Deflation is the net result of prices that fall for a protracted period of time. In other words during a period of deflation, your money buys more than it used to. Furthermore, the longer you wait, the more your money is worth and consequently, the more you can buy with it. This provides a strong incentive for consumers to hoard cash and wait to make purchases. After all, if prices are dropping you'll be spending less if you just wait. What's wrong with our money buying more? So far it sounds like a good thing.

To see the down side of deflation you have to look at it from a company's perspective. A manufacturer buys raw materials at a certain price and converts them into a finished good. The company then tries to sell those finished goods at a profit based on its real costs. However, the inventory that the company holds drops in value every week during a period of deflation until often they have difficulty making a profit. Furthermore since customers are wise to the game, they are holding off making any purchase and the inventory sits on a store shelf with its value dropping and dropping... and dropping. As the inventory builds up, companies see that they have to cut production due to declining demand and falling profits.

That's where it starts to hit home. Companies cut production by laying off workers en masse. Since deflation affects nearly every company across the board, unemployment can reach staggering levels. Now, in addition to those customers who are simply waiting for lower prices, there is a growing segment of the population without a job and without enough income to buy even if they wanted to. Demand falls further, which makes prices drop more, and even more workers are let go.

Borrowing during a period of deflation can be a painful experience as well. Whether it is a consumer borrowing on a credit card or a business borrowing for expansion or replacing capital equipment, in just a few months, they know they will likely still owe more on the loan than the items are worth. With each passing month, this difference between the real value and borrowed amount grows worse. Think of this in terms of today's declining home values. Nobody wants to buy a house that may be worth $50,000 less than they paid for it in a year or two.

Deflation, by definition, only occurs when inflation is less than zero. We are not there yet. Although oil prices and many commodity prices have fallen, overall, we are still paying more for goods and services as time goes by. Goldman Sachs has released an estimate that, by the end of 2010, inflation will still be at 0.25%. While that is extraordinarily low, it is still a positive number and doesn't give consumers any price incentive to wait before making purchases.

For now, then, it doesn't look like we are in for any significant deflationary period, but if unemployment continues to rise and consumer demand continues to fall, the danger does exist. It is something we need to watch out for at this point. There is also the danger of things swinging in the other direction. Runaway inflation makes your money worth less and less every day. If the government expands the money supply too much to get us through this period of recession and tight credit, we may find that once we start climbing out of the current economic woes, inflation takes holds and we could see sky-rocketing prices, but that's a discussion for another day.

Author: Brad Sylvester