News

Here’s the “Deficiency” Which Leads to “Falling Prices”

Let's start off with a comment from the 2020 edition of Robert Prechter's book, Conquer the Crash:

An economic contraction begins with a deficiency of total demand for goods and services in relation to their total production, valued at current prices. When such a deficiency develops, prices for goods and services fall. Falling prices signal producers to cut back production, so production declines.

On that note, here's an excerpt from a May 3 USA Today article titled "Besides millions of layoffs and plunging GDP, here's another worry for economy: Falling prices":

As if Great Depression-size job losses and a cartoonish contraction in the nation's economic output weren't enough, analysts are starting to fret over a new risk from the coronavirus pandemic: deflation.

Deflation, or a sustained period of falling prices, may sound like a good thing: Goods and services cost less, saving consumers money. But deflation prompts shoppers to put off purchases on the expectation that prices will fall further if they wait. That can lead to a toxic cycle in which lower spending prompts businesses to cut wages, further pushing down consumer purchases and prices.

Deflation also can make it harder to repay mortgages and other debt, which become costlier in inflation-adjusted terms.

The economy can get stuck in a rut, similar to the "lost decade" that battered Japan in the 1990s.

Economists similarly worried about deflation during the Great Recession of 2007-09. But while average annual price increases dipped below 1% in 2010, they never declined. The current recession, however, has featured a more abrupt and dramatic blow to the economy.

"I think the risk of the U.S. falling into a deflationary trap is higher now than at any time during the Great Recession," says [an] economist of [a major financial analytical firm].

Yet, when it comes to defining deflation, it's well to put "falling prices" in their proper perspective.

Let's return to the 2020 edition of Conquer the Crash:

When the volume of money and credit rises relative to the volume of goods available, the relative value of each unit of money falls, making prices for goods generally rise. When the volume of money and credit falls relative to the volume of goods available, the relative value of each unit of money rises, making prices of goods generally fall. Though many people find it difficult to do, the proper way to conceive of these changes is that the value of units of money are rising and falling, not the values of goods.

The most common misunderstanding about inflation and deflation -- echoed even by some renowned economists -- is the idea that inflation is rising prices and deflation is falling prices. General price changes, though, are simply effects.

Enter your email address to get email updates and special offers. It's free!