Intro: Economists fear deflation for reasons that go completely against the basics of economics. Prices fall during times of falling money supply growth, high real GDP growth, or increased hoarding. In any case, the decline in prices is the market’s way of increasing the purchasing power of money to ensure that output itself doesn’t decline.
Economists are in broad agreement that deflation is problematic for the economy as it results in a reduction in demand. The idea being that if prices fall then it will discourage people from buying things in anticipation that prices will fall even further. Presumably under this logic, left unchecked, prices and spending would continue falling until the economy shrinks into oblivion. Nothing could be further from the truth.
Simply supply and demand dictates that, all else equal, falling prices lead to greater purchasing power for any given level of money that people have. Falling prices are the market’s response to either falling money supply growth, high real GDP growth, or increased hoarding (a reduction in people’s willingness to spend the money they have). This had led economists to differentiate deflation into good deflation and bad deflation.
Economists often use the term good deflation to describe a situation where prices are falling and real GDP growth is strong, while they use bad deflation to describe a situation where prices are falling and growth is weak. These definitions seek to place some causality on falling prices when in actual fact deflation is just a by-product. It is not falling prices themselves that make so-called ‘bad deflation’ problematic, but the falling money supply that caused it.
Falling money supply itself is something that is worth trying to prevent for several reasons, most importantly the risk that falling prices in the absence of falling wages could create a rise in unemployment. Nonetheless, given any fall in the money supply, fully embracing lower prices and wages is the only way to limit the economic disruption.
It is easy to see how the idea of a price deflation spiral occurring in the absence of a collapse in the money supply is simply impossible. Should prices collapse in the context of positive money supply growth the only explanation would be that real GDP growth is strong. Otherwise inflation would result from too much money chasing too few goods.
Case Study: The Importance of Deflation in Greece
Take the deflationary episode in Greece over the past decade or so. Falling prices are often seen as the problem, but in fact the ultimate problem was the fall in the money supply. Faced with a ~30% decline in the money supply, falling prices were essential to allow the existing money to purchase more goods. In the absence of deflation, purchasing power would have been hit even harder and the economy would have suffered even more.
Case Study: Problems Caused by Preventing Deflation During the Great Depression
In fact, it was the failure of wages to fall in line with the collapse in the money supply that made Greece’s recession so severe. A similar situation occurred in the US in the Great Depression. The banking crisis caused the money supply to fall by around 30%, creating a huge shock to the economy. Policymakers believed that it was the fall in prices and wages themselves that was the ultimate cause of the economic weakness and so put in place policies to prevent prices and wages from falling in the mistaken belief that this would ‘spur demand’. With the natural tendency for prices and wages to fall prevented by government policy, the collapse in nominal GDP occurred through an inevitable fall in output rather than a fall in prices.