Why is deflation such a bad thing?

It seems like deflation worries in the media are fairly prevalent these days. Here's a snippet from a typical article (this from CNN):

"Deflation usually represents a system-wide contraction in demand, with consumers waiting on the sidelines as they wait for prices to decline even further."

Doesn't this happen in the consumer electronics industry all the time? In fact, obsolescence seems built into the model. The same digital camera you bought last year can be had for half the price this year and that cycle of innovation keeps a fairly constant fast pace. You can in fact almost guarantee that you are paying more for the electronics you are buying today than you would tomorrow.

This doesn't seem to stop spending though.

Comments

[Neo(e)con]

What you are talking about in a particular industry sector -- consumer electronics -- is not deflation. It is a change in demand for a particular product. People demand less of the old product because there is a new product. Lower demand = lower price.

Deflation is a macro-economy wide event. And it is an extremely bad thing. If everyone stops buying stuff because they think that prices will be cheaper at some imaginary point in the future, the entire economy pretty much grinds to a halt.

If everyone thinks cars are going to be cheaper next year than today, car makers will stop making cars because noone is buying them. That means they buy less steel, tires, and fuel, and that the people who make steel, tires and fuel buy less iron-ore, raw carbon and refine less petroleum...and so on and so on.

Unemployment will rise, people will spend even less, demand will drop further, lowering price further and causing suppliers to cut workforce even more, and on and on.

There are very few ways to break that cycle and that is the reason that the Fed is so scared of it. What they are doing instead is to make the cost of borrowing cheap, i.e. drop interest rates and print money, so that the opportunity cost of hoarding is less and so that people spend more.

In the long-run, fighting deflation by lowering interest rates or printing money will lead to inflation, and consequently higher interest rates. Deflation is by far worse.

[claw]

People won't stop buying things forever though right? So even though prices are dropping if you need to have something (car, food etc) you will still end up buying it. At some point the deflation will end naturally.

Back to the consumer electronics sector - the whole category of products keeps getting cheaper/better/faster and it is in a consumer's interest to wait as long as possible before buying something. Is this not analogous to the deflationary cycle you've outlined?

[Neo(e)con]

Though getting better and faster, the category isn't getting cheaper, at least in terms of profit. If there were zero long term profits to be had, there will be no new entrants to the market. Such a case is evidently not true.

Price drops for last years products for reasons far different from deflation. These reasons are due to the basic factors of demand. Some are: availability of substitutes and alternates, and change in price of complements, change in technology.

For instance, p-eople pay less for last years digital camera than this year because more are available, because iPhones and other devices take pictures that are equivalent, because today's camera is more technology is better than last years.

This has nothing to do with deflation. All things equal, if there is no new innovation in technology, if there are no alternates, and if there are no substitutes, and yet prices fall, then you end up in deflation, which is what people are scared of to start.

This is a good place to start on basic economics: http://www.investopedia.com/university/economics/

[Neo(e)con]

Eventually people will start buying stuff. But what we care about is the near-term where businesses get hurt, people lose jobs and people stop buying things.

I refer you to Keynes' famous quote about people all being dead in the long-term. http://en.wikipedia.org/wiki/Long_term

Don't worry about the long-term; you have no capability of dealing with it. Your business needs to figure out how to deal with the next year. The period prior to which equilibrium is established is will be hard.

[Payday Loans]

The bad thing for deflation is surely for the retailer market. They will be challenge to lower their price. The people would probably look for items that have cheaper price. Saving money may seem like the most practical things to do amid the current recession. But in actuality, it can be harmful to a diminishing economy. According to the Wall Street Journal, economists call it the “paradox of thrift.” Another example is if you avoided getting payday loans but then found out you bounced a check and found out that was much more expensive. This also applies to deflation. Deflation results in lower prices and increases the value of money. The pessimistic part of this is you are going to really need those lower prices if you end up facing unemployment because your employer cut production just to meet competitive prices. Not really a pretty picture, right? However, there is good news, just like how payday loans are good news for people seeking to avoid late fees or overdraft charges. There is a very small chance that this recession will lead to deflation. Most economists agree that we will probably not see deflation anytime soon, and Feds are saying that things will get worse before they get better. So does that mean there is hope?