just hold cash instead of debt. That selling of debt to buy cash would drive interest rates back to 0%. The real interest rate rises (higher than they should be), hurting the entire economy.

    In general, I have no problem with deflation. But with our debt (government, business, and consumer) driven economy, deflation will do much damage.
  5. That is not entirely correct.

    The main problem is what is known in economics as "sticky wages".
    There are two reasons, why wages are sticky (to the downside):
    - Running contracts, most job contracts run over several years, the minimum is several months
    -Psychological anchoring to your "old wage" in nominal terms. That means if prices go down 2% and you earn 1% less you gained. But your self-esteem is hurt, because the number is smaller.

    So you see prices go down, wages won't. Businesses might swallow their losses for a while, then they have to lay off workers. If people are afraid to lose their job, they don't consume, even if that fear is totally unfounded.
    Other people who can afford to consume might wait a little for better prices. Businesses suddenly have less and less demand and lay off workers...

    The other reason why deflation is poison has to do with credit availability and asymmetric information. You would need to read Stiglitz's "New approach to monetary economics" to understand that. But trust me, deflation is still underestimated, it can break up a whole economy in no time.
  6. They will print away before they let deflation kick in... Credit is limited during deflationary periods because of the purchasing power factor I mentioned earlier.
  7. yeayo


    Yeah that's why debt laden nations prefer hyperinflation. Tax, spend, and consume ad infinitum.
  8. Cry me a river. For one, mortgage rates would drop to 1% or less. Just basically enough to cover the risk of default and a tiny profit.

    Two, you're talking about 13% annual deflation for a 1 million dollar house to goto 500,000 in 5 years.

    I'm talking about deflation around 1% so that house would be worth 950,000 in 5 years. the mortgage balance would still be less than the value of the house.
  9. anything that can double in 5 years can also be cut in half in 5 years.
  10. cakulev


    As a consumer you will postpone your buying decision because you’ll speculate you can get the product/service cheaper. This cause demand to fall which feeds the deflation further.
    As a producer/service provider you have to make budget plan to cover your expenses. While some of the expenses will go down because of deflation, interest rate will always be positive. So what you are going to see is shrinking profit margins. Do you want to take the entrepreneur risk in such an environment?
    Not to mention all those real estate speculators that are overleveraged to the death and their only hope is constant asset appreciation.
    #10     Nov 11, 2005