Nov 15, 2008

Deflation in the developed world

I was discussing deflation with a friend a couple of days back and was planning a blog post on it.. lucky for me that The Economist ran a story containing most of what I wanted to say (and some more).. read the story here..

Text-book economics tells us that deflation has the opposite effect of inflation.. deflation favours lenders rather than borrowers which...
  1. Increases the real burden of fiscal debt on the government. Since debt is largely denominated in nominal terms, the tax on nominal income (which is the source of debt-servicing) has to be raised higher to service the debt. 
    One argument against is that the government can simply print money to service debt. This is not the case in the Western world where the printing press is independent from the debt issuing agency. However, more thought needs to go into this aspect of deflation..
  2. Indebted consumers suffer as interest payments increase as a portion of their dimishing nominal income. This will almost certainly lead to contraction in consumption, aversion to debt and other ugly effects which will hurt the GDP.. 
  3. The same sad story holds true for corporate investments.. 
The net effect of all this is what many would charmingly call a "vicious deflationary spiral" that kills the economy, growth and standards of living...

The sad reality is that text-book economics seems to be coming to life.. according to the above article in The Economics, bond markets expect consumer prices in America to fall by as much as 2½% over the next year.

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