NCPA - National Center for Policy Analysis

Is Deflation A Real Danger?

November 26, 2001

Prices are falling everywhere. Consumer prices (CPI) dropped 0.3 percent in October, and the producer price index (PPI) fell 1.6 percent from September to October, the biggest one-month drop in the index's history since 1947.

  • Some economists worry about deflation -- a general decline in prices -- because they fear consumers will postpone buying, which will in turn depress production, threatening even lower prices.
  • Deflation hurts borrowers because they have to repay their debts in costlier dollars.
  • Borrowers might then default, and lenders would have less to lend, triggering a chain reaction of layoffs, defaults, bankruptcies and tight credit.

But other economists think deflation is a greater danger in theory than in practice.

  • Despite last month's drop, the CPI is still up 2.1 percent in the past year.
  • Producer prices dropped in 1991 and 1997 without dragging down consumer prices.
  • We have had two recent recessions with deflation -- 1937-38 and 1948-49 -- and recovered from both quickly when the Fed eased money and credit.
  • When the Fed didn't pump money into the system -- from 1929 to 1933 -- we had a classic deflationary spiral: consumer prices fell 205 percent, unemployment went from 3 percent to 25 percent and 10,797 banks failed.

The main current worry is that a devastating global inflation might overwhelm central banks like the Federal Reserve. Lower prices would cripple export earnings of developing countries, which would hurt trade. Debtor countries could default on bank loans. Developed countries' manufacturers would experience lower prices, profits and capital investment. Thus, the Fed has radically cut interest-rates over the past year -- to make sure deflation's theoretical dangers remain just that.

Source: Paul Samuelson, "Just How Great A Threat Is Deflation?" Dallas Morning News, November 25, 2001.

 

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