Ask the Editors: What's Wrong with Deflation?

Corey asks:

Policymakers are concerned about possibly deflation - but I'm confused as to why lower prices is a problem. It's been happening in technology for decades without mayhem? And after the oil price shocks of 2008, I'd expect prices of other goods to drop as the cost of maintaining the supply chain have come down. My question is how do we tell the good type of deflation (firms are learning how to be more efficient) from the bad type, and what exactly is the bad type?

In theory, deflation sounds great!  You have your same paycheck, and everything costs less.  What's not to love?

There are two problems with deflation.  The first is that everyone has the same paycheck.  But since the stuff they are producing is worth less, they are suddenly less valuable to their employers.  Some of those people will suddenly be producing less than they are paid, and their employers will show them the door.

In theory, people will accept lower wages.  But in practice, wages (and more than a few prices), are what economists call "sticky" downward.  It is easier to fire people than to lower everyone's wage 5%.  The result is unemployment.  Anyone who has been unemployed for a long time can testify that it is much worse than a small wage reduction.  This may be why wages seem to be proving much less sticky in this downturn than in previous recessions--but the rising unemployment rate testifies that they are still sticky.

The other problem is that you don't just have your same paycheck; you have your same debt payments.  For business owners, or those who were laid off and had to accept a job at a lower wage, their debt becomes steadily harder to repay.  The result can be business failures, bankruptcies, and other unpleasantness.

Of course, hyperinflation isn't exactly amusing either.  With monetary policy, a very small amount of fairly predictable inflation (under 2%) seems to be optimal:  enough to grease the wheels of commerce without providing any nasty disincentives to invest in the future.