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Would Deflation Be a Good Thing or a Bad Thing?

George Washington's Blog
Thursday, Nov 20, 2008

A headline from Associated Press today reads "Dow slips below 8,000 on growing fear of deflation". See also this and this.

But would deflation be a good thing or a bad thing?

Well, lower prices are good for consumers. As Business Week puts it:

"A bit of deflation that boosts real wages may be the best way to get American households out of the hole."
(higher "real wages" means that people's wages will go further because the prices of things we buy will be lower).

But Nobel economist Paul Krugman argues that deflation would be bad because it would drive up the cost which corporations have to pay to borrow money.

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The Guardian points to other adverse effects from deflation:

Another effect of falling prices is to increase the burden of any given amount of debt, even as banks and households are sharply paring debt, or deleveraging, in reaction to financial turmoil and a wave of bad economic news.
"The problem with negative inflation is that the real value of your debts is increasing," Societe Generale economist James Nixon said. "In a deleveraging cycle you need negative inflation like you need a hole in the head." ***
Deflation would be problematic because, if sustained, it could lead consumers and business to curb spending further, shrinking economic activity and reducing demand even more, and pushing prices lower still.
So its a mixed bag. On the one hand, lower prices would bring some relief to consumers, at least in the short-run. But consumer and corporate debt would be more burdensome, and deflation would lead to a further economic slowdown, which could eventually lead to salary cuts and further layoffs by employers, and - ultimately - a depression.

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