As if we didn’t have enough to worry about with the economy, now I read that it’s not inflation that is the worry, but instead the threat of deflation is a serious risk that economists are watching.

Inflation, of course, is when prices rise.  We normally see an element of this over time.  What we’re used to seeing is a small amount of inflation per year.  The inflation rates of 3-5% over the last decade or so is considered healthy.  I am too young to recall the inflation rates of 10-15% in the late 1970’s and early 1980’s, but that’s an example of inflation that runs rampant.

As recently as the summer, the threat of a similar inflationary rate was on the minds of many.  With energy and oil prices rising rapidly, this was forcing up the prices of just about everything, presenting a big threat of rampant inflation.

Now, just a few months later the threat of inflation has subsided and we’re now threatened with deflation.  This is where prices actually fall.

Most people love the idea of falling prices, so this is generally seen as a good thing.  This would be true for you and I making our weekly grocery shopping trip, but for the economy as a whole it’s actually a serious threat.

The major reason for deflation being bad ties back to debt.  When prices fall, the debt that companies (or individuals) carry is suddenly even more of a burden in a time of falling prices.  Equate inflation/deflation to earning a salary: If you earn $50,000 in a year, and inflation is 4%, then your salary the next year is $52,000.  However, in a deflationary time, your salary might decrease to $48,000. If prices fell across the board, then the cost of your goods would go down an equal amount, and you would be no better or no worse off.

However, the problem comes in for people that carry debt.  If you bought a house when your salary was $50,000 with loan payments of $1,000 per month, those will remain constant.  If your salary increased but the loan payments remained the same, chances are you’ll be able to keep up on the loan with everything else remaining in check.  But, if your salary goes down, then you suddenly have less money coming in, but still have to make those loan payments.

For anybody that’s carrying debt, deflation is similarly troublesome.  Since most companies finance their operations through carrying debt, whether it be short term or long term, this is a big threat.   Deflation can put big squeezes on companies.

Deflation can also slow down consumer spending, which drives over 75% of our economic activity here in the USA.  The reason for that is that once prices start to fall, people often hold off on buying something because they don’t want the value to fall further, or they just figure they can hold off and get it for cheaper later.  Does this sound familiar?  It ought to, because this is the prevailing thought process in the current real estate market.  How many people are afraid to buy a house because they’re afraid it will be worth less after they purchase it?  There are a lot.

Deflation is also a key indicator of slowed economic activity.  Normally, a key factor to prices is supply and demand.  When economic demand is healthy, this will keep prices from falling.  Deflation is a key indicator that economic activity as a whole is slowing.

The last time we saw prolonged deflation?  The 1930’s, also known as The Great Depression.

Keep an eye out on the news for this, as I wouldn’t be surprised to see this come to light in a much bigger fashion if the threat continues.

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