Wouldn’t it be nice if prices of products actually fell instead of rising? For many of us in India who have been facing the brunt of galloping prices over the past several months, this would seem clearly welcome. But much as we may like to pay less, a sustained decline in prices, deflation, may not be in our best interests. Here’s why.
Economists have long held that while high inflation (currently being seen in India) increases economic hardship and is a clear no-no, mild inflation is a good tonic for growth. The latter provides the right incentives (reasonable profits) for providers of goods and services to continue producing. This, in turn, keeps employment and spending at healthy levels, attracts additional capital into businesses, and keeps the wheels of the economy chugging along.
On the other hand, there would be cause for serious worry if deflation sets in. Deflation, in fact, is considered to be a bigger evil than inflation, and evokes strong action by policymakers who try every trick in the book to prop up prices. The predicament of a slowdown-induced deflation currently seems to be high on the worry list of the US and many European countries, even as the authorities in India are grappling to rein in high inflation.
The wet blanket
To be clear, what the RBI and the Government in India may be hoping for, currently, is disinflation, and not deflation. Confused? Disinflation is a drop in the rate at which prices rise, while deflation is a decline in the prices.
Disinflation would reduce inflation, but still keep rates at levels good enough to sustain the animal instincts of the business community. Deflation, on the other hand, would drive down prices and throw a wet blanket on the economy. This is because deflation sets into motion a self-feeding downward spiral of negativity. This leads to undesirable consequences including high levels of unemployment, recovery from which could be long and painstaking.
Deflation often results from a slowdown in which reduction in demand vis-à-vis supply causes prices to dip. With a sharp decline in prices, consumers tend to postpone purchases in the belief that prices will head further lower. This adds to the pressure on businesses, which in addition to a fall in prices also see an accumulation of inventory.
Production cuts are hence resorted to, which result in factory closures and consequent layoffs or salary cuts. With unemployment increasing, income levels in the economy fall, leading to further cuts in consumer spending and more pressure on prices. A vicious cycle emerges, the cascade effect is felt across sectors, and the economy goes into defeatist mode.
The trouble accentuates when businesses and individuals start defaulting on their loans, and banks go slow or freeze their lending activities. Declining corporate performance also results in stocks taking a beating on the equity markets. Deflation can cause slowdowns to become full-blown economic recessions and depressions.
Some of the prominent periods when deflation played havoc include the sharp fall in prices in the US economy during the Great Depression of the late 1920s and early 1930s. Also, after the boom of the 1980s, the Japanese economy experienced what is called as the ‘lost decade’ (1991-2000) during which prices crashed.
To prevent deflations and to tackle the downward spiral caused by them, governments resort to large-scale spending, and undertake massive projects to increase employment, incomes, demand, and prices. Also, huge sums of money are pumped in to propel demand and get the economy back on track.
For instance, in the aftermath of the financial market crash in 2008, the US government undertook big-ticket stimulus measures and QE (quantitative easing) to revive the economy. Central banks also resort to rate cuts to make money available cheaply and revive demand. Bank rates in Japan hovered close to zero for a long time in a bid to revive demand and prices.
Similarly, at present, rates in the US and Europe have been reduced considerably. However, given that there is a floor below which rates cannot go, this measure has not always been effective. Governments also resort to tax cuts to prop up demand and prices.
Not all the same
So, should all price declines be frowned upon? No. Deflation, which affects prices across the economy on a sustained basis mainly due to decreasing demand or liquidity problems should be a red flag.
However, this is not the same thing as a fall in prices of goods and services due to technological innovations and increased competition. Computers and laptops, for instance, have become increasingly cheaper due to advances in technology.
However, in this case, lower prices have given a fillip to demand, benefiting both producers and consumers. Also, a decline in prices, if it is a temporary phenomenon due to a high base effect, may not be much to worry about.
By Anand Kalyanaraman
The Business Line, Published on October 9, 2011