For the past few months there has loomed the real possibility of serious deflation.
That would entail, not a shallow, temporary dip in prices, but a major, prolonged drop.
A decline in inflation would be good news for consumers, but it would alter the prospects for our economy. It boosts real incomes for individuals and widens profit margins for firms. Still, there is a downside to deflation.
It makes overhanging debt more onerous. Households would be inclined to pay off loans, while others would be reluctant to spend, as they would be waiting for ever-lower prices. In that economic climate, the threat of deflation would be an important hurdle to surmount for any business revival.
In the 1930s, a U.S. economist, Irving Fisher, cited the likelihood of “debt-deflation,” a fall in prices and heavy debt loads. That would bring about a rush for consumers and businesses to repay loans as the availability of credit evaporates. Deflation increases the real (adjusted for deflation) costs of debt, and makes interest rates so recalculated and more burdensome.
Then more repayment turns into what Fisher called a process whereby “liquidation defeats itself” with depressing effects on the economy.
One of the worrisome trends in recent days is the decline in credit. Banks in North America are cutting back on their lending because of so many defaults. Too, there is hesitation among businesses to borrow and that leads to a decrease in capital spending.
We have been in an era when very low interest rates led issuers of bonds to use the borrowed funds to finance all kinds of ventures, some of very questionable viability in the long term.
Over the past half-year the boom in commodity prices has ended. Witness the dramatic collapse in oil prices, which now are about one-third of their peak last summer. Other commodity prices have tumbled too. At those levels the year-on-year change in the retail prices of building components as well as other raw material prices, food and fuel, will turn sharply lower in this year. Deflation clearly is underway in many parts of our economy.
The rescue package presented by our governments, the U.S. Federal Reserve System, and central banks throughout the globe could offset some of that downward pressure on prices that eventually will be reversed as the result of renewed demand. However, that takes time to work its way through the economy. Spending on infrastructure as Canada appears to be doing now, for instance, takes many months before activity actually starts.
Meanwhile, one must hope that the rising tide of deflation does not take hold and turn this downward spiral of the economy into a 1929-type depression.