Why Falling Prices Are Actually a Really Bad Thing

Here is another factor you might consider. What happens to government finances during deflation ?

Well, deflation means falling prices. Prices sponsor wages. Falling prices means falling wages. The large majority of government tax income is a tax on wages, or a tax on consumption. Both of these go down.

Now this wouldn't be so bad, except ... Governments loan money both to fund expenditures and to pay interest on their old loans. Inflation effectively means they can spend 2% of the total amount of their old loans "for free" (by loaning it) (they key thing to realise here is that doing so does not increase the burden on their income, it was 2% of taxes, and it still is). They get this double, since they get it both on the income side, and on the new loans.

Deflation means the opposite. Tax revenues go down, interest payments go up. Unless they want to drastically cut spending, that means they have to use pretty much all of their yearly new loans just to pay back interest.

The problem is also the difference between years :

year 1 : 2% inflation -> government can spend 104% of it's budget year 2 : 2% deflation -> government can spend 96% of it's budget

So 2% inflation necessitates a 10% cut in loan-based spending, which is about half of government spending. So a seemingly tiny amount of deflation requires a 5% spending cut by the government at minimum.

But that is not all. Government taxes have always been effectively a percentage of GDP. Governments have historically been unable to raise tax income. Deflation will lead to a fall in GDP, historically of at least double the amount of the deflation, sometimes much more.

So the other half of government income goes down by ~4% (very, very optimistically).

Now because falling prices and wages mean that the stress on social services increases (for obvious reasons), government expenditures go up, usually again by much more than the amount of deflation you see. It leads to pretty much every part of social security going up. Unemployment, for obvious reasons. But also pensions (people will go on a pension earlier because there's no work) and even illness and disability (well we all know why).

So 2% deflation effectively means the government has to cut spending by ~10%, WHILE social security expenses go up.

The government controls central banks. QE, ostensibly to "cause inflation" hasn't caused inflation (rather the opposite). So in order to absorb this financial shock, the U.S. government has instead decided to finance it's operations by direct money printing, by lending from the money printer. They ran a risk by lending the way the constitution said they should lend, so they "cheated". Now we see the EU (and dozens of other governments, including China and lots of smaller ones) doing the same.

This is also an extremely important factor in central bank behaviour, as they are controlled by governments, and it is the reason that we have not seen the end of QE (except maybe in America, but to be honest, I think there is a non-negligeable chance the US will lower rates instead of raising them, in 6 months).

Yup, also a great point. In the small, anyone holding a mortgage during a deflationary spiral is steadily squeezed. In the large you'll see businesses and government penalized for taking out loans to invest in capex, market expansion, etc, and existing loans become steadily more and more expensive.

Past performance does not guarantee future results :)

Firing and rehiring destroys morale. A perfectly stable and functional company can destroy itself by trying something like this. Employees will start to realize that no matter what they do they're getting shafted and their productivity will drop. Some will seek employment elsewhere, but those are often the ones you want to keep. You'll be stuck with mediocre and bad employees. When you try to fill in positions with new employees, they see a dysfunctional shop and start looking for the exit.

Yeah man, super true!

For example if prices were to start falling I'm going to start putting off the following purchases:

1. New computer

2. New TV

3. New stereo

4. Toilet paper

5. Food

6. Gasoline

7. Rent

8. A new-to-me used pickup truck

9. Clothing

10. Several dozen other things which I can't really wait for but which I will pretend I could for the sake of making a point

EDIT: Yes guys, I do realize that it's a marginal effect and that people aren't going to STOP buying TP. The point I'm trying to make, though, is that the "deflationary spiral" told as a story isn't entirely accurate either. People don't STOP buying things, they simply reduce their consumption ever-so-slightly and if EVERYONE does that, it cuts growth.

My point, though, is that there are a whole bunch of things which aren't really elastic or which already have falling prices but don't cause general malaise. Yes TV purchases do get put off for the next best model, but eventually people do buy TVs and the industry has models that work even given this reality.

In my personal opinion it's not that deflation itself is bad it's that it takes a long time for the deflation to work through the economy and for expectations to readjust. And given the maniacally long maturity of mortgages it takes half a lifetime to reset expectations and it's simply unrealistic.