There are mounting fears that deflation has snuck up on us in the dark and is setting a trap. Or at least, that's what the media seems to be suggesting. We'll look at whether deflation is something to fear and whether it has ever actually happened or is likely ever to happen.

IN PICTURES: 8 Ways To Survive A Market Downturn

What Is Deflation?
In recent articles describing the coming deflationary apocalypse, no two definitions are alike. One even mentioned good deflation as a general increase in the supply of goods leading to lower prices, which seems a lot like the law of supply and demand - a related, but separate economic force. Another pointed out that deflation leads to falling prices; except this was presented in a negative light. The truth be told, consumers would be expected to undergo the horrors of paying less for goods and services in an economic deflation.

The concept of deflation would have to be unfamiliar for anyone under the age of 80, because we've seen nothing but inflation, brief periods of disinflation and the slightest whiffs of disinflation from the great depression forward. It's telling that inflation has hit double digits several times in the last century and been a single digit presence most of the other years, while deflation has only ever touched double digits once in history and is often visible only in retrospect as a slight retraction in the relentless climb of inflation. (To learn more, see our Inflation Tutorial.)

The Currency Dealers
The Great Depression is the fallback for anyone who can't explain why paying less for goods is a bad thing. The problem with using a great depression-style deflation is that the "deflation" of the great depression was not an increase in the purchasing power of each dollar, but the throttling of the money supply.

During the Great Depression, the Fed saw gold reserves grow and money supply shrink, something that should have been impossible under a gold standard with a reasonable Fed. By reducing the money in circulation, the Federal Reserve essentially destroyed the ability of supply and demand to balance.

Producers of all types were dropping prices, which should have eventually hit a point at which people would buy, but there was no money with which to buy. This led to more than just lower prices. It touched off failure after failure as the lack of money - a medium of exchange - shut down the normal processes of the economy.

It is no coincidence that much of the businesses and work that did go on in the U.S. during the depression was of the barter/direct trade variety. The great depression gives deflation a bad rap because it was the scapegoat for poor monetary policy. Oddly enough, the same is not true for inflation even though the stagflation of the '70s was nearly as damaging in terms of the destruction of real wealth. (To learn more, see The Great Inflation Of The 1970s.)

Deflation AND Deficit Spending?
We no longer have a government that is shy to buy up assets to backstop the economy. As TARP proved, we'll even buy up car companies, let alone injecting capital into banks. So where is this deflation to come from? At best, we may get lucky and have a period of disinflation - a slowing of the inflation that usually ticks on like clockwork. Still, even this is unlikely because - and there's no way to dress this up - the U.S. is running an extremely fat deficit. Deficits have to be paid, and an old favorite for payment short-cut is, you guessed it, to crank up inflation. (For more, check out Top 6 U.S. Government Financial Bailouts.)

Why One and Not the Other?
It's worth asking why inflation is such a non-issue and deflation is something to be feared. After all, you and I see our savings eaten away by every percent of inflation and our purchasing power decrease at the same time. If inflation favors debtors, then surely deflation favors savers. This is correct. By any of the myriad definitions of deflation, a dollar increases in actual value. This means that the dollar value of debts will also increase for those who have them, whereas the purchasing power of savings will increase for those who have some.

The U.S. government, however, is one of the largest debtors in the world, via bonds and outright loans. Similarly, banks and the entire financial system are debt-financed for the most part, again with bonds and loans. So, you can understand why deflation would be a nightmare for them. This is why deflation has never happened in the real sense other than through monetary bungling.

The Bottom Line
When people talk about the fact that computers are cheaper today than ten years ago, they are talking about increased production (and efficiency) pushing up supply and lowering demand - this is supply and demand at work, not monetary policy. Deflation and inflation are controlled by the supply of money.

Since we moved to a fiat currency, it has been inflation more or less non-stop. Periods of disinflation are rare, and true deflation is the Loch Ness monster of economics – known only through tall tales meant to spread awe and terror. We've learned to deal with inflation and its steady tax upon our wealth, surely we could adjust to a dollar going further and prices dropping. In truth, a hard money policy would be the best solution, but given the choice between being bled by inflation or helped by deflation, why not give deflation a try for once? (To learn more, see Deflation: A Two-Sided Coin.)

Catch up on your financial news; read Water Cooler Finance: The Unrelenting Claw Of Bernie Madoff.

Related Articles
  1. Investing

    What’s Holding Back the U.S. Consumer

    Even as job growth has surged and gasoline prices have plunged, U.S. consumers are proving slow to respond and repair their overextended balance sheets.
  2. Economics

    The Problem With Today’s Headline Economic Data

    Headwinds have kept the U.S. growth more moderate than in the past–including leverage levels and an aging population—and the latest GDP revisions prove it.
  3. Economics

    Explaining the Participation Rate

    The participation rate is the percentage of civilians who are either employed or unemployed and looking for a job.
  4. Economics

    Understanding Organic Growth

    Organic growth is the increase in a company’s revenue and value due to internal operations.
  5. Economics

    Explaining Market Penetration

    Market penetration is the measure of how much a good or service is being used within a total potential market.
  6. Economics

    Calculating the Marginal Rate of Substitution

    The marginal rate of substitution determines how much of one good a consumer will give up to obtain extra units of another good.
  7. Economics

    What Qualifies as Full Employment?

    Full employment is an economic term describing a situation where all available labor resources are being utilized to their highest extent.
  8. Economics

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  9. Fundamental Analysis

    Is India the Next Emerging Markets Superstar?

    With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP.
  10. Economics

    A Look at Greece’s Messy Fiscal Policy

    Investigate the muddy fiscal policy, tax problems, and inability to institute austerity that created the Greek crises in 2010 and 2015.
  1. Monetary Policy

    The actions of a central bank, currency board or other regulatory ...
  2. Cost, Insurance and Freight - CIF

    A trade term requiring the seller to arrange for the carriage ...
  3. International Monetary Fund - IMF

    An international organization created for the purpose of standardizing ...
  4. Black Money

    Money earned through any illegal activity controlled by country ...
  5. Inflation

    The rate at which the general level of prices for goods and services ...
  6. Delivered Duty Unpaid - DDU

    A transaction in international trade where the seller is responsible ...
  1. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  2. Is Argentina a developed country?

    Argentina is not a developed country. It has one of the strongest economies in South America or Central America and ranks ... Read Full Answer >>
  3. How can the federal reserve increase aggregate demand?

    The Federal Reserve can increase aggregate demand in indirect ways by lowering interest rates. Aggregate demand is a measure ... Read Full Answer >>
  4. Are Social Security benefits adjusted for inflation?

    Social Security benefits are adjusted for inflation. This adjustment is known as the cost of living adjustment (COLA). For ... Read Full Answer >>
  5. When has the United States run its largest trade deficits?

    In macroeconomics, balance of trade is one of the leading economic metrics that determines the trading relationship of a ... Read Full Answer >>
  6. What is the utility function and how is it calculated?

    In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!