The model for every government is to have a stable currency that can sustain growth and encourage production. As the Treasury and Federal Reserve began pouring hundreds of billions of dollars into the financial market over the last few months, there have been many who worried these actions would result in inflation – prices rise as the purchasing power of each dollar falls.
This however has not taken place. Despite the Fed’s creation of hundreds of billions of dollars out of thin air and the Treasury’s massive foreign borrowing campaign, the prices of everything from gas and groceries to electronics and clothing has gone down. Most of us are struggling through economic hardship of our own, and the recent drop in prices has been a welcome relief; but these price corrections could have a more sinister undertone. When prices fall across the board the phenomenon is called “deflation.” If this occurs over the course of a few months we typically herald it as a relief. If it occurs over an elongated time period, it spells doom to an economy.
When prices drop across the board companies are forced to lay off workers, lay offs lead to decreases in disposable income which in turn lead to decreased consumption. In order to bring in customers companies must drop prices further, thus setting off another cycle. If this spirals out of control we could see massive joblessness, falling personal income, and prices so low companies cannot afford to produce or sell goods.
When Fed chairman Ben Bernanke was an economics professor at Princeton University he considered deflation to be one of the greatest threats to an economy and a key driver of the Great Depression. In 2002, while serving as a board governor to the Federal Reserve, Bernanke stated publicly that he would prefer driving rampant inflation then suffering the consequences of a deflated economy. The point is obviously to find a stable medium; neither maxim is preferable, but in his eyes one is certainly worse than the other.
We have some proof that prices are already dropping. Aside from what can be gathered by merely observing one’s own checkout receipts, we have seen the consumer price index (CPI) fall by a record 1.7 percent in November alone. The deflation of retail prices has been at a 10 percent annual rate for nearly three months. Retailers, and most service companies for that matter, typically drop prices in time for the holiday season but what we are witnessing is truly historic.
Another measure of the CPI – the so-called “core CPI” which does not measure volatile food and energy prices – declined by 0.1 percent in November as well. This marked the first decline in that measure since the recession year of 1982. David Wyss, a chief economist with Standard & Poors, believes that the chances of general deflation are unlikely right now. However, if the recession continues deep into 2010 (as many expect it to) we could face a very real risk.
We may also be witnessing the tip of a very real iceberg, one that could sink our economic ship for good. We may think that lower nominal prices are good, but if everyone is out of work it will no longer matter how much anything costs. If that is the case, then the second Depression will have officially taken hold, and we will all be left in its wake.