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Deflation and the Economic Recovery

The combination of lower prices and large-scale government stimulus could trigger a self-sustaining economic rebound

Is price deflation a sign of an accelerating economic downturn? History is not encouraging. Periods with falling prices—consider Japan in the 1990s and the Great Depression—have been unhappy times, economically.

But there's another possibility: The fall in some consumer prices could be part of the "normal" adjustment to unprecedented economic circumstances. These price declines, combined with the coming "wall of money"—the enormous monetary and fiscal stimulus on the way in 2009—could actually accelerate an economic rebound.

Certainly prices are falling at a record rate. The November consumer price report, released on Dec. 16, showed a 1.7% decline in consumer prices. That follows an almost 1% drop in October, which combined is by far the largest two-month decline on record.

And there are plenty of reasons to be worried about a deflationary downward spiral. As companies cut prices, that means falling revenues and more pressure to cut jobs. With fewer people employed, consumer demand drops and companies have to cut prices again and the economy spins out of control.

Employed Workers' Buying Power

But there's another important factor that points in the other direction. One of the distressing aspects of the so-called U.S. boom of 2003-07 was the fall in real wages for most workers. That is, even as the economy seemed to be growing, most workers experienced less and less buying power. That helps to partly explain why they had to borrow so much on their homes, and why the accumulated debt ultimately turned out to be a big problem.

The sharp fall in prices reverses this trend, at least for employed workers. To put it another way, with total annual wages running at roughly $6.5 trillion, the drop in prices over the past two months is akin to a $150 billion-to-$200 billion boost in buying power. If the price declines continue, most employed Americans will actually be able to afford more goods and services, since companies typically find it easier to fire workers than to actually reduce pay for the ones who remain.

But if the unemployment rate rises too fast, and more people are out of work, increased buying power for employed workers is not enough—and that's where monetary and fiscal stimulus comes in. The Federal Reserve, through its interest rate cuts and various bailout programs, has been pumping money into the financial system at an astounding rate. Banks and other financial institutions are sitting on a giant mound of money they can loan, if and when conditions improve.

Obama Stimulus Package

At the same time, it looks as if President-elect Barack Obama is likely to propose a stimulus package that could reach as high as $1 trillion. Some of that money will get spent right away, in the form of assisting state and local budgets and funding unemployment benefits. Then the rest of it will come on stream later in 2009 and 2010, as infrastructure, research, and green spending gets revved up.

In the best-case scenario, the combination of lower prices and large-scale government stimulus could trigger a self-sustaining economic rebound. Lower prices mean more buying power for employed workers and higher government spending means more workers employed. Once it looks safe, the banks jump in and start lending again at low rates.

Of course, this is not likely to happen until the end of 2009, given the time lags for fiscal stimulus. And there's going to be plenty of bad news along the way that could derail any incipient rebound. But falling prices, if they don't continue for too long, could help clear the way to recovery.

Mandel is chief economist for BusinessWeek. His new textbook, Economics: The Basics, has just been published by McGraw-Hill.

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