NPR’s Planet Money podcast is one of my favorites. Today’s takeaways are from their 1,012th episode, titled “Inflation, Deflation,” which aired on July 1, 2020.
We’ve all heard of inflation and even the less-known term deflation, but we haven’t had to think about them much here in the United States for about 35 years. That’s because prices have remained stable, with about a three percent increase year-to-year, for more than three decades. Inflation happens when the economy heats up and prices increase year after year after year. Deflation–inflation’s counterpart–is when the economy cools and prices fall for a long period of time.
Yes, health insurance and college tuition have increased significantly over the past couple of decades, but, really, in the past 35 years average prices of most things we need have really only risen maybe one, two, three percent per year.
Inflation–where prices of every day goods rise significantly over a long period of time–is most hard on people who are on a fixed income, such as retired people. They do not have a salary that rises accordingly. Deflation, on the other hand, affects most negatively those who are in debt. The price of their debt (house payment, car payment, etc.) remains high even though the value of everything else, including their income, is falling.
Inflation and deflation do not come out of nowhere. They happen when there are dramatic shocks to the economy.
To best understand inflation, we need to think back to the 1970s in the United States when the oil embargo resulted in rapid inflation. When there is too much spending relative to the economy’s ability to produce goods, we tend to get inflation. Think about it this way–too much money chasing too few goods. Demand higher than supply. A need for gas, but not enough gas. People have money and are spending it like crazy, as long as they can get their hands on goods. When there is too much money chasing too few goods, sellers figure they can raise prices. And they do.
We’re not talking about everyone wants avocados and there aren’t any avocados; we’re talking about aggregate demand. Everyone wants everything and there is not enough of everything. Demand has to be across the board to cause inflation.
Inflation does strange things to the economy. One example is about buying a house. If you bought a house in the ’70s for $43,000 with a monthly mortgage of $200, your mortgage would stay the same–and seem woefully low–as your wages and the price of everything else around you increased. Inflation isn’t such a bad thing, for the debtor, at least, when it comes to mortgages or other debts that are designed to remain stable over the years.
As inflation increased from six percent to 11 percent and even higher, something had to be done. Since demand was too high compared to supply, the answer was to reduce demand. Eventually, people got tired of the ever-increasing prices so they stopped buying as much. And what was the result? The nation entered a recession. Fewer goods were produced and people lost their jobs. While this was trying, inflation did indeed fall. It fell to a normal three percent, where it has remained for 35 years.
Now to talk about the opposite of inflation–deflation. A good example is Japan. In 1997, there was a banking crisis and banks stopped lending money. People stopped buying and thus there was a scenario that was the opposite from inflation–there were too many goods on the market. Falling demand leads to falling prices. It’s not super obvious at first, but it sure is if it continues year after year after year. The recession in Japan lasted for many years and the prices of goods just kept falling and falling. Soon, everyone was expecting prices to continue to drop. They thought, “Why shop now? Wait until the prices go even lower.”
Businesses tend not to develop new products during a prolonged recession. Why pay the high cost of development only to sell at a really low price? Companies may move their business to another country at this time, to a country that is not experiencing a recession. Basically, everyone gets a bad attitude. Why buy now? Why waste the time developing new products now?
Let’s think about the house situation. If you bought a house before a recession starts, it’s going to be just the opposite of what happens during inflation. Your house payment is always going to be ridiculously high compared to the cost of everything else and compared to your adjusted income (and, most important, compared to the new overall value of your home). It’s a contract and the price remains the same despite the price of everything else falling. This time, the homeowner really loses out, but the bank wins, just the opposite of inflation.
The way to fight deflation is the opposite of how to fight inflation. Instead of encouraging people to stop buying, you want to encourage buying. The way to do this is to decrease interest rates, which will, in turn, raise prices. People do not change their mindsets immediately, however. It takes years to convince people to start spending their money again. It took years for Japan to recover from deflation, with prices rising only about a half of one percent each year.
Inflation and deflation are both scary and last for a long time and mess with consumers’ minds. So here we are in the year 2020 and COVID has resulted in quite a shock to the economy. The question is, what is going to happen? Will we enter a period of inflation or deflation? Many businesses and companies have shut down, which is a reduction in supply. There is, however, also a shock on demand. Tens of thousands of people lost their jobs, they’re just staying home, and they are definitely not purchasing as they used to.
This is a one-two punch; both supply and demand have been hit at the same time. If things go the deflation route, companies will start producing but people will not be in the mood to buy. They’ll be thinking that they better save up and be better prepared for the next time something like this happens. This would cause prices to fall (deflation).
With an inflation scenario, people might suddenly–or, more realistically, gradually–start going out to eat, start catching up on things that need to be done that they didn’t do for months (haircuts, clothes shopping, home and yard maintenance), and socializing and traveling. If we get all this demand and the supply is not yet there, we will enter a period of inflation. Goods and services are definitely harder to come by at this time. Restaurants can only operate at partial capacity. The same with salons. Meat packing plants and other industries may be out of operation. Travel is limited.
It’s a fascinating moment right now with our economy. There are many broken pieces. Things will depend on what ends up getting repaired first. And if we’ve learned anything from what happened in the U.S. in the 1970s or what happened in Japan, once inflation or deflation starts, it tends to gain inertia and it’s very difficult to break out of it.
Since most Americans were not adults in the ’70s and/or are not aware of what happened in Japan, what they know–the slow, steady rise of prices over the past 35 years–might be just the inertia that continues at this time and we might, might, be able to avoid a huge economic mess as a result of COVID.
A String of Pearls 