Reading the latest economic news recalls the popular box store warning “Watch out for falling prices!” We may well be entering a period of generally falling prices in our economy, an overall deflation. Falling prices aren’t always a good thing, however, and this time, analysts are concerned about negative economy-wide effects.
Naturally, consumers welcome lower prices for the goods and services they buy. But economy-wide economic events don’t take place in a vacuum, and no one is exclusively a consumer. In order to acquire the goods we don’t produce, we each are also suppliers of something of value to the market. When we see generally falling prices, as in a deflation, the real value of payments to labor and other resources is growing, and so is the real burden of outstanding debt balances. Because the purchasing power of money is increasing (good for consumers), contractual dollar payments are becoming increasingly costly (not so good). It’s rising costs and shrinking revenues that that give deflation its sting; higher real costs are bad for employers, suppliers, and producers, and because they depress production, are ultimately bad for employees as well.
The gyrations of stocks and financial markets, and sinking real estate values have more than overshadowed attention to what otherwise would be stunningly good news for consumers. Falling prices for gasoline would have generated cheers of delight and approval just a few months ago, when regular unleaded gas was selling for upwards of $4.00 per gallon. Currently under $2.00 per gallon and still falling, the price drop has created minimal joy—certainly not proportional to the angst that accompanied every increase in gas prices during their upward climb. One reason: whipsaw activity in stock markets, banking failures and credit market ills, insolvency in some U.S. industrial sectors, and high-profile financial industry mismanagement or fraud.
Falling prices a problem? Like inflation, deflation is a matter of degree. Almost daily we are reading alarms about the dangers of deflation, and even the need for reflation (or re-inflation) to offset it.
There are rational economic reasons behind a deflation—it is not an illness visited upon the economy, in other words, but it is a painful cure for perceived ills. The downward trend in prices is an indicator that goods, services and non-cash assets are less in demand than previously. For a variety of plausible reasons, consumers and businesses are changing the mix in which they prefer to hold their assets, typically moving away from illiquid and less liquid forms of wealth (clothes, jewelry, autos, hobby collections, etc) to more liquid forms like cash (or close substitutes for cash). Even in the current environment, there are entrepreneurial opportunities that exist.
The current trend in economic news does show prices of producer goods heading steadily downward, energy prices falling, and reports of record new lows for starts in the housing industry reports for housing starts. In particular, falling world energy prices are proving to be a mixed blessing. Consumers may get through winter with lower transportation and heating bills, but fewer jobs to pay for them. And once again, we are mainly looking to the Federal Reserve, along with increased regulation through the U.S. Congress and Treasury, to stabilize the economy. Ironically, it is the Fed’s expansionary monetary policy, along with regulation that promoted excessively risky mortgage deals, that created a need for our current deflationary adjustments.
Workers who lose jobs or fear job loss will reduce spending. Producers facing higher real resource costs and shrinking revenues will respond with attempts to reduce output, cut benefits, lay off workers, or close. The cycle of declining incomes, revenue, and prices becomes self-reinforcing, until prices and costs realign. So the fastest way to move through the adjustment is to allow markets to clear out unsustainable price and wage contracts. Barring a sudden and drastic upsurge in American productivity (which has not occurred), a situation in which prices throughout the economy are dropping signals that consumers and producers both attempting to make adjustments in their economic plans.
We have become conditioned to expect the Federal Reserve to safeguard our general financial happiness in the U.S. We look to the Fed to ensure that credit is plentiful and cheap, and that a growing quantity of cash is available for lending, spending, borrowing and investing. A reinflation cure in this case is almost certain to prolong the adjustment period by preventing prices and costs from realigning quickly and appropriately.
It may seem counterintuitive, but we can attribute much of the need for this general price adjustment to recent credit euphoria generated by the Federal Reserve, plus the U.S. Congress and Treasury stipulations that had forced banking—and particularly mortgage lending—firms to eschew prudent credit-worthiness criteria with their customers, have helped to produce what promises to become a significant deflationary recession. Will re[in]flation help? Some analysts, members of the Fed, and political leaders argue for reinflation, but its far more likely to prolong the period of adjustment; it’s a “hair of the dog” cure; counterproductive in the long run. It’s largely the Fed’s money spree that got us here in the first place.