Are Falling Prices a Bad Thing?

Popular opinion seems to be that falling prices — or even stable prices — are bad for the economy, but I’ve never seen any good arguments about why.  I’ve just read another article about this, that gives six clearly numbered reasons, so let’s look at what the article says to see if they hold up.

First, the article says, “When shoppers see persistent price declines, they hold out on buying things…. As a result, consumer spending flails.”  People tend to buy things because they want to own them or consume them, so this argument seems weak.  One area in which prices have persistently declined for 35 years is electronics, yet that industry is thriving as prices plummet.  If this argument was true, how did Apple Computer become the most valuable company in the world by selling products whose prices have persistently declined since the company was founded?  Is there any reason to think that the computer industry, or electronics more generally, is different from other industries in that regard?

The second argument the article gives is, “Businesses behave pretty much the same way.”  Businesses always try to manage their purchases so that they buy only what they need when they need it, and don’t want to stockpile inputs or output.  This argument is weaker than the consumer argument.

Third, the article says, “pricing power — the ability to charge more — vanishes. That makes it harder for them to grow profits.”  Profits are the difference between costs and revenues, and if prices in general are falling, declining costs should match declining revenues, so this argument fails because the logic behind it is incorrect.  Again, think about Apple Computer.  Has the fact that they have sold only products that have persistently fallen in price hurt their profitability?

The article’s fourth argument is, “Lower profits = less money to go around to workers. Employees don’t get the raises they were expecting, they cut back on spending even more, and the ugly cycle repeats. That’s why they call it a deflationary spiral.”  This argument is wrong on so many levels.  First, it assumes falling prices result in lower profits, but I’ll return to my example of the computer industry to show this isn’t true.  Even if it is, how much will workers cut back on spending when the prices of things they buy are falling?  Their raises aren’t as big (again, feeling sorry for those who work in the computer industry, where prices persistently fall), but lower prices mean they can afford to buy more.  Finally, making up a term for something that isn’t true, like “deflationary spiral,” sounds authoritative, but doesn’t make something that’s not true into something that is true.

Fifth, the article says, “The sad thing is, even when prices are falling, the amount you owe doesn’t. Borrowers get crushed under the weight of that debt.”  This is the only one of the article’s points that has an element of truth, but any advantage of borrowers seeing their debts inflated away is offset by creditors who see the value of their assets inflated away too.  That’s a wash.  And, conventional wisdom seems to suggest people take on too much debt anyway, maybe because they see that the government’s stated policy is to inflate it away.  A deflationary environment would make borrowers more cautious, and would not penalize lenders.  Would a policy that encourages people to save rather than borrow really be a bad thing?

Sixth, the article says, “Policy makers usually have an antidote to economic slowdowns, but it’s trickier when interest rates are already near zero. That’s exactly the situation with the ECB and much of the industrialized world. That forces officials to turn to unconventional tools.”  But this point holds only when policy makers want an inflationary environment.  If the first five points don’t hold, this one doesn’t either.

Since the beginning of the Industrial Revolution, technological advances in all industries, from farming to electronics, have lowered the cost of producing goods and services, so if money really kept a constant value, prices would continually fall to reflect the fact that it really does cost less to produce things.  Even a stable price level means the value of money is falling, because it is not accounting for continually declining costs of production.

Arguments against falling, or even stable, prices are common, but when they are examined in any detail, they do not seem to hold up.  Meanwhile, the Fed continues its explicitly inflationary policies.  The price level has increased by more than 20 times since the Fed was established in 1913.  Twenty dollars buys less today than a dollar bought back then.  When costs fall, prices should fall, not rise.  Falling prices are not a bad thing.