All eyes are on the European Central Bank this week, with analysts expecting that the ECB will
cut its benchmark refinancing rateby 25 basis-points.
Weak inflation and unemployment data could spur the central bank to act, analysts say. For its part, the U.S. also saw its own “meh” inflation stats recently.
Great, continue the trend! Consumer prices should fall, fall, fall. Make things cheaper!
Not so fast.
Even though we’re still seeing mild inflation, the thinking above gets kicked around every so often, so it’s worth remembering that “deflation” — when consumer prices are falling as opposed to rising — is not a good thing.
Of course, it’s inflation that’s usually harangued as the greatest economic evil. We’ve seen inflation and not deflation in recent memory. Not to mention it bleeds our savings accounts and is criticised as a means by which governments erode debt over time.
But lower prices? Paul Krugman has a great explanation here of why that’s a bad thing, the thought being that if prices are constantly dropping, consumers will delay spending. Why buy that F-150 today when it will be effectively “cheaper” next week?
A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum affair, since creditors experience a corresponding gain. But as Irving Fisher pointed out long ago (pdf), debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. So deflation exerts a depressing effect on spending by raising debt burdens — which, as Fisher also points out, can lead to another kind of vicious circle, in which depressed spending because of rising real debt leads to further deflation.
All of this spreads across the economy. When debtors, like companies, cut spending, revenues and profits go down which means job cuts and wage cuts.
But since we’re currently seeing “low” inflation as opposed to deflation, how does this apply?
“Even with low but positive inflation the zero lower bound may be binding; inflation that comes in lower than borrowers expected leaves them with a worse debt burden than they were counting on, even if the inflation is positive; and since relative wages are shifting around all the time, some nominal wages will have to fall even if the overall rate of inflation is a bit above zero,” Krugman writes.
“So the argument that deflation is a bad thing is also an argument saying that some economic problems get worse as inflation falls, and that too low an inflation rate may actually be economically damaging.”
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