"Bad deflation" is a more difficult concept to define. Paulsen simply states that "bad deflation has emerged because even though selling price inflation is still trending lower, corporations can no longer keep up with cost reductions and/or efficiency gains." Both Luskin and I have difficulty with that answer, as it seems like half an explanation. Luskin concludes that bad deflation is actually caused by "the revaluation of a country's monetary unit of account by that country's central bank". In essence this is really factor 1 "The supply of money goes down" from our list. So "bad deflation" is caused by a relative decline in the money supply and "good deflation" is caused by a relative increase in the supply of goods.
These definitions are inherently flawed because deflation is caused by relative changes. If the supply of goods in a year increases by 10% and the supply of money in that year increases by 3% causing deflation, is this "good deflation" or "bad deflation"? Since the supply of goods has increased, we have "good deflation", but since the central bank hasn't increased the money supply fast enough we should also have "bad deflation". Asking whether "goods" or "money" caused deflation is like asking "When you clap your hands, is the left hand or the right hand responsible for the sound?". Saying that "goods grew too fast" or "money grew too slowly" is inherently saying the same thing since we're comparing goods to money, so "good deflation" and "bad deflation" are terms that probably should be retired.
Looking at deflation as a disease tends to get more agreement among economists. Luskin says that the true problem with deflation is that it causes problems in business relationships: "If you are a borrower, you are contractually committed to making loan payments that represent more and more purchasing power -- while at the same time the asset you bought with the loan to begin with is declining in nominal price. If you are a lender, chances are that your borrower will default on your loan to him under such conditions."
Colin Asher, an economist at Nomura Securities, told Radio Free Europe that the problem with deflation is that "in deflation [there's] a declining spiral. Businesses make less profits so they cut back [on] employment. People feel less like spending money. Businesses then don't make any profits and everything works itself into a declining spiral." Deflation also has a psychological element as it "becomes rooted in peoples' psychologies and becomes self-perpetuating. Consumers are discouraged from buying expensive items like automobiles or homes because they know those things will be cheaper in the future."
Mark Gongloff at CNN Money agrees with these opinions. Gongloff explains that "when prices fall simply because people have no desire to buy -- leading to a vicious cycle of consumers postponing spending because they believe prices will fall further -- then businesses can't make a profit or pay off their debts, leading them to cut production and workers, leading to lower demand for goods, which leads to even lower prices."
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