And Now Deflation

By Dec 16, 2008, 1:16 PM Author's Blog  

Consumer prices fell by 1.7 percent last month, according to the Bureau of Labor Statistics. That’s the steepest drop in 61 years. Why? Because producers and sellers have discovered that consumers have just about stopped buying. The only way producers and sellers can shrink their inventories and pay their bills is to slash their prices low enough to get some consumers to buy. Automakers with acres of unsold cars are giving deep discounts. Retailers with piles of Christmas goods are holding “40-percent-off” sales. Cable-TV operators are cutting monthly fees.

The good news is that all this price cutting is helping average people at a time when wages and benefits, and jobs, are also being cut. The bad news is it’s also cutting deep into producer profits, causing them to cut even more jobs and wages. The big danger is it may cause some consumers to delay purchases, thinking they can get a better deal when prices drop further. That’s a self-fulfilling prophesy. If more and more consumers take this view, sellers will have to reduce prices further to get them to buy now. That may sound good until you realize it means more layoffs, and more cuts in wages and benefits.

Deflation is more vicious than inflation because it’s much harder to reverse deflationary expectations than inflationary ones. Japan’s “lost decade” is evidence. The last time America witnessed a fall in consumer prices as large as we have now was in 1947, when wartime mobilization and large-scale government spending were winding down, there was lots of underutilized capacity, and producers and sellers were trying to lure consumers back into the habit of buying. What producers and sellers didn’t know was that a whole new generation of returning GI’s and baby-booming parents were about to spend like mad.

Now, the situation is quite different. Rational consumers are starting to save whatever they can because they’re understandably worried about the future.

The sooner we have a major stimulus package, the better. The danger is that it will be too small.

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