Deflation a Closer Look
Falling Prices, how can that be bad for the economy?

By Ali Jaffery

Shouldn't consumers be happy when prices fall? That depends on what causes deflation. When technological progress leads to rising productivity, or output per hour of work, the economy can produce more each year with the same workers and equipment, and companies can cut prices while increasing sales. Between 1865 and 1879, manufacturing output rose 6% a year while prices fell by 3% a year. Wages were basically unchanged.

Deflation is more worrisome when it results from declining demand, as it did during the Great Depression when prices tumbled 24% between 1929 and 1933, bankruptcies mounted, thousands of banks failed and the unemployment rate hit 25%.

It is a central banker's nightmare. William McDonough, the 68-year-old president of the Federal Reserve Bank of New York, recalls his father taking him in the late 1930s to see breadlines and "people in jail who were there for stealing food for their families." The Depression, he said in a speech in March, "was a very real thing to the people who created the Federal Reserve's mandate and they never wanted it to happen again."

The 1930s demonstrate that deflation is most dangerous when debt burdens are heavy, as they were in the 1920s and are today. "When a deflation occurs ... without any great volume of debt, the resulting evils are much less," Yale University economist Irving Fisher wrote in 1933. "It is the combination of both ... which works the greatest havoc."

A company borrows on the assumption that rising sales volumes and prices will enable it to repay the debt. As prices fall, it becomes more difficult to make payments on debt. A company may be forced to cut wages or jobs, or go bankrupt. The same applies to households that suffer falling income and have to cut spending to service debts. If too many businesses and households do this, the result is depressed demand that fuels further deflation.

Another risk from deflation is that consumers may delay spending because they expect goods and services to get cheaper.

More troublesome is that deflation makes it impossible for a central bank seeking to jump-start the economy to get inflation-adjusted interest rates -- the ones that economically matter -- below zero. (When inflation is at 3% and the Fed cuts rates to 2%, the inflation-adjusted rate is minus 1%.) For that reason, modern central bankers consider a low inflation rate -- typically between 1% and 3% -- ideal. The U.S. is now in the lower part of that range.

The odds of deflation also are damped by the fact that inflation has been low and stable for years. As long as businesses and consumers expect that to continue, and set prices and wages accordingly, the deflation risks are diminished.

But in the fall of 1999, US central bank (Fed) officials gathered to talk about deflation: What would they do if faced with deflation, or widespread falling prices, and they already had cut interest rates to zero?

Deflation is dangerous because it makes it hard to boost the economy by cutting interest rates, and because it makes debt harder to repay.

At this meeting, researchers brainstormed about possible ways the Fed could spur spending, such as adding a magnetic strip to dollar bills that would cause their value to drop the longer they stayed in one's wallet.
Other proposals, some possibly not legal, were for the Fed to lend to private companies or buy things such as stocks, real estate or even goods and services, such as used cars. And then there are those magnetic strips. Marvin Goodfriend, a top economist at the Richmond Fed, proposed at the Woodstock conference that a way to stimulate the economy if interest rates are already at zero is to levy a fee on banks that keep cash on deposit with the Fed rather than lending it out, and to find a way to make currency worth less the longer it goes unspent -- thus the magnetic strips. When someone deposited a bank note, a "carry tax" would be deducted according to how long it had been since it was withdrawn. These charges for holding on to cash would effectively create negative interest rates.
"Asking people to carry around some one-dollar bills that are worth 99.4 cents and some that are worth 98.4 cents would be a terrible nuisance," Alan Blinder, a former Fed vice chairman, observed at the Woodstock meeting. He added, "Prevention is far better than the cure."
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