A few days ago Carl Noble wrote a blog about the latest Federal Reserve (Fed) meeting and some new language regarding deflation. The question some might have is why is deflation such a worrisome prospect?
First off, there is a psychological component to deflation. If consumers perceive that prices will be cheaper tomorrow than today, then why buy today? Seems logical and innocent, but if less consumer spending leads to softer profits, then employment falls, and eventually income goes with it. With less income, who’s going to feel confident to spend, especially if prices are assumed to keep going down? Yep, it can lead to a vicious downward spirals that is very hard to reverse once it gets some momentum.
Deflationary danger levels rise even further when starting debt levels are high (like they are today). In environments where income and assets are low or declining, but debt levels stay the same, debt to income and asset levels get worse by default. This can lead to forced selling, and it can lead to using income to reduce debt (deleveraging) rather than spending or investing it. Reducing debt for an individual is healthy, but when everyone does it at once it exacerbates a weak or falling growth environment (aka the Paradox of Thrift).
The good news is that Helicopter Ben Bernanke appears to be willing to wage war against a budding debt deflation, and new attempts to reflate assets and income may be on the horizon. The bad news is that there is no way the Fed or any other monetary or fiscal authority can guarantee policy tools will be strong enough to combat deflationary impulses that were unleashed during the financial crisis. Hopefully, easy money and rising asset prices can lead to confidence, renewed spending, new jobs, better income, and a reversal of deflationary tendencies. But anyone feeling too confident about the efficacy of monetary policy in thwarting debt deflations should force themselves to examine the Japanese economy over the last several decades. That is truly scary…
