Deflation should be the least of our worries.

Deflation is a symptom of economic contraction, not its cause, according to Dean Baker. The conventional wisdom is that in a period of generally declining prices ("deflation") people will defer purchases to get even lower prices and that this tendency becomes widespread and chronic and slows economic activity. Baker says that even in the worst of times the general price level declines very slowly, and he points out that the steep decline of computer prices over 30 years has caused demand to explode, not shrink. What does cause economic contraction, he says, is declining asset prices such as homes and 401(k)s if people have been liquidating that wealth to make purchases. If people stop spending, it's because they have less money, not because they're waiting for bargains. Sounds right to me.

Update on Saturday, January 10, 2009 at 10:53AM by Skeptic

In response to Paul Krugman's reference to a "deflationary trap," I posted this comment.

Dean Baker argues persuasively that deflation should be the least of our worries. http://www.prospect.org/csnc/blogs/beat_the_press_archive?month=11&year=2008&base_name=the_post_promotes_nonsense_on

In general, consumers (accounting for 70% of GDP) don’t defer spending because they are waiting for bargains. If they defer spending, it’s because they don’t have money. For example, everybody knows that all consumer electronics will cost less and have more features next year than this year, but we buy now anyway. Rent and food purchases are never deferred to save a few percent (although a home purchase might be).

Might automobiles be an exception? It depends. Can I lower my monthly payment today by trading in my old car because interest rates are down? Has the value of my old car declined a lot? Is my lease expiring? How’s my credit rating?

Deflation would be bad for consumers if their nominal incomes go down because they would have less money to spend after paying off the face amount of pre-deflation debt–but that’s not bargain-hunting behavior.

Deflationary prospects probably would discourage some business investment but not for the reason PK suggests. When analyzing a project with deflationary assumptions, revenue projections would be smaller over the project life, and that’s the reason a marginal project would be scrubbed, not to get a lower capital cost by waiting. On the other hand, if wages are sticky and don’t decline as fast as prices, business margins would be squeezed, and that would tend to make an automation project more attractive.

Deflation would be bad for debtors (and good for creditors), but it’s unclear there’s a “trap.”

Update on Friday, January 30, 2009 at 04:26PM by Skeptic

More on the "deflation trap," by Paul Krugman, and he's worried.  In this post, though, he doesn't say the problem is spending deferral by bargain hunters.  He focuses on the problem debtors have paying the face amount of pre-deflation debt.  If they're paying off debt with shrinking incomes, their spending necessarily declines, and that feeds a downward spiral.