“Deflategate” is blowing up in the New England Patriots’ faces, but there’s a different and much more dangerous version of deflategate stalking the global economy.
And make no mistake: Deflation is much worse than inflation, meaning a real deflategate could undo all the progress made in wake of the Great Recession — and then some since.
When it comes to deflation and the economy, falling prices cause all manner of problems across the economic landscape. What’s worse is that policymakers have very few tools to combat deflation. Yes, central banks can buy bonds to prop up prices in the debt market, but we’ve already seen the effectiveness of such a policy. (The helpfulness was unclear at best.)
Furthermore, there’s not much a central bank can do with short-term rates. The Federal Reserve responds to inflation by raising short-term rates because that tightens up the money supply. Fewer consumers and businesses borrow when the cost of debt is rising.
When deflation hits, though, interest rates can indeed fall into negative territory … but when people and businesses pay banks to hold their money, it leads to stagnation.
Deflation is a nightmare, there’s no question about it, and a rising dollar and tumbling commodities prices are making an American deflategate look more likely every day.
To get a sense of just how bad deflation damage can get to consumers and investors alike, here are five ways in which deflation clobbers the economy:
5 Reasons to Fear Deflation
Buy Tomorrow: When prices are falling, consumers and businesses have no incentive to buy now. Indeed, the smart move is to wait for prices to get even cheaper. Deferring purchases saps demand, which causes prices to fall further. At the same time, lower sales and prices take a bite out of corporate profits, which are the key to a rising stock market.
Crushing Debtors: Debtors love inflation, and it’s easy to see why: If you borrow $100 today but that same amount is worth $80 in the future, you save 20 bucks when you pay that debt back! Inflation lowers the real cost of debt, but deflation does the opposite. Indeed, the real cost of debt rises, as $100 today becomes $120 tomorrow. That forces debtors to cut back on other expenditures to keep up with their debt payments, which further saps demand.
Investment Stalls: There’s nothing quite like inflation to get consumers and businesses to invest their hard-won cash. After all, money has to earn a return above the rate of inflation or it will lose purchasing power over time. Deflation removes that pressure to put excess cash to work. The no-risk move of sitting on cash can generate a decent return, while falling prices for things like goods or stocks make investing unattractive. Ultimately, that starves the economy of the capital needed to grow.
Multinational Pain: A rising dollar vs. other currencies is wonderful for vacationers. Fly to Europe and you’ll discover that a dollar buys more euro than it did before. That effectively makes foreign goods and services cheaper. However, it hurts U.S. companies that export goods. U.S. goods and services become more expensive overseas, which makes them less competitive. Furthermore, revenue falls when sales are converted back into dollars because the foreign currency in question now buys fewer greenbacks.
Wage Rage: If deflation extends to wages, look out below. Companies can lower labor costs by keeping wage gains below the rate of inflation. But deflation upends that equation and makes it very difficult to cut wages. (Just watch how workers respond.) That leaves companies with no option other than layoffs. Hey, fewer workers mean lower labor costs. Additionally, rising unemployment helps to lower wages because jobless folks are willing to work for less.
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