Tuesday, March 31, 2009

Look Out Below

The Wall Street Journal wrote a story today on the signs that deflation might be on the horizon for Spain and other Euro Zone countries:

Spain became the first country using the euro to post an annual decline in consumer prices in the current slowdown, underlining concerns about the potential for deflation in parts of Europe, as an important research institution reported that the entire euro zone has been in recession since January 2008 -- just a month after the U.S.

You might wonder why people worry about deflation. Lower prices seem pretty good, right? Not quite.

A deflationary economy contains too many goods and too little money. To adjust, prices fall, meaning every dollar you have can buy more stuff. In other words, in Year X $1=1 apple, but in Year Y, with deflation, $1=1.1 apples.

Although this seems good, it can be disastrous for an economy. If you know that your money will have more purchasing power in the future, you will have an incentive to hold onto it instead of spending. When everyone in an economy does hoards cash instead of spending, its contracts the overall demand for goods, which leads firms to fire workers, which further contracts demand for goods, which leads more firms to fire workers, and so on. A classic deflationary spiral.

Deflation also increases the burden on people with outstanding debt, because if you have a fixed-rate interest payment, it remains the same, while the money you use to pay it is worth more. Let's say you have a 7% car lease that costs you $500/month Year X. Even with deflation, it will cost you $500/month in Year Y. But, whereas that $500 was only worth 500 apples in Year X, it's worth 550 apples in Year Y. The actual dollar amount of the payment remains the same, but it's really costing you more*.

So although falling prices might seem good for your pocketbook, somewhat counter-intuitively, they would actually be terrible for this economy.

* If you want to know the math behind this, just take a look at Fischer's equation, which tells us that the Nominal Interest Rate = Real Interest Rate+Inflation Rate. Using algebra, we can show that the Nominal Interest Rate-Inflation Rate=Real Rate of Interest. Therefore when the the inflation rate is negative (which it is under deflation), we will actually get a higher real interest rate.

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