Deflation Is An Economist’s Worst Nightmare

A deflating currency can lead to a devastating downward spiral for an afflicted economy.

As economies in the European Union continue to sputter following a weak recovery from the financial crisis, economists are increasingly warning the public about the dangers of deflation.

But why exactly is deflation considered dangerous?

Most consumers are familiar with inflation, which causes prices to rise every year. This happens because the amount of money circulating in the economy increases, making each dollar worth less.

Deflation, on the other hand, is basically the opposite. Less money in the economy means that each dollar is worth more, and prices drop.

And while that may sound like a good thing for consumers, it can have severe consequences for the wider economy.


The Deflationary Spiral

When money becomes worth more over time, hoarding cash actually becomes an investment strategy.

This means that consumers become more reluctant to spend, because they know that a dollar today will be worth more tomorrow.

And as consumption decreases, businesses lose revenue, and are forced to reduce wages and let go of workers.

In turn, consumer demand is reduced even more, and prices drop further.

This is called a deflationary spiral, and is considered by economists to be a vicious cycle that is very hard to stop.

Deflation graph

Image courtesy of the Federal Reserve Bank of San Francisco.

The Great Deflation

One of the most striking examples of deflation was the Great Depression, where a deflating currency made the economic situation even worse for millions of people.

Between 1929 and 1933, the Consumer Price Index – which measures the effects of inflation – fell by more than 25%, as the above chart shows.

And while this meant that each dollar could buy more, it led to a collapse in demand and subsequently massive unemployment as businesses shuttered.

Another example is Japan’s lost decade in the ‘90s, where persistent deflation contributed to a decade of tepid economic growth.

Preventing deflation

No one is entirely sure how to prevent deflation or reverse its course once it’s started, as in Japan’s case.

However, in the last decade politicians and central bankers around the world have been taking large-scale measures that would seem to promote inflation, rather than deflation.

The Federal Reserve’s quantitative easing program, for instance, injected hundreds of billions into the economy, increasing inflation. Japan has recently embarked on a similar program, while the European Central Bank is mulling its own version.

Of course, inflation comes with its own set of risks – it’s just a lot more manageable.

Updated. Cover photo of a deflating balloon courtesy of the National Archives via Flickr, the Federal Reserve building via Wikipedia.

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Ole Skaar