Is Deflation Bad?

Inflation is defined as the increase in the general price level, not the price of any particular item. The opposite of inflation is deflation: a general decline in price level. There are various statistical measures that indicate whether an economy is suffering (that’s the right word) inflation or deflation.

Price indices measure how the price level changes with time. I learned about them in grad school: Laspeyres, Paasche, Marshall-Edgeworth, and Fisher price indices.

We all know intuitively that inflation is not good for us because we have to pay more out of pocket for the same stuff we bought before. We also know that when the price of an item goes down, it is good for us. For example, today we can buy a lot more smartphone for $200 than we could 10 years ago. So then wouldn’t it be great if all prices were to fall (like they do in electronics as Moore’s “law” predicted)?

Sadly our intuition is out of whack with reality on the matter of deflation.

It’s fairly easy to understand deflation can be harmful. But it requires thinking systematically about prices, production, money supply and related ideas.

An important point to keep in mind is that prices are relative. Therefore all prices cannot fall — at least one price has to go up (if all others are falling) and at least one price has to go down (if all other prices are rising.)

The “price” of a dollar falls during inflation and rises during deflation. Remember we don’t live in Lake Wobegon where all the children are above average; some have to be below average.

I am too lazy to take the time to explain how that works. Why bother reinventing the wheel? Just read a few articles on the web, think about it and be done with it.

As I have confessed before, I have a difficult time understanding money. But this much I know for sure: money supply has to increase to keep pace with a growing economy. As I have declared before, one of the many major bugs in bitcoin is that its supply is fixed forever. For now, I leave it for the interested reader to work out the reason. I may, if the stars align, write it out one of these days.

Economists do it with models. One of the best contemporary master of the craft of model-building is Paul Krugman. in August 1998, Krugman wrote a piece on Slate titled The Baby-Sitting Economy. It’s behind a pay wall but you all know how to get around that.

Fortunately for us, Tim Harford (the Undercover Economist) did a wonderful job in his book The Undercover Economist Strikes Back: How to Run—or Ruin—an Economy. NPR ran an excerpt from that book in 2014 which does a great job of critiquing Krugman’s baby-sitting economy. It’s worth a read.

Now a bit about deflation, the topic of this piece. I asked an AI to do the needful.

What is deflation?

It is a sustained decrease in the general price level of goods and services, which can harm the economy by reducing spending, increasing debt burdens, and slowing growth.

Deflation occurs when the overall prices of goods and services in an economy fall consistently over time, rather than just temporarily for specific items. It is measured using indices like the Consumer Price Index (CPI), and is distinct from disinflation, which is a slowdown in the rate of price increases rather than an actual decline in prices.

Why is deflation bad?

While falling prices may seem beneficial because money can buy more, deflation often signals deeper economic problems such as weak demand, oversupply, or reduced investment.

Reduced Consumer Spending: When prices are expected to fall further, consumers may delay purchases, especially for big-ticket items, which reduces overall demand and slows economic activity.

Declining Corporate Profits: Businesses earn less revenue as prices drop, while fixed costs remain the same. This can lead to cutbacks, layoffs, or even closures, further weakening the economy.

Increased Debt Burden: Deflation raises the real value of money, making existing debts more expensive to repay. Individuals and businesses may struggle to meet obligations, increasing the risk of defaults and financial instability.

Rising Unemployment: Lower spending and profits force companies to reduce costs, often by cutting jobs, which further reduces demand and can create a deflationary spiral.

Stagnation of Economic Growth: Deflation discourages investment because businesses and individuals anticipate lower returns in a declining-price environment. This can stifle innovation and long-term growth.

Potential for a Deflationary Spiral: In severe cases, falling prices lead to reduced spending, higher unemployment, and further price declines, creating a self-reinforcing downward cycle that is difficult to reverse.

Historical Context

Periods of deflation, such as during the Great Depression or Japan’s economic stagnation in the 1990s and 2000s, demonstrate how sustained price declines can trap an economy in a prolonged downturn, with high unemployment and low investment.

In short

Although deflation increases the purchasing power of money in the short term, its broader effects—reduced spending, higher debt burdens, lower profits, and slower growth—make it a serious threat to economic stability. Policymakers often aim to prevent deflation to avoid these negative feedback loops and maintain healthy economic activity.

Here’s a bit of music. The singer is the Cuban singer Celia Crux (1925 – 2003). I love her Cuban accent. “Locky me to be born in Havan . . . Tito Puente the king of them all.”