Economics for Lawyers (aka Dummies): Understanding Deflation

Many I have met in the the legal world appear to be completely ignorant (blissfully or otherwise) of the most simple of economic concepts. This is unfortunate in and of itself, but it also symptomatic of the same problem spread broadly among the general public. Blawgconomics is therefore happy to provide loyal readers with a public service announcement on a hot economic topic that, for many reasons, can be difficult to understand; deflation.

Many people understand inflation. Very simply, when aggregate demand for goods outstrips supply, ceteris paribus, prices go up. Oil prices a few years back, or food prices during a drought are good everyday examples. Though extreme inflation is often villified, and rightly so, by economists and pundits, low level inflation is a sign that an economy is growing. This is because it indicates that businesses and consumers are demanding a large amount of goods.

It is true that rising prices in an economy mean that its currency is worth less. However, if an economy is growing overall, and inflation isn't due to short-term factors such as energy spikes, this is not largely concerning because wages and income will typically rise at a commensurate level. There are many other factors impacting inflation, not least of which is the money supply, and rampant inflation can certainly derail an economy incredibly quickly. However, for purposes of this discussion, the key takeaway is that some inflation is natural and good as it points to economic growth.

Fewer people seem to be able to grasp the inverse of inflation, deflation, perhaps due to its rarity in modern times. Even fewer understand why it can be so bad. Deflation is an increase, not of goods (though this can be a factor), but in the value of money. At first blush, increasing the value of money might seem to be a pretty good thing. And it can be, if you are an individual holding a surplus of cash or are a large creditor owed cash payments in the future. However, on the balance, deflation can be very damaging to an economy, for, among other reasons, the negative impacts it has on borrowers and on spending, and because of the propensity of these factors to lead to deflationary spirals.

A simple example may prove helpful. If you owe a bank $10,000 on a loan, and you have $10,000 now, you can pay it off and be done with it. However, if you are making fixed payments, and the value of each dollar you are paying back is increasing as time goes on, you as the borrower are losing out. This has tremendous implications for both consumers and businesses who will be loathe to borrow knowing that they will face the duel costs of interest and currency losses in the future if they do. Therefore, the impact of deflation on borrowers is that it decreases their propensity to borrow. This has implications for everything from the housing market to small business start-ups to large corporate operations.

In addition to impacting borrowing, deflation has a negative impact on spending. If the value of currency is rising, many, savvy businesses in particular, will hold cash rather than spend it on projects and therefore employees. This is because they anticipate that the cash they are holding will continue to increase in value, creating an opportunity cost in spending it. This increased cost, factored into investment decisions, causes many projects that would otherwise be funded to be put off. This predictably causes growth to decline until the opportunity cost of initiating projects, in other words the deflation, declines.

Both of these factors, as noted, can lead to deflationary spirals. A deflationary spiral occurs when such decreases in both borrowing and spending lead to less production, lower wages and higher unemployment. Unfortunately, these factors tend to feed into themselves, creating a vicious circle (or in this case, spiral), and are often outside the ability of policymakers and bankers to control. Some economists believe that a deflationary spiral was one of the factors in the prolongation of the Great Depression, and such a phenomenon was seen in Japan in the 1990's and through the 2000's. It is not difficult to see why some economists believe that low levels of deflation can be much more damaging than moderate or even high levels of inflation.

Though it is not the prevailing theory in the US at the time, some economists do believe that deflation is a threat. When one considers that government intervention in the form of increased money supply is one of the only ways to fight this problem, it is painfully obvious, with the money supply and the national debt currently at astronomical levels, that this would be disastrous. Even with some supporting the idea that it is a threat, it is a notoriously difficult concept to discuss as economists of different schools are at odds over the exact causes for deflation and thus deflationary spirals.

Fortunately, despite many other problems, recent economic signs, including the growth rate, do not seem to point to deflation as the final outcome of the financial crisis. However, even low odds of it occurring combined with its prevalence in the media make a cursory understanding of the concepts surrounding deflation necessary.

UPDATE: The Wall St. Journal has an excellent list of tips on how to beat deflation in this weekend's investor section.

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