Smells Like Deflation

Oh, buried in the press release on 2nd Qtr 2010 GDP estimates is this item:

The price index for gross domestic purchases, which measures prices paid by U.S. residents,
increased 0.1 percent in the second quarter, the same increase as in the advance estimate; this index
increased 2.1 percent in the first quarter.  Excluding food and energy prices, the price index for gross
domestic purchases increased 0.8 percent in the second quarter, compared with an increase of 1.6
percent in the first.

Gee, 0.1%! That’s pretty close to zero and the negative numbers. Deflation (negative inflation on the price index) isn’t going to help us. In fact, it’s likely to make things much worse.

Why is deflation so bad?  After all, when we’re shopping we always look for ‘lower prices’, so why is deflation, which is a general decline in prices so bad?  The answer is the difference between micro and macro and the fallacy of composition.   When it’s just the price of one item and we are the buyer, then lower is good – it’s a better value.  But remember there’s a person that wants that price to be higher – the seller.  And in macro, when we’re talking about the entire economy, we are all not only buyers, but all of us are also sellers.  So the logic from micro that lower prices are good only holds true for consumers/buyers of particular goods.

There are two reasons why deflation, a general drop in most prices, is bad.  First, it discourages people from spending. If a purchase is at all delay-able, then it makes sense to wait because the price may be lower.  But that also means less spending in general and less employment as firms can’t sell their existing inventory.  This particularly applies to consumer durable goods industries (cars, appliances, computers), but it also heavily hits business investment spending and housing investment.

The second reason, and more severe, is because deflation means incomes/wages are not going up either. In fact, deflation means incomes are dropping. But your payments and debts on earlier purchases don’t decline.  So payments on debt take an increasing share of our incomes leaving less and less to spend on GDP.

Yeah, it smells like deflation. And that’s not a good smell.