At first glance, the effects of deflation can seem like a good thing – after all, deflation is accompanied by falling prices, which certainly make consumers happy. But deflation is often a sign of a recession and, in the long run, is not a good thing at all. Here are four reasons why:
Decline in Prices & Wages
Yes, deflation means a decline in prices, which can seem like a good thing. However, deflation in an economy isn’t selective – in order for prices to fall, wages fall too. In theory, your money will go further in a deflated economy. But because deflation is just a general decline, it’s likely that employees will see cuts in their wages or hours.
Increase in Unemployment
If wages aren’t cut, then the other option is unemployment. Many employers find it difficult to cut salaries or wages – or, for those paying minimum wage, they can’t cut them. There is often a rise in unemployment caused by deflation. Deflation is caused by long-term decline in demand, which in manufacturing or service industries will lead to a decrease in supply – thus, layoffs and increased unemployment rates.
Debt Doesn’t Deflate
Deflation is terrible for debtors. While deflation happens, the price of your already-incurred debt doesn’t change. Prices and wages may fall, but debt doesn’t. This leads to people cutting back on spending in order to pay on debts, or ultimately, defaulting on their debts. Foreclosures and repossessed cars lead to accumulated bad debt, causing a ripple effect and in the worst-case scenario, leading to bank runs if depositors become too nervous about the future of their bank.
[Read: How to Invest During Deflation]
Consumers Hoard Money
Overall, deflation is terrible for economic growth. As consumers watch prices fall, they hold tightly to their money in the hopes that prices will be lower tomorrow than they are today. Moderate drops or deflation may have a positive impact on consumer spending, but drastic ones will certainly cause people to hesitate when they spend.
Conclusion: Why is Deflation Bad?
When deflation hits, production of goods slows down. Manufacturers and business owners try to liquidate their inventory. Unemployment rates rise, consumers begin to default on debts and demand plummets. Consumers hoard their money with the hope that prices will continue to drop. In the worst situations, bank runs can happen and governments try to stabilize the economy through policies. All in all, while deflation may seem like a good thing at first blush, it is a dangerous situation for the economy and market.