Deflation: What is it and why should I care?
Very few of us alive today have lived through a period of deflation. The last time the
U.S. experienced deflation was during the Great Depression in the 1930’s. Many of us
recall periods of inflation, since we’ve experienced inflation in varying degrees steadily
since World War II but deflation and its effects are strangers to our thinking.
The textbook definition of deflation is “a decrease in the general price level of goods and
services (including wages).” Deflation can also be described as the opposite of inflation
or a negative inflation rate.
In periods of inflation dollars become worth less and consumers tend to buy more goods
and services because they will be more expensive tomorrow. It’s also a better time to
be a borrower rather that a lender since debts are paid back in cheaper dollars. The
real interest rate is lower than the nominal or stated interest rate (i.e. if your nominal
rate to borrow is 5 percent and inflation is 2 percent, your real interest rate is 3 percent).
Inflation generally encourages consumption (spending) and borrowing.
The effects of deflation are the opposite. Since people’s expectations during a
deflationary period are that prices will be cheaper tomorrow, they tend to defer
purchases. They will also have to repay borrowings with dollars that are worth more.
It’s better to be a lender not a borrower during deflationary periods. The effects on
interest paid to borrow is also the reverse of inflation since loan principle and interest
must be repaid in harder not cheaper dollars. If your nominal (stated) rate to borrow is 5
percent and deflation is 2 percent your real interest rate is 7 percent!
A related term of interest is “debt deflation” originated by economist Irving Fisher. The
phrase refers to a period of extensive over indebtedness that leads to deflation.
If deflation persists, a “deflationary spiral” can occur. As prices decline consumers
hoard their cash or pay down debt waiting for prices to drop further. As a result,
production slows since less goods and services are needed. As demand drops
businesses stop hiring and begin to lay off employees. Significant deflation has always
caused unemployment to rise and output to fall. This process tends to feed on itself
further perpetuating the deflationary spiral.
Why should all of this concern the average American? After the extreme buildup of debt
in the 1920’s, persistent deflation lasted until World War ll during which the
unemployment rate reached 25 %. This was also the case after the massive buildup of
canal, turnpike, and steamship debt in the 1820’s and early 1830’s and the large
accumulation of railroad debt in the 1860’s and early 1870’s.
The Federal Reserve and the Government through Congress and the Treasury have
taken and continue to take measures to stimulate demand. Low interest rates, tax
credits, cash for clunkers etc. etc are examples of their actions. Will they be
successful? Too early to tell. It may be that the best we can hope for is a long period of
zero or slow economic growth bouncing between modest deflation and low inflation as
the economy works through the excesses of the past few years. Time will tell. A long
period of negative growth isn’t in our domestic or the global communities’ best interest.
Ben Bernanke, Federal Reserve Chairman, pointed out in a 2002 speech on deflation
that “deflation is always reversible in a fiat (paper) money system”
Let’s hope we don’t have to test his claim.
October 2009
John D. Ritchie, Managing Principal
Great Northern Asset Management
(360)-567-3300
Great Northern Asset Management provides investment advisory services to individuals
and families.
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