Why Is Deflation a Bad Thing for the American Economy?

• Author: Jeffrey Simmons
• Posted: 2024-08-05

You have likely heard talk about how the Federal Reserve is doing anything in its power to fight deflation. While you may think that prices going down is a good thing for you, deflation is actually the worst thing for the U.S. economy. It threatens to pull the economy into a long-term recession. You would think that if inflation is bad, then the opposite of inflation would be good. However, that is not the case. Generally, what is bad for the economy is also bad for you as a consumer. Here are five reasons why deflation is bad for the American economy and consumers.

Debt Is Worth More

As a consumer, you may owe money for your mortgage and your credit card bill. The debt that you have already incurred remains the same. However, the value of your assets has shrunk. You still need to pay the same debt payments that you otherwise would have had to, even when overall prices have gone down. In that way, your debt becomes worth more, which makes it harder for you to pay back. This is even more true if deflation has caused your pay to be slashed. The same thing holds true for the U.S. Government. The relative value of government bonds goes up as the dollar is worth comparatively more, and the government is in a worse financial situation.

You Will Spend Less

Deflation incentivizes saving. As a consumer, you would wonder why it would make sense to spend money today when something could cost less tomorrow. This means that you will put money away to use at a later time. If your dollars were worth more tomorrow, it would make perfect sense for you to put them away. Now, take an economy that aggregates tens of millions of microeconomic decisions like yours to spend less. What this means is that consumer spending across the entire economy will drop. Considering the fact that consumer spending makes up over two-thirds of the U.S. economy, it means that the entire economy is in trouble. While you will spend less for things that you buy, the overall economic situation will deteriorate because the fall in consumer spending will take down the entire economy.

Deflation Lowers Consumer Sentiment

Overall, deflation is just a bad look for the economy. It creates a perception that things are not right. In turn, this keeps business from spending money on equipment and from hiring new workers. Consumer sentiment is the forerunner of economic growth. When it is low, people keep their money in their wallets. While inflation is also not good, moderate inflation at least creates the perception that there will be some future growth. This is why the Federal Reserve hates deflation and fights hard to keep it from happening. They will literally pull out all the stops to inflate the economy when it is moribund.

Inflation Rates Are Negative

In a deflationary environment, interest rates are effectively below zero. People would not want to borrow since they will functionally end up having to repay more than they borrowed because tomorrow's dollars would be worth more. To spur borrowing, the Fed would need to cut the interest rate down below zero. However, this is something that would politically be very tough for the Fed to do. Credit would come to a screeching halt, not because banks do not want to lend, but because people do not want to borrow.

Your Wages Will Decrease

When the prices of everything drop, your labor is also one thing that is affected. When you work for a living, you are essentially in the market selling your services to your employer. When there is deflation, your employer can cut what they are willing to pay you for your services. While pay cuts will not automatically happen at first, they are inevitable in a deflationary environment. Falling wages have a host of other negative effects, including decreased consumer spending.

As you can see, there is a certain moderate amount of inflation that is healthy for the economy. Everyone expects a pay raise each year, which becomes possible when producers can raise their prices to pay for the increased costs of labor. People have come to expect that prices increase gradually, and it is considered a sign of health for the economy. When the opposite happens, the economy is in for a long slow period.