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Why do we care about falling prices?

Why should we care that prices are falling?  Isn’t it better for consumers to pay less for goods?  The prospect of deflation is so scary to economists and central banks alike, that it is causing the latter to pour trillions of dollars into their respective economies to prevent these drops in prices.  Just recently, the European Central Bank (ECB) pledged to buy government bonds as part of yet another quantitative easing to the tune of €1.1 trillion.  Many consumers do not understand the concept.  This is why everyone is concerned:

  1. As everyday shoppers see persistent price declines, they will tend to hold out on buying goods and services.  The thought process behind this is simple – why pay an amount today for something that will be even more of a deal next week.  From a global view, consumer consumption comprises an enormous chunk of most countries’ gross domestic product (GDP).  For instance, consumer spending in the U.S. accounts for roughly 70% of GDP.
  2. Now consider businesses.  It turns out they do the same thing as consumers – postpone purchases.  This will generally include not purchasing raw materials, investing in new technologies and equipment or even hiring additional employees.  Another offshoot for companies is the loss of pricing power, that is the ability to charge more for their goods or services.  Profits will suffer.  This leads to a condition in which if a company wants to grow, they’ll have to slash prices which, in turn, makes things worse.
  3. As everyone knows, lower profits means lower payouts to employees.  Employees expecting a raise become disappointed and for some, disillusioned.  This leads to further cutbacks by companies and you can begin to see why the cycle will repeat itself.  This by definition is a deflationary spiral.
  4. Not to pile it on, but, as prices are falling, the amount a consumer or a company owes does not.  Borrowers, both individuals and companies, become over- burdened by the sheer weight of debt.  In even a mild scenario, companies and consumers hold back on additional purchases in order to meet their debt obligations.
  5. Finally, policy-makers usually have the antidote to an economic slowdown, but it becomes vastly more difficult when interest rates are near zero.

This is why economists and central banks are sounding the alarm on falling prices, better known as deflation.

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