A man passes a furniture store advertising liquidation prices in Manassas, Virginia.
A run-of-the-mill economist would define deflation as the loss of money supply and credit in the markets. Simply stated, the value of money erodes as prices drop sharply. The value of labor and goods and services goes into free fall.
Investment drops in a period of deflation. Who wants to put money into assets which may continue to lose value? Who wants to buy goods and services and hire people when all of those may cost less in the future? (See pictures of TIME's Wall Street covers.)
Deflation may not have had a bad name until it hit the Japanese economy in the early 1990s. The financial activity in the Asian nation went into a long hibernation. The pace of commerce slowed to a point which had not been seen in the modern history of the country.
Whatever the risks of deflation, it is a natural enemy of the depression which sits just on the other side of a rapidly deepening global recession. Deflation could conceivably make economic matters worse by enticing businesses and consumers to delay purchases based on hopes that prices for goods and services will keep falling. But, there is a potential benefit to a sharp drop in the value of almost everything.
The point comes when consumers believe that assets are so inexpensive that they will not be this low again for decades. A house which was once worth $500,000 is on the market for $125,000. A new appliance which would have sold for $600 a year ago can by bought for $200. Consumers, who have panicked over their debt and lost jobs, have finally saved enough money and paid enough debt so that unspeakably low prices bring them back into the market.
The same set of dynamics hold true for businesses. If they have any cash flow at all, they put it toward improving their balance sheets and hoarding cash. But, when labor which once cost $20 an hour moves down to $8, the temptation to make very modest investments in adding employees and expanding production eventually becomes irresistible.
Consumers and businesses who believe prices will fall forever may hasten a depression by deferring purchases. Deflation, however, may be the only floor that the economy can hit to prevent the global financial system from entering the worst period in over a century.
— Douglas A. McIntyre
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