Will Deflation Derail World Economies?

AMA2-23-15Low prices delight consumers. But those falling prices may signal darker days ahead in the form of deflation, which flattens economies and leads to long-term recession. As prices drop and sales flatten in many of the world’s leading economies, experts fear a global epidemic of deflation that could have long-term effects on local and international commerce.

Consumers don’t like inflation, but central banks do. Inflation means higher prices and a sense that money doesn’t “go as far as it used to.” But a little inflation keeps commerce humming and debts being paid. It helps a country’s economy avoid deflation, which has a less obvious but more detrimental effect on local development and international trade. For government run central banks, the magic number for inflation rates that keep economies afloat is about 3 percent.

Deflation accompanies falling prices. Unchecked, it can create the dreaded “deflationary spiral” in which prices drop, but consumers don’t buy. That creates a surplus of goods and supplies that aren’t being used. To move them along, prices drop even further. But if people still don’t buy, the cycle continues, spiraling down into a hole of stagnation and recession.

When that happens, less money circulates in the economy. Consumers buy less and have more trouble paying down debt. That happens on a national level, too, as counties going through a round of severe deflation struggle to manage their own indebtedness. Let unchecked, long periods of deflation can plunge a country into economic chaos for years.

The current epidemic of deflation is hitting well-off countries in North America, Asia and the Eurozone. According to a recent article from The Economist, inflation rates in many of those countries is running well below the sweet spot of 2 percent – or is likely to do so in the near future.

In North America, Canada and the US are still seeing significant economic growth, but their inflation rates are still low – and falling oil prices are threatening to push them even lower. But the economic giants of Asia are seeing more trouble ahead.

In china, the inflation rate is below 1 percent. Japan’s rate is significantly higher, but a variety of factors affecting Japan’s national and international financial health threaten to push it down. In other Asian countries such as Thailand and Vietnam, deflation has already settled in.

The situation in the Eurozone is worse. As the Economist reports, 15 of the Eurozzone’s 19 member states are already in deflation. The most public face of the Eurozone’s economic troubles is Greece, but prices are flat for major categories of goods in more prosperous members such as Spain and Britain as well.

What’s behind the worldwide wave of deflation? One easy target is falling oil prices, which have dropped at times to prices under $100 per barrel in world markets. But the drop in oil prices actually has an upside – and oil price shifts are only one of many factors contributing to the threat of a round of deflation.

Lower oil prices mean savings for consumers in the form of lower gas and heating prices. The cheaper packaging of goods like cleaning products and soft drinks also passes on savings o buyers. That means consumers have a title more money available to buy other things, or to pay down debt. Governments benefit in the short run, too, from collecting more taxes and tariffs on energy consumption and usage fees from corporations.

In the long term, though, continued low prices overall keep the economy stagnant. If prices stay low, so do wages, and the job market suffers. Debt, both personal and national, gets harder to pay. People buy less, and the economy falls into s pattern of stagnation and paralysis that’s difficult to turn around without artificial intervention.

That’s when the central banks step in with quantitative easing – a plan to stimulate growth by pumping money into the economy, manipulating interest rtes, or both. The US Federal Reserve is in the closing stages of its latest round of Quantitative Easing since the massive housing collapse of 2008 plunged the country into recession. That stimulus involved the buyup of billions of dollars worth of mortgage backed securities and bonds in an effort to push interest rates low and keep money moving.

Now, the European Central Bank is rolling out a similar plan to buy treasury bonds and other kinds of securities in an effort to get more euros into circulation, The Bank of Japan is planning its own initiative to keep inflation at a comfortable rate and forestall deflation. Other countries are mulling similar interventions to stop the slide,

It’s too early to claim that deflation will dominate the world’s economies. The US dollar is trading strong in world markets against other currencies, which also affects international commerce and pricing, and other factors – including oil production – are constantly in flux. But for consumers in general and investors in particular, it’s worth remembering that falling prices may have rising costs.  (Top image: Flickr/PhilipTaylor)

Read more from The American Monetary Association:

Deflation and Oil Prices: Should Investors Worry?
Swiss Franc Fallout Ripples Round the World

The American Monetary Association Team

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