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Explainer: Why is deflation so harmful?

John Makin, writing for conservative-leaning think tank the American Enterprise Institute, warned on Monday that "Now is the time to preempt deflation." Conservatives are usually inflation hawks. So, why are some of them calling for "aggressive monetization" to avoid the deflation threat in the U.S. and Europe?

Deflation is an actual fall in prices, rather than just the inflation rate getting lower, which is call disinflation. Recall that the fear of deflation was the main reason the Federal Reserve instituted the first round of quantitative easing. What was the Fed so afraid of?

There are three main reasons to fear deflation.

First, when people expect that prices will be lower in the future, they spend less today. If you're thinking of buying a new car and expect the price will be a lot lower six months from now, why not wait?

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Thus, falling prices shift consumption from the present to the future as consumers wait for prices to fall, and the drop in demand can further depress the economy, lead to more price decreases, more cuts in spending -- and a downward spiral into a recession.

Second, deflation raises the inflation-adjusted interest rate, and that can cause consumers to spend less on durables like cars, appliances and houses that are purchased with credit. Rising inflation-adjusted interest rates also increase the cost of borrowing and can depress business investment.

That's not the end of the story. As consumption and investment spending fall, aggregate demand declines, and that causes prices to fall even further. The result is even more deflation, more cuts in consumption and spending, further decreases in prices and the economy crashes in what Irving Fisher called a debt-deflation spiral.

Another way to say this is that deflation discourages new borrowing and makes existing borrowers worse off because it raises the inflation-adjusted value of debts and makes the debts harder to pay off. So, it imposes a burden on borrowers.

Now, it may seem as though the increase in inflation-adjusted payments by borrowers is matched by lenders' higher earnings -- the borrower's loss is the lender's gain. But that's not correct. The reduced consumption by households as their loan payments rise isn't matched by a corresponding increase in consumption by lenders (who are generally wealthy and tend to save the extra income). Thus, overall spending falls. That depresses demand further, prices fall more and the result is Fisher's debt-deflation spiral.

The third problem with deflation is that wages and prices are generally sticky. That is, they don't adjust as quickly as needed to keep supply and demand balanced. Wages tend to be particularly sticky in the downward direction. The problem is that when prices are falling but wages aren't, it increases the inflation-adjusted cost of labor, and that leads to unemployment. The rise in unemployment leads to less spending, and that causes prices to fall further. Once again, the economy can enter a downward spiral.

Finally, it's important to note that outright deflation isn't required for these problems to emerge. Disinflation -- when inflation rates are above zero but declining -- can also be troublesome.

Central bankers have an aversion to inflation. Indeed, it seems to be a requirement for the job. But what they really fear is deflation. Evidence from the Great Recession, when prices fell by around 25 percent, and from the "lost decade" in Japan suggests it can lead to big problems for an economy -- and monetary authorities are unwilling to take a chance of that happening again.

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