Deflation: Why we should be worried

down-crash-graph-529For the past few decades, we have been bombarded by the dangers of inflation and why central banks need to curb it. Now, the concept of deflation is starting to become more prevalent and we hear the term bandied about but few are aware of the implications of falling prices. Surely paying less for the things we want and need is a good thing so why are the economists getting so worried about the possibility of deflation arriving on our doorstep?

Investopedia defines deflation as a general decline in prices, often caused by a reduction in the supply of money or credit.

In America, Britain and the euro zone, central banks have a 2% target for inflation. In all three, it is below that target. In Italy, Spain and Greece, which have experienced wrenching crises and recessions, it is below zero (as it also is in Sweden and Israel). Japan, which finally escaped from deflation in 2013 after more than a decade of struggle, is battling not to return.  Even in China inflation is below 2%, compared with a 4% central government target.

The Economist (October 2014) reports: ‘The lowflation of being consistently below an already low target is bad in itself; the deflation it could easy lead to is even worse. There are several reasons. The belief that money made tomorrow will be worth less than money today stymies investment; the belief that goods bought tomorrow will be cheaper than goods bought today chokes consumption. Central bankers can no longer set real (that is, inflation-adjusted) interest rates low enough to restore demand. Wages, incomes and tax revenue all stall, undermining the ability of households, businesses and governments to pay their debts—debts which, in real terms, will grow more burdensome under deflation.’

The threat is especially acute because central banks in much of the rich world have already lowered their interest rates to zero. Alternative paths to stimulate spending, such as fiscal policy, are blocked by politicians seeking to look tough.

All this results in a gradual slow-down of the economy, a lack of investment and reduced employment demand leading to a consequent reduction in the standard of living.