Gross, Daniel, Newsweek
Byline: Daniel Gross
What's so bad about falling prices?
The talk about the economy in recent weeks has been somewhat deflating. There's the ongoing crisis in Europe, disappointing jobs numbers, a falling stock market--and the prospect of deflation itself.
Deflation--the evil twin of inflation--rears his ugly head with great infrequency. He hasn't been seen around these parts for nearly 80 years, and there's no committee that convenes to declare his return, as the National Bureau of Economic Research's Recession Dating Committee does for economic contractions.
Economists generally agree that deflation is a widespread fall in prices, as measured by the consumer price index (CPI). "I don't know if there is a textbook definition, but I would want to see a full year of falling consumer prices before I announced that deflation was in process," says Brad DeLong, professor of economics at the University of California, Berkeley. The CPI, up 2 percent in the past 12 months, fell in both April (-0.1 percent) and May (-0.2 percent) and has been basically flat for the first five months of 2010.
What's so bad about deflation? After all, it's a pleasant surprise when prices of many items fall. Generations of Econ 101 students and central banks have been schooled to think that inflation is the great bogeyman, since it erodes the value of savings. And for much of our lifetimes, moderate inflation has been the norm. Well, it turns out there's good deflation and bad deflation.
Bad deflation is the kind we had in the Great Depression. "The last time we really had significant deflation in the U.S. was in the 1930s," notes Michael Bordo, professor of economics at Rutgers University. "Between 1929 and 1933, prices fell on average by 15 percent." This deflation was driven by a decline in output, demand, and credit--too little money and wages chasing too many goods and workers. The Depression-era cratering of wages and prices was disastrous because it rendered companies and consumers less able to pay their debts.
But there have been periods of good deflation, in which prices fell even as the economy boomed. In the 1920s, known to this day as the roaring '20s because of the decade's economic vibrancy, prices fell about 1 percent per year. …