Many Americans are about to learn that falling prices (deflation) are much worse than rising prices (inflation).
In an inflationary period, prices go up, but every price increase does two things. It lowers the real income of the person paying those higher prices, and it raises the real income of the persons collecting those higher prices.
If the price of an automobile goes up, for example, that extra new selling revenue goes to the merchants selling the car, the manufacturers of the car or the workers employed making the car--and most often it is divided among the three in roughly the same portions that the old revenue was divided.
Since almost all prices go up in periods of general inflation, almost everyone is a loser when they pay other people's prices and a winner when they receive that extra income from their own price increases. While those on fixed incomes lose in inflationary periods, very few are in fact on fixed incomes. The elderly, for example, all receive indexed Social Security pensions. The net result is an income distribution that changes very little in inflationary periods.
With higher capital values and rising incomes, spending typically increases during inflationary periods, and often real growth accelerates. Real standards of living end up rising, although by much less than the gain in nominal money incomes. Thus, after correcting for inflation, real per-capita personal consumption expenditures rose 15% in the inflationary decade from 1973 to 1983.
In contrast, deflation sets off very different patterns of events. Initially, there is a much more uneven incidence of effects.
Borrowers Go Broke
Those who have borrowed a lot of money find that they go broke. Consider your typical farmer. He borrowed to buy land and equipment when prices and land values were high and rising. He must repay those loans in the context of falling prices and land values--down 50% in much of the Midwest.
As a result, he must raise many more bushels of wheat than expected to pay off those loans. In addition, when land values are falling, the size of the mortgage is often bigger than the current value of the property. In such cases, the inevitable result is bankruptcy.
A similar process is now under way in the oil industry. And as these industries go down, their supporting industries--farm machinery, oil services companies, local banks--find that they have sold goods or made loans to customers who cannot repay. As a result, these service industries find that they, too, cannot repay their suppliers or loans and join those filing for bankruptcy.
As incomes and asset values fall, those in the deflationary areas of the economy who go broke must cut back on their purchases. This then leads to fewer sales and slower growth for the rest of the economy.
Investment Spending Slows
In addition, no one makes new investments in industries where prices are falling. There is already too much idle capacity; that is why prices are falling. Consequently, investment spending slows down in parallel with consumption spending.
Much of the current slowdown in economic growth and the current fears about a recession ahead can be traced to deflation in oil and farming and their resulting effects on other industries.
Deflation has a positive side. Real incomes rise for those who get products at lower prices but have not suffered from any of the income reductions caused by those lower prices. But in any widespread deflation, the unaffected are relatively few in number and are unlikely to expand their purchases as fast as those going broke are contracting their purchases.
History also teaches us that it is very easy for deflation to get out of hand.
In the mid-1920s, farm prices started to fall. The economy slowed. Then farm prices were joined by falling financial prices and reduced asset values in the aftermath of the 1929 stock market crash and the 1930 banking crisis. This led to declining industrial prices. Investments were sharply reduced, incomes fell, consumption was cut back--and the net result was what is now known as the Great Depression.
In the 1930s, the situation was aggravated by a Federal Reserve Board that further depressed the economy by effectively keeping real interest rates very high. The Fed wouldn't--or couldn't--lower interest rates as fast as prices were falling. As a result, in 1933 the nominal interest rate for "Baa" (medium-grade) corporate bonds was 7.8%, but prices were falling 5.1%--and thus the real interest rate (the rate of interest minus the rate of inflation) was 12.9%.
Sees the Same Pattern