Hamilton Explains Why Deflation Is Bad

James Hamilton at Econbrowser explains why deflation is bad:.

It is also quite clear to me that deflation– an increase in the number of goods you can buy with an individual dollar– can be even more destructive. Since this may be less obvious to many readers, let me review some of the reasons why I say that.

For people struggling under debt burdens, deflation makes repaying the loan more difficult and less likely to happen. If that leads to a wave of bankruptcies, everyone, including creditors, can end up losing out. Debt burdens and delinquencies remain a significant problem holding back the economic recovery today. These problems would magnify enormously if a serious deflation were to get underway.

Deflation also means you can earn a positive rate of return just by stuffing money in your mattress. That creates an incentive for consumers, firms and banks simply to hoard cash rather than invest it productively. Even very sound investments can have a hard time competing for lenders’ dollars when the alternative of hoarding becomes sufficiently lucrative.

I’m personally persuaded that the 25% drop in the overall price level in the U.S. between 1929 and 1933 was one factor contributing to the depth and severity of the Great Depression. Our recovery began pretty dramatically when the U.S. reflated by dropping parity of the dollar with gold in 1933. Other countries had a similar experience– things began to improve only after prices began rising.

Today the U.S. is flirting with deflation, as we have been for well over a year.  We are flirting with much more serious trouble than what we have already seen.