Personal Finance 101: Deflation and You

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Michael writes:

I’ve read several articles recently that claim the United States is headed into a period of deflation, but they made it sound like that was bad news. The way I understand it, deflation means lower prices for everyone. How can that be bad?

pf101Several commentaries from various writers and radio broadcasters are circulating at the moment predicting a “deflationary spiral” for 2009 and beyond. I read about this first in the November 13 issue of The Economist in an article entitled Depressing Times. On the surface, that might seem like a good thing, but when you dig deep, it’s not a good thing at all.

What is deflation? Deflation is the direct opposite of inflation. Deflation occurs when, over time, prices on goods and services go down instead of up. Deflation can occur in just some specific sectors – like cars, for example – or it can strike everything and cause all prices to fall.

Deflation is rather unusual, actually. In developed countries, a constant but relatively low level of inflation is actually the normal state of affairs. That’s why, normally, year after year, we see prices of the ordinary things we buy inch upwards – it’s inflation at work.

Isn’t deflation a good thing for consumers? Over the very short term, it is a good thing. If deflation occurred over a very short time, ended, and prices started to climb again, that’d be great – it’d be like a global 5% off sale everywhere, and that would undoubtedly be a good thing for people who are just worried about putting food on the table and buying Christmas presents for their kids.

Things get problematic, though, if deflation happens over a long period and comes to be viewed as the norm. When that happens, people stop spending money.

Why would deflation cause people to stop spending money? Think about it. Let’s say you were thinking about buying a new car, for example. The current price tag on that model was $20,000. However, you knew that deflation was at work and all prices were falling. Wouldn’t you think to yourself, “You know, I could just wait a year and that car would only cost me $19,000.”

Compare that to a situation with inflation. You see a car there for $19,000, but you know prices are going up. You can reasonably expect that next year the price of that car will be $20,000, so there is some push to buy that car now rather than later.

And that’s the key difference. Inflation encourages people to spend money now – deflation encourages people to choose to spend money later.

If a lot of people choose to spend their money later and not spend their money now, products go unsold. Because there’s no demand, manufacturers slow down production. Factories slow down. People get laid off – and then can’t spend money anyway. Retailers cut costs to try to attract buyers. And the cycle continues.

That sounds nasty. What can I do to protect myself if deflation happens? The best thing you can do is not to assume that deflation will continue forever. Don’t delay purchases with the idea that the price will continue to drop everywhere. Instead, do careful bargain hunting, but pull the trigger when you find the item for a suitably low price.

This is similar to the logic of why it’s a waste of time to obsess over timing the stock market. No one knows for certain when the stock market is at an absolute bottom, so you shouldn’t waste time trying to guess when that bottom is. Instead, take advantage of the fact that prices are down, period, and make smart purchases.

If you’re worried about your investments, the solution, as always, is to diversify. Don’t have all of your retirement money in domestic stocks. Spread it out to international stocks, bonds, cash, real estate, and so on. That way, no matter what happens, you have some stability.

For now, though, don’t worry about it. Keep making sound financial choices. Spend less than you earn and sock away the rest. Practicing good, sound financial behavior in your day-to-day life will provide the basis for weathering any storm.

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26 thoughts on “Personal Finance 101: Deflation and You

  1. Plus if the entire world was deflating then you would be earning less money and that would be even more incentive to spend less. I wonder if you are right and we will enter into a period of deflation.
    Hopefully I will be earning enough money from my entrepreneurs blog to get me through this economic downturn period. I don’t think it will last longer than 2 years though.
    Thanks for the article

  2. You make it sound like factories making less crap is a bad thing. Most of the things we buy are wants, and disposable at that. A DVD you just bought will not be on your shelf in 20 years. Our land and our oceans are full of consumerist junk. So are our closets.

    I say, let deflation happen! It will get people back to solid values: needs over wants, just like it did during the depression. We are a wasteful society, and set up to need that waste to thrive. Insane!

    Put those out of work people into industries that will actually benefit us as a society in the iong run- expanded recycling, composting the lunch waste at public schools, washing things with muscle instead of toxins, offering affordable childcare to every hard-working parent in this country.

    What is needed is a new mindset, and the willingness to endure growing pains as we switch from a junk and marketing based economy to something that will sustain our children’s children.

    Criminy- if we can bail out AIG, then we can afford a few sheckles to try something new!

  3. I wonder how much of the deflation can be contributed to the fact that gas prices are going down (which I don’t think is deflation at work, I think that it was a false shortage/price gouging and people revolted)

  4. @kristine –

    “A DVD you just bought will not be on your shelf in 20 years.”

    Maybe for you. Sheesh, I still have vinyl records from the ’70s (and older) that get played once a year.

  5. The consumer electronics industry seems to be in a perpetual state of deflation. Computers, cameras, iPods, TVs, and DVD players all get cheaper AND more capable as time goes on.

    I’d be curious to know why deflation in other consumer areas causes problems that don’t seem to be as much of a problem with CE.

    Is it the buyer’s expectations, better marketing, a business model that expects more hesitation on purchases and rides through it?

  6. My knee-jerk response about this description of deflation is to agree with Kristine; setting aside for a moment the short-term social upheaval involved (a lot to set aside, I agree), one possible socioeconomic response would be a national shift toward manufacturing necessities rather than luxuries and toward employing people in the kind of jobs that are essential to a stable nation: hospitals, utilities, public construction, education, agriculture, law enforcement, sanitation, etc., at least until an inflationary cycle begins again, which is probably inevitable in a stable society.

    Hmm, you know, I realize that I’m more or less suggesting a New Deal for America — take those who’ve been left unemployed because the factories making “consumerist junk” closed down and put their skills and smarts to use in the equivalent of a Civilian Conservation Corps, fixing up our national parks; the Civil Works Administration, building bridges to somewhere; a Public Works Administration and a Works Progress Administration, building or fixing up roads and other public works. Deflation wouldn’t diminish the national importance of national parks, sustainable-energy plants, better roads, or better and more teachers for the nation’s children.

    I’m not a fan of big government, really. But when private enterprise lets you down as badly as it has, maybe it’s time to try something else for a while. One thing I *am* a fan of is my tax money going toward public programs, roads, parks, education, and the like — not toward bailing out banks, property owners, and auto manufacturers. So, yeah, Kristine, I agree; it seems to me if we can afford to bail out AIG, we can afford to put our money where it’ll do the nation and its citizens more long-term good.

  7. Something Trent did not mention with wide-spread deflation, income deflates as well. A true deflationary cycle is wages dropping faster than the price of goods.

    Dropping prices can not support high wages unless profit margins increase. In true deflationary times, that is not likely. But not all prices will drop, many basic necessities (food, clothing, energy) will increase in price as dwindling supplies and higher demand bucks the overall economic trend.

    Long term deflation means a societial shift from industrial/urban living back to agrarian/rural subsistance. Large industries will collapse without anyone purchasing their products and all those jobs would vanish. Large cities could not be sustained without the infrastructure to support a densely packed populace. Back to the Dark Ages.

    Yet another example as to why all debt is bad. Losing the farm would mean losing food, shelter, income all in one swipe.

  8. In general I like what Kristine and Dru have to say above but Carl has a point too. If prices for goods are dropping then it seems obvious that either people are losing their jobs or having their wages cut. If you’re one of those unlucky people, it’s very bad news at your house. Dropping prices then merely means that you’re not in as big a heap of trouble as you would have been otherwise. It’s only when your income remains constant during a deflationary period that you reap the benefit of lower prices.

  9. Hi Trent,

    I think all things considered it is better to remain relatively stable than to have deflation or inflation. We have had a large amount of what I call shadow inflation in the past few years. This deflationary cycle is natural, and will help create balance.
    I doubt any deflation will last for too long because of how much money our governments pump into the system.

    Cheers,
    Jeremy

  10. Historically Social Security payments have increased because of inflation, so I guess we could expect them to decrease with deflation. Your mortgage payments would remain the same except with an ARM they might decrease. House values could decrease, which could put you in the position of owing more than it is worth — something we are already seeing. Bonds may be called where the interest rate is above the market. People who pay alimony might sue to reduce it.

    Should we expect the government to adjust the minimum wage *downward*?

    Meanwhile all those credit card and car loan principals will be just as big as they ever were; but you might be making less money to pay them with.

  11. Trent, I cannot believe you fell for such a common myth. You repeat it here:

    “If a lot of people choose to spend their money later and not spend their money now, products go unsold. Because there’s no demand, manufacturers slow down production. Factories slow down. People get laid off – and then can’t spend money anyway. Retailers cut costs to try to attract buyers. And the cycle continues.”

    THIS IS A MYTH!

    Let me give you an example. You have $20,000 of discretionary income. You can spend it (let’s say, on a car). But you decide not to. Oh no!

    But you have to do something with that $20,000. Typically, if you don’t spend it, you will invest it — either in a savings account, a CD, stocks, bonds, etc. As long as you don’t put the money in your mattress, the money goes into the economy either way!

    Remember, when you invest, either a company or a bank has the ability to use that money — just the same as they would if you spent it! (In fact, sometimes savings is BETTER, due to fractional reserve lending being able to create more money.)

    Spending is NOT the only way money helps the economy! Do not fall for this myth. It’s the same myth that told people to pull money out of their houses and use them for ATMs and drove our savings rate to a negative number.

    Deflation after a long period of high inflation is a good thing. More savings is a good thing. Don’t let whoever likes to circulate these “spending is the only thing that can save the economy” rumors get to you.

    Please read “Economics in One Lesson” – it’s a book, by Henry Hazlitt, that is now in the public domain: http://www.hacer.org/pdf/Hazlitt00.pdf

    Especially the chapter on “Bailing out the X industry”…

    Also, a more recent summary of the same idea on the WSJ: http://online.wsj.com/article/SB122663413095027641.html

    -Erica

  12. If a car company suffers because they made too many cars and can’t sell them all, I can’t find any sympathy for them. The people I do feel sympathetic towards are the workers who are at risk of losing their jobs.

    If our economy has been flourishing because so many people have been able to get easy credit and spend more money than they could afford… then maybe the situation now is a necessary correction. The unfortunate thing is that people who have done everything “right”, who are not heaped in debt, who pay their mortgages on time, are also the ones who are suffering.

  13. This is one big reason that I am buying my house now, in a “down economy,” rather than later. It may seem selfish, but I know that prices will not continue to slide forever. At least not in the part of the country where I live. But I intend to capitalize on the housing downturn to now get into a home that I was priced out of before.

  14. I say bring on the deflation! Of course, I have no debt, a paid-off house and enough money in the bank to live on for about 18months or so. It won’t be so nice for people who have debt. Then again, inflation wouldn’t be so nice for me since I have no debt.

  15. I like how all these comments about “manufacturing necessity instead of junk” completely ignore reality. The things you describe are not really necessities and not wanted buy most people. People want to buy DVDs and other “junk.” It serves a purpose that people want on the individual level.

    How many people want to pay extra to “compost public school lunch”?

    I guess it’s really easy to spend other people’s money when it isn’t yours or you relieve on confiscating money by force to fund your pet projects.

    There is really no such thing as society
    “putting people to work”- at least not in a world I want to live in. People put themselves to work and create work in services where they are needed and there is a demand. If there is an actual demand for services people will choose to fund them voluntarily. If you have rely on force to fund your pet projects, they are not worthy.

    If you think DVDs and other things are “junk”, then create something that isn’t junk and people want. Don’t just make a “jobs program” that wastes other people’s money and production.

  16. kristine has some good points. I for one have begun to think twice about my purchases. I haven’t bought a CD, DVD in years, but even things like books I’m more willing to “rent” from the library than buy. Not to mention I am more concerned about the packaging things come in and whether or not it is recyclable. We’re also trying to cut down on our paper towel, sandwich bag, disposable diaper and other consumables usage. Our trash now is about equal to or less than the amount of stuff we recycle. I’m hoping to get it down to about one bag a week, instead of the current 2 or 3.

  17. @ Kristine, I really don’t think we should hope for anything near a Great Depression. That would be a lot of pain to most of our society. Don’t cut off your nose to spite your face.

    @ DArin, I think the reason electronics like computers and such can exist with deflation is simply because those items get better with each new product generation. If they were producing the same quality stuff every year and had deflation then that industry would hurt, but since they can make it better, faster and cheaper the consumers still have a reason to keep coming back for more. And decreasing prices allow the products to be sold to a ever wider world wide market.

    Jim

  18. If you talk to anyone who lived through the Great Depression, (and therefore have lived through the great inflation of the late 70′s)they will tell you that deflation is bad. On th surface it might sound good – reducing consumerist junk, etc. but it really means closing factories, more hunger and a lower standard of living, globally. You can complain all you want about the “consumerist” society, but in the USA and other such countries, the “poor” (actally those below some arbitrarily-defined “poverty level” live like kings compared to the average or “rich” people in many other countries.

  19. Report came out today – Record 1% drop in consumer prices (i.e. Deflation). That being said this “deflationary” period could be seen as a readjustment akin to the stock market getting more in line with proper prices.

    Most people who have at least taken intro economics understand the Supply and Demand Curve. But what happens if that Demand curve shifts to the right? Then prices increase – this may be the market’s way to shift us back to a normal X.

  20. @ Greg C, when the main purpose of those programs is to give some kind of employment to people who are unemployed then I think it’s a good idea.

    It may be a bit of “make work” type of job but at least you are getting *something* in return for your tax dollar. Or would you prefer we just pay unemployment and welfare to vast numbers of people who are without a job?

    In the scenario of another “New Deal” we aren’t talking about men and women who want to just sit home on their butts. The people put to work want jobs.

    I certainly wouldn’t ask for a 2nd great depression so we could clean up our parks, but if rampant deflation caused one then what? If we’re paying a significant percentage of citizens some kind of money it sure would be nice to at least get those clean parks out of it.

  21. I don’t have a problem with a Civilian Conservation Corps – as long as those employed actually DO the work. The public infrastructure in this country is in dire and desperate need of repair – aging bridges and roads everywhere, railroads that need to be revived so that trains can offer an alternative form of travel and shipping. The problem I’ve seen in a lot of private industry is too many Americans without the old-fashioned American work ethic. I don’t want the overnight worker who hides and sleeps on his shift repairing a bridge I cross, thanks very much; I want the guy or girl who works hard regardless of supervision working on that bridge, that road, that railroad. I DON’T agree that it’s make-work; I think it’s an opportunity to fix some of the things that people are always saying need to be fixed. And thanks, I WILL keep my DVDs for 20 years – why do you think I bought them???

  22. One thing that I don’t think has been mentioned is that deflation makes it extremely hard to pay off debt (which obviously can not deflate). In this economy, when so many people are over-leveraged, that would be bad for everyone and drive people on the edge even closer to foreclosure.

  23. Can you imagine this new administration having to lower Social Security payments because of deflation?
    What a wondrous awakening for the liberal base.

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