How does deflation harm the economy?

How does deflation harm the economy? During a deflation, people spend less, which slows down economic growth. January 20, 2009

Plastic-wrapped cars are at a standstill on a Sante Fe assembly line late last month in Hyundai Motor’s plant in Ulsan. The company temporarily suspended production there due to falling consumer demand for automobiles worldwide in the wake of a global economic slowdown. [YONHAP] What would you guess is the one word that central governments around the world are most afraid of these days? In the midst of a global economic downturn, that word is most likely to be “deflation.” This word refers to a continuous decrease in the prices of products and services. It’s the opposite of inflation, which means that the general price of products and services will rise. At first glance, a decrease in prices sounds like a good thing. It sounds like you can save money because goods are cheaper. This is an understandable response. Korea has a lot of experience with inflation. But deflation is relatively new to us. However, if prices go down steadily over a prolonged period, the economy can suffer. Deflation is just as harmful as inflation. Think of it this way: Both high and low blood pressure are bad for your health. Why is deflation a danger to the economy? Deflation over a long period can lead to a catastrophe like the Great Depression that started in 1929 in the United States. This event was the most serious economic depression in the 20th century. If prices persistently go down, what will happen? First, consumers will not want to buy any products. They will wait because they think prices will go down even more. If products don’t sell and are left to pile up in storage, companies eventually reduce production. If this happens, companies will need fewer employees and will eventually fire staff, which will raise the rate of unemployment. If the number of people who are unemployed keeps going up, the average income in households will decrease, which will make people tighten up their wallets even more. This will once again lead to people buying less and a further fall in prices. In short, with this deflationary downturn, the economy will shrink and eventually deteriorate. If product prices fall, the value of money goes up. In contrast, inflation destroys the value of money. For example, if a loaf of bread costing $3 during normal economic times rises to cost $5 or even $10 because of inflation, each dollar you own is basically worthless. In times of deflation, that loaf will cost $2 maybe even $1 or even less, making every dollar more valuable than before. Therefore, deflation makes people hang on to their cash. They stop buying products, real estate and stocks, leading to a massive economic slowdown. If deflation gets worse, banks will suffer because they have loaned people money through mortgages to buy homes. The problem is falling property prices. A mortgage is a loan people use to borrow money from the bank or a company. If a borrower fails to pay back the loan, the lender has the right to repossess the borrower’s house. But if deflation is wrecking the economy, the value of the house might not be enough to cover the original loan. This means the bank loses money. If many people fail to pay back their loans when house prices are falling, banks will eventually think it is too risky to loan any more money. If banks act this way, it will get harder for companies to find sources of money. This results in a liquidity crisis because there is no money fueling the economy and businesses eventually go bust. Because people are worried about prolonged deflation, countries are doing everything they can to lower interest rates and feed money back into the system. Ben Bernanke, the U.S. Federal Reserve’s chairman of the Board of Governors, made a speech back in 2002 in which he repeated U.S. economist Milton Friedman’s statement that money could be “dropped from helicopters” if needed in order to avert a deflationary depression. However, there is a limit to how much a government can “devalue” money by lowering interest rates. The key interest rates in the U.S. and Japan have already approached 0 percent. Also, if a global economic slowdown affects the real economy, people will become wary about the future and spending money. So even if an opportunity for investment occurs or if valuable products come out at cheap prices, consumers won’t want to spend cash. In times like this, governments get involved by spending tax dollars on large public projects to boost spending and investment. The U.S., Europe, Japan and China have all started large civic projects. Korea has, too. The government’s sudden announcement to develop the nation’s rivers and roads for large-scale investment projects should be seen in this context. There is a reason for this “sudden” decision. If governments don’t act fast enough to prevent the situation from getting worse, there will be no medicine to make the situation better. After all, look what happened to Japan in the 1990s, the “lost decade.” During this time there were simultaneous asset, real estate and stock price bubbles. Before this, Japan experienced an economic high and could stand almost on par with the U.S. economy. But during the downturn, companies that had invested in real estate and banks that loaned out mortgages lost huge sums of money. After this, Japan’s economy developed at a snail’s pace. In particular, belated government efforts to improve the economy simply made the situation worse. By the time Japan lowered interest rates and supplied cash, the deflationary spiral had already gone too far downhill, and nobody wanted to spend or invest. At present, governments around the world are pumping out cash to prevent a similar situation from arising. Nobody wants a lost decade. However, no one is sure if these attempts at solving the problem will work. Everyone is waiting to see what happens next. However, even if this plan succeeds, most experts say there will be consequences. The massive amounts of cash the central government has printed and the loans that it borrowed for funding public projects will eventually become a burden for the general public. At present, governments have decided to spread the pain. The idea is so that we will feel less pain but over a longer period, which governments think is better than a short, sharp shock.