Is The Economy Heading Into A Deflationary Spiral?

One year ago, economists were worried about inflation. Now, they are worried about deflation — prices for everything from corn to soybeans to gold are falling. While it might seem like lower prices could be a good thing, unchecked deflation can bring economic activity to a standstill. Economists say the risks of deflation should not be ignored.

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It's Morning Edition from NPR News. I'm Steve Inskeep.

ARI SHAPIRO, host:

And I'm Ari Shapiro, sitting in for Renee Montagne. What a difference a year makes. Last October, people were writing articles predicting the great inflation of 2008 and 2009. People were forecasting that oil might hit 200 or $300 a barrel. Ethanol production was supposed to make corn prices go through the roof, and now, well, oil is heading toward $50. Prices from everything from corn to soybeans to gold are falling, and economists are raising the specter of deflation, lower prices for everything. NPR economics correspondent Adam Davidson is here to tell us why this is something we should be worried about. Hey, Adam.

ADAM DAVIDSON: Hey, Ari.

SHAPIRO: Well, lower prices sound like a good thing. So what's the problem?

DAVIDSON: Yeah. This is a weird thing about deflation. I myself have to kind of remind myself why it is such an ugly, ugly thing because of course, we spend all our lives hoping prices will go down and wanting everything we buy to be a little bit cheaper. So when everything is going down in price that seems like a good thing. And it would be a good thing in the short run but the problem is that eventually when prices are going down continuously and people predict that prices are going to go down in the future, they dramatically change their behavior. So, let's say you were thinking of buying a car, you had the money to buy a car but you noticed cars were a thousand bucks cheaper every month.

Well, you might say, well, I am not going to buy one this month, maybe I won't even buy one for six months. I will just keep waiting for it to go down. The car company might say, well, we could build a factory this month for $100 million but if we wait six months it will be $90 million. And basically what you see is everyone from the consumer to big businesses are putting off everything, because there is no reason to spend money now if everything is going to be cheaper in the future, and that starts ending economic activity.

SHAPIRO: Sure, but it's hard for me to imagine that if I've decided I need a car or computer or I am a company that needs to build a factory that I'm just going to wait forever. If I need it, I'm going to buy it eventually, even if prices keep going down, right?

DAVIDSON: Right, and this is on a spectrum, so, you know, you're going to buy something to eat today, you're not going to say, I'm going to put off eating for a few months and wait for food prices to go way down, but if you were thinking of starting a new food business, you might say, now is a lousy time, why would I spend a thousand dollars making my, you know, cornmeal bread when...

SHAPIRO: When I could spend $900 down the road.

DAVIDSON: Right, or spending $1000 today, my product won't be ready for two months, and two months from now, I'll only be able to get $900, you know, back, so I can't - there is no way for me to make money in this deflationary environment. So there are things that would still happen but there is an awful lot of stuff that simply doesn't get done in a deflationary spiral, it just doesn't happen. And innovation, new products, those are the kind of things that fuel this economy and those are exactly the kind of things that stop happening.

SHAPIRO: What can the government do to help avoid a deflationary spiral or to stop one once it starts?

DAVIDSON: That's the big problem. When there is an inflationary crisis like there was, say, in the late '70s or early '80s, the government can raise interest rates very high and that slows economic growth and slows inflation, but when there's a deflationary spiral, there is a floor. The government can only lower interest rates to zero. It can't go to negative, and that means, there's just isn't as much they can do to get us out of deflation. It's a very hard cycle to break.

SHAPIRO: OK. So this is a terrible thing that the government can't do much to stop. How scared should we be? Are we likely to enter a deflationary spiral or is this kind of a far-off specter that we don't actually need to worry about?

DAVIDSON: There are certainly signs pointing to its possibility. What I will say is the government has a very hard time stopping it once it starts, but there are things the government can do to make it less likely for it to start, and that is the real focus of not only the US government but the European central bank, Asian central banks. There is a real effort to get the economy growing, but that of course means that, you know, two years, four years down the road, we might not have deflation, but we might have inflation, which might not be as bad, but it isn't great either.

SHAPIRO: OK. Well, if we enter a deflationary spiral, will you just give us a call and let us know?

DAVIDSON: I will, I will let you know but I might wait a few weeks because I might want to buy a cheaper phone or use cheaper minutes.

SHAPIRO: Thanks, Adam.

DAVIDSON: Thank you, Ari.

SHAPIRO: That's NPR's Adam Davidson and you can find lots more about deflation and all sorts of other economic topics at our Planet Money website and blog. It's at npr.org/money.

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