Deflation — Our Latest Worry

As we enjoy the holiday season with friends and loved ones, it’s hard to remember a time when we have had so much concern about how many of us are going to fare during an economy that grows ever more dismal by the week. Many have lost their jobs; others are looking over their shoulders wondering if they are going to be next. While some businesses have failed, others are on life support. It’s sure enough to put a damper on the holiday cheer.

And now we have our latest worry, the growing threat of deflation.

The biggest problem with deflation is that when businesses need to continually cut prices to spur sales, they eventually respond by cutting production. That results in growing job losses, and could, in the worst case scenario, even cause a depression.

We have heard from many that these are the worst times since the Great Depression. Now something comes along that may actually cause another depression.

How did we come to this? The simplified version goes like this.

The engine that drives our modern economy is credit. Consumers need credit to buy things like cars and houses and businesses need credit to have a steady reliable source of operating capital for things like buying raw materials and making the payroll. Cheaper and more available credit usually means people can spend more and businesses in turn can make and sell more goods which heats up the economy.

But when the economy gets too overheated, prices in general go up (inflation). So central banks like the US Federal Reserve (aka 'the Fed') will then put the brakes on the economy by raising interest rates making credit more expensive and less available. When the economy became weak and more became unemployed like in this last year, the Fed cut interest rates to stimulate credit. In normal times, this works reasonably well.

But the huge number of bad mortgage loans came back to hurt a number of financial services companies. Some failed while others were rescued by the government to try and keep the credit markets from collapsing. The $700 billion bailout from the US government was to try and make sure that credit would be available to businesses.

But smarting from the bad loans and weak economy, banks were still reluctant to extend credit. So the Fed continued to cut interest rates to banks to try and make more credit available. But now the Fed’s rate is as low as it can go (about zero) and credit is still hard to get. Companies like those in the auto industry can’t sell cars because credit is tight and they are also running out of operating capital for the same reason. So they must cut back production and lay off workers to try and stay afloat.

But people who are out of work (or are in fear of losing their jobs) drastically cut spending which forces companies to keep cutting prices (deflation) to attract customers until they have to further cut back on production and lay off even more workers which can lead to a deflationary spiral like the one that is believed to have caused the Great Depression of the 1930s.

Since interest rates cannot be lowered any more than they are, most economists (even conservative ones) feel that the only way to get out of this dire situation is for the government to stimulate the economy by pumping money into job creating projects like rebuilding the infrastructure even if it means massive budget deficits and the risk of possible inflation later on after the recovery.

So with the prospect of another depression coming if we do not do enough, the incoming Obama Administration’s first order of business is to put together a stimulus package that is large enough (and effective enough) to pull us out this mess we are in. As economics professor and former Secretary of Labor Robert Reich wrote in his blog on the subject of deflation:

The sooner we have a major stimulus package, the better. The danger is that it will be too small.