NCPA - National Center for Policy Analysis

Dealing With Deflation

November 19, 2001

The U.S. economy is now experiencing a sustained reduction in the general level of prices, or deflation, says Richard W. Rahn. o Last month, the Producer Price Index posted its biggest decline on record, 1.6 percent, and the Consumer Price Index fell by 0.3 percent.

  • All of the major commodity price indices are down by 11 percent to 20 percent for the year.
  • Many commodity prices are even below where they were 10 years ago.

Falling prices allow consumers to buy more with their money. However, unanticipated inflation or deflation leads to a misallocation of resources, increased risk and lower levels of investment and growth. In contrast, a stable price level enables producers, consumers, debtors and lenders to make long-term plans.

  • For instance, businesses that borrowed to finance expansion, anticipating that the Federal Reserve would maintain stable money have been less able to service their debt.
  • Key assets such as real estate will also begin to fall in price.
  • Debtors must pay back in more valuable dollars than the ones they borrowed.
  • And those who live off interest from their savings, as do many retirees, will suffer as the rate of interest drops because of deflation.

The Federal Reserve has been increasing the money supply rapidly in recent months. Unfortunately, the Fed waited too long to start cutting interest rates. Now the real rate of interest has actually risen for many less credit-worthy borrowers and consumers.

We can't spend our way out of deflation, says Rahn. But monetary stability and rapidly removing tax, trade and regulatory impediments to economic growth would help.Source: Richard W. Rahn (Discovery Institute), "Defeating Deflation," Commentary, Wall Street Journal, November 19, 2001.

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