Why do indebted governments fear deflation?

Question

It's widely accepted among people who follow finance that various governments around the world, including the US government, are doing (or their central banks are doing) everything possible to keep their economy out of a deflationary state. (cf. Ben Bernanke's "drop dollars from helicopters" comment.) The rationale given is that deflation makes your debt more expensive and harder to service.

This rationale doesn't make sense, at least not on the surface. With inflation, prices in general go up as the value of the currency goes down; with deflation, prices in general go down as the value of the currency goes up. Therefore, in a deflationary environment, debt service would become more expensive but all the other things on your budget become cheaper, and therefore, as long as debt service comprises less than 50% of the budget, doesn't the country come out ahead?

Answer 1

They don't or shouldn't, fear deflation absolutely. But it's a complicated issue because there are two causes of deflation/inflation. One is changes in the money supply, the other is changes in production.

Changes in production that cause prices to fall are beneficial to everybody. Society becomes materially richer, and this is the great economic success of the last 100 years.

However, prices will also shrink if the money supply falls, since there is less money to buy things with. That in and of itself wouldn't be such a big problem in a market based environment where prices could adjust up and down. However the one thing that can't adjust its price is debt, debtors have made a commitment to re-payments irrespective of whatever the money supply and deflationary situation is.

It depends where you are in the world right now, as to whether the money supply is expanding or contracting. The situation in Greece is particularly problematic:

This is very similar to the Great Depression pattern in the US which saw a 30% drop in the money supply 1929-1932. Once something like this gets established, it creates self-reinforcing negative feedback loops throughout the economy. For example, part of the reason for the drop is Greeks moving money to banks in other countries that they expect to stay in the Euro. But because of that, Greek banks can't make new loans without violating their regulatory requirements, and that further causes the money supply to shrink.

Answer 2

There are numerous reasons why deflation is bad and countries are doing as much as they can to fight against deflation:

1. Debt becomes more expensive: As mentioned by others, this can make it more difficult to pay off.

2. The economy is dwindling: I feel that this is a more dangerous effects of deflation. Now when deflation occurs, it may seems that our current purchasing power increases. So effectively, people should purchase more goods. The problem in this is that if price does not recover, this signify that people do not respond to the initial price reduction and thus it also signify that people are spending less money on goods and services. This can be very detrimental since it will cause less overall demand for goods and services in the economy. This, will in turn, cause reduction in revenue and profits. Thus, businesses will react to the dwindling demand by cutting down cost through closing factories and firing people. Persistent deflation can cause a spiral downward effects in which businesses cut down on production or go bankrupt, causing a further reduction in the economy's overall income and increase in the economy's unemployment rate. This spiral effect is one of the reasons why deflation is not desired.

3. The difficulty in getting rid of it: a persistent reduction in price signify that the people either are losing income or they do not have faith the current economy. For example, if prices are falling, people should generally spend more since now they have higher purchasing power. However, if the price keep falling means that the economy as a whole is cutting down on its spendings. Adding to the effects described in two (2), people will continue to lose faith in the economy and saving more. This can cause a feedback loop where people see the price falling -> see their income falling -> see the economy is getting worse -> spend less -> price falls -> repeat. Thus this spiral effects can cause much headache to the goverment especially if the government try to do as much as they can to increase the price.

Thats my take for why deflation is not desired.

Answer 3

Deflation is when the purchasing power of money goes up because of either a reduction in available currency or an increase in productivity. A sympton of deflation is a persistent decrease in the cost of goods and services.

Well, we should look at the two possibles causes of deflation. The first possible cause of deflation is a reduction in the amount of available currency and the second is an increase in the amount of goods and services available to consumers.

Let's take a look at this example. There are four oranges and four pounds, if we were to evenly distribute the amount of available money (£4.00) to the amount of available goods (four oranges), then each orange would be worth £1.00.

Now, let's take a look at this second example. The amount of available currency decreases from £4.00 to £2.00. Again, if we were to evenly distribute the amount of available money (£2.00) to the amount of available goods (four oranges), then each orange would be worth £0.50. You can see how the cost of each orange has decreased -- this is good for consumers because the price of goods goes down and they can buy more (this is known as an increase in the purchasing power of money), but its bad for the government because it shows the economy is moving very slowly (known as stagnation) and they need to respond by stimulating the economy and encouraging more people to spend money -- if the economy moves too slowly and stagnates, then the economy will grow very slowly and might begin to collapse.

Okay, now let's take a look at this third example. The amount of oranges increases from four oranges to eight oranges. Again, if we were to evenly distribute the amount of available money (£4.00) to the amount of availabe goods (eight oranges), then each orange would be worth £0.50 again. This is good for consumers because once again, the price of goods has gone down and they can buy more, it's also good for the government because it shows the economy is running smoothly and there is a lot of economic growth -- because there was an increase in productivity and more oranges were produced. This type of deflation is quite good and should be encourged.

You can see how the first type of deflation is quite bad in the long run, but the second type is very good for the consumers and in the long run. Normally, governments that aren't in debt will seek the second type of deflation, however indebted governments seek inflation and dislike both types of deflation. Why? Well, deflation is bad for debtors because they have to pay back debts tht were borrowed with higher-valued dollars, this effectively increases the amount of debt -- this is bad for indebted governments.

A lot of economists also believe that under deflation, consumers will choose to not spend and will wait for the prices to go down further -- however, some economists disagree with this idea because most people are going to buy something when they need it, they aren't going to wait a long time for the prices to go down and then buy it -- we have a mentality where everybody wants things when they're new and there are also certain things (like food) that we need now, not in the future. Though, this generally depends on your view.