On the surface, everything getting cheaper sounds like a dream come true. It’s not. The prospect is so terrifying that it’s prompted central bankers around the industrialized world to pour trillions of dollars into their economies to prevent a sustained drop in prices. The European Central Bank followed suit Thursday with a historic pledge to buy government bonds as part of an asset-purchase program worth about 1.1 trillion euros ($1.3 trillion).
1. When shoppers see persistent price declines, they hold out on buying things. They ask, will I get a better deal next week, next month, next year? As a result, consumer spending flails. For most nations, that’s a big chunk of their economy, and any slowdown in consumption threatens growth.
2. Businesses behave pretty much the same way. They postpone buying raw materials, hoping to get a break on costs, and delay investing in that splashy new facility or hiring an extra hand.
3. Additionally, their pricing power -- the ability to charge more -- vanishes. That makes it harder for them to grow profits.
In such an environment, if companies want to grab a bigger market share, they have to slash prices. That makes things worse.
4. 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.
5. The sad thing is, even when prices are falling, the amount you owe doesn’t. Borrowers get crushed under the weight of that debt. In a mild scenario, companies and consumers hold back on other purchases to continue meeting their obligations. When things get really bad, they go bust altogether.
6. 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.
Policy makers have been raising and lowering interest rates for a long time but quantitative easing -- a Japanese invention from the 2000s -- is a relatively untested tool. Its effectiveness is still controversial among many economic circles.