Tuesday, November 18, 2008

Prices Are On Their Way Down--That’s Good News, Right?

Considering all the bad news in the headlines now, the fact that prices are falling is probably making most people ecstatic. The biggest excitement of course is likely surrounding gas prices, which fell nearly 25 percent last month, according to a Bureau of Labor Statistics (BLS) press release. And while prices of goods other than food and energy actually rose 0.4 percent last month, according to the same report, as the cheaper commodity prices come into play for manufacturers, we are surely going to see these prices fall soon enough. Since Americans, along with the rest of the world, are in penny-pinching mode right now, these new lower prices are a godsend. This good news, though, could quickly turn bad if it gets too out of control.

Of course we like to see prices fall; that means we can now buy more stuff than we could before, and for the most part falling prices are a good thing, especially when they had been inflated so much in recent years. What we have to watch out for is deflation. Deflation can be a horrible thing, and even though you might think it is good, it most certainly is not. Deflation leads to lower company profits, layoffs, business closures, falling wages, loan defaults (deflation increases the real interest rate on loans) and so on. People lose the incentive to spend, and borrowing becomes nearly extinct as borrowers don’t want to borrow and banks don’t want to lend. Deflation can even be the catalyst that pushes a country into a depression, and we know we don’t want to go there again.

Deflation is an extremely scary thing to think about in reality, and the only scarier thing to think about is the fact that we might not be able to prevent it from happening. Typically, preventing deflation has been as easy as lowering interest rates and adding to the monetary supply. Interest rates are already at 1.0 percent, meaning there really isn’t much more room to maneuver. Japan had to deal with their own bout of deflation during their so-called lost decade, and they weren’t able to dig out of it even with interest rates at 0 percent. Sure, there are a few other things that the government can pull out of its sleeve, but again, there is no guarantee that anything is going to work this time around.

If the government is able to help us prevent deflation, it is also possible that they could end up creating another boom and bust cycle. The following is an excerpt from an opinion piece by Gerald P. Driscoll, the former vice president of the Federal Reserve Bank of Dallas, published in the Wall Street Journal:

“The economy now confronts deflationary forces. If past is prologue the Fed will concentrate on those deflationary forces for too long and rekindle an asset boom of some kind. The fiscal "stimulus" being contemplated by Congress could be another economic accelerant. If both the fiscal and money stimulus efforts kick in just as market forces also kick in, we're likely to see another unsustainable boom that will be followed by a bust.”

Either way it seems that we are likely headed for an undesirable outcome. This reminds me of the game Operation I used to play when I was a kid. The smallest mistake in any direction is going to cause all heck to break loose. I don’t know about you, but I sure hope Obama and his new staff have amazingly steady hands.

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