What Is So Terrible About Deflation?

The Federal Reserve and most other major central banks of industrialized nations follow a price stability mandate or goal.  Usually the goal is around 2% annual inflation and anything lower is discouraged.  Price stability is not quantified as inflation at zero or even near zero (0% - 1%).  In the following discussion we assume that the Fed has been pursuing a zero inflation target (even though they are currently clearly trying to avoid deflation) as that is most clearly where we (the United States) currently are.  The following problems are brought up with such low realized level of inflation (from Mishkin's Monetary Policy Strategy, pg. 359):

"One reason relates to downward nominal wage rigidity.  If the inflation rate were to approach zero under the condition of downward wage rigidity, it would be difficult to achieve real wage adjustment in response to changed market conditions, such as a negative demand shock.  The result would be higher-than-desirable real wages, higher unemployment, and lower economic growth"

In layman's terms: If prices fall and wages are resistant to falling with them, then real wages have gone up and more workers are going to get whacked.

"A second reason relates to the impossibility of reducing nominal interest rates below zero, which means that if inflation is close to zero, real interest rates cannot be pushed below zero when this might be necessary to in order to stimulate economic activity"

A third issue with such a low level of realized inflation, which let me repeat myself by saying would be equal in our case with a hypothetical zero inflation target by the Fed, is that:

"A zero inflation target may lead to periods of deflation, which could promote financial instability and make it harder to conduct monetary policy because interest rates no longer provide a useful guide to the stance of monetary policy"

Deflation is also a key factor promoting episodes of financial instability in industrialized nations because debt contracts in industrialized nations frequently have long maturities.  This means that a deflation leads to an increase in the real indebtedness of both households and firms, which in turn leads to a decline in their net worth and a deterioration of their balance sheets.  Taking the "credit view" with decreased net worth, adverse selection (defined as the problem created by asymmetric information before a transaction occurs: The people who are the most undesirable from the other party's point of view are the ones who are most likely to want to engage in a financial transaction) and moral hazard (the risk that one party to a transaction will engage in behavior that in undesirable from the other party's point of view) problems increase for lenders, who therefore cutback on lending.  Mishkin describes the following outcome:

"The decline in net worth also leads to a decline in the amount of collateral a lender can grab if the borrowers investments turn sour, and the reduction in collateral therefore increases the consequences of adverse selection, because loan losses resulting from default are likely to be more severe.  In addition, the decline in net worth increases moral hazard incentives for borrowers to take excessive risks because now they have less to lose if their investments fail."

Apparently Paul Krugman wrote about this as well.

What does a debt deflation entail and are we headed for one?

The process of debt deflation goes a little something like this:
Unemployment increases this leads to a sudden drop in income and more people filing for unemployment insurance.  Suddenly people feel poorer and both home spending and consumer spending decline.  Producer Prices then fall because business are cutting back on inventories.  Furthermore, lower import prices also puts downward pressure on consumer and producer prices.  Last but not least home prices continue to fall.  Consumer prices then decrease due to lower input costs (via producer price index declines and import price declines) -  this lower price level causes the real value of the debt burden to increase.  This increased financial strain will lead to the next round of defaults and further reduction in consumer spending. This leads to more unemployment and even worse some unemployed 27 weeks or longer are no longer eligible for unemployment insurance.  This leads to a further decline in incomes leading to more cash strapped households on the brink of desperation and another round of defaults as some (newly unemployed or uninsured laborers) are unable to make their debt payments.
                                         
Debt Deflation in the Economy:

Recession Hits ----> Unemployment (Increases) + Unemployment Insurance (Increases) ---> Income (Falls) -----> Spending (Falls)([Consumer Spending (Falls) + Home Spending (Falls)] )------>  Price Level (Falls) ([ Producer Prices (Fall) + Import and Export prices (Fall) + Home Prices (Fall)]-----> Consumer Prices (Fall)] ) --> Real Debt Burden (Increases) --> Defaults (Increase) ---> Consumer Spending (Falls) --> Further Unemployment (Increases) + Unemployment Insurance (Fall)]---> Income (Falls) ----> Defaults (Increase) + Consumer Spending (Falls)---> and on and on


Lets look at the most recent evidence:

 Unemployment has increased and those receiving unemployment insurance has decreased:

This is surely to have some more effects on the already depressed consumer and home spending:

The Producer Price Index has declined as of late to reflect the sharp cut back in production from businesses reaction to the lamesauce consumer demand:

Import prices have fallen recently:

Home spending and home prices continue to be trending downward:

Price deflation leads to an increased real debt burden and as we have seen defaults continue to be on the rise.  As we have just seen some data suggest that this may be occurring and the fact that severe financial crisis do sometimes lead to debt deflation leaves me very worried.  We would be experiencing a full-blown debt deflation right now if it wasn't for two things: sticky wages and unemployment insurance.  The inflexible nature of wages allows those who do have jobs to keep spending.  This - in addition to unemployment benefits - has prevented the severity of the crises from reaching the debt deflation stage.  The governments ballooning debt has not been the work of bailouts but of unemployment insurance payments.  This has represented a massive transfer of debt from the private to the public sector and the extension of these benefits have proved undeniably important for keeping our economy afloat.