A plague of falling prices: deflation and how to stop it

Deflation psychology has arrived in Canada. I saw it in my own home and only realized it later.

I might not have realized it at all but for a U.S. Labor Department announcement that only a few months ago would have sounded like good news. No inflation.For a change, the price of a hypothetical basket of normal household goods, called the consumer price index (CPI), was not getting more and more expensive.

In normal times, prices rise nearly every month. And generally that's nothing to worry about, so long as prices don't rise too much. High inflation is admittedly painful for people on fixed incomes. And hyperinflation like Zimbabwe's destroys an economy. But for most people, low inflation of two to five per cent, say doesn't hurt at all. That's because wages and prices tend to go up together. When prices go up about three per cent, your paycheque goes up about three per cent. Even investors are OK if they have the right investments. Stocks, property and Canada Pension Plan benefits also tend to rise with inflation.

But when the U.S. government released its figures for October, everything changed. Not only did prices fail to rise in the month of October prices actually fell one per cent.

Falling prices sound good. If you're in the market to buy something, and if you have money in your bank account, deflation is good for you. Gas is cheaper at the pumps. Finally you have the prospect that your money will go further.

'If you are convinced that prices are falling, the psychology changes. In that case, delaying a purchase only makes it cheaper.'

But the news struck terror into the hearts of economists and sent markets into another sharp decline.

The reason economists worry about deflation is, like many issues in economics, rooted in human psychology.

When prices are rising, the best time to buy something you need is now. If you buy it next year, it will be more expensive.

But if you are convinced that prices are falling, the psychology changes. In that case, delaying a purchase only makes it cheaper.

As Bank of Montreal economist Michael Gregory pointed out in an interview on Wednesday with the CBC's Fred Langan, deflationary psychology had already hit the U.S. market in a big way. Prices for houses, the biggest thing most people are likely to buy in a lifetime, are falling. If prices are falling, Gregory says, "I'm not going to buy it now."

And here comes the confession.

In Toronto, where I now live, there has been a shortage of people to do house renovations. Condos shooting up all over the city have had a lock on many of the best carpenters, plumbers and plasterers. Those few who were left were hard to get. Other homeowners, many of them using loans borrowed against their rising property values, had bid up the price of contractors.

In my household we've been saving up, with a plan to insulate and maybe put a second bathroom in our drafty concrete basement. But even before hearing the inflation news from the United States, we decided to put off calling a contractor.

This was our logic: as construction projects slowed, we reasoned, some of the heat would come out of the renovation market. Contractors might be more inclined to return our calls. They would be less inclined to laugh when we told them how small the job was. And maybe, in a buyer's market, prices would be lower.

As I listened to BMO's Gregory talk about how deflationary psychology had arrived in the United States, I realized it had arrived in Canada, too. It had arrived in my home.

One of the reasons deflation is considered so poisonous is that it's a case where one of the cornerstones of the market economy turns on its head. Capitalist theory tells us that individuals acting for their own benefit are supposed to make things collectively better. But in deflation, individuals and businesses working for their individual benefit make things worse.

The other damaging thing about deflationary psychology is that it acts on people who are otherwise relatively untouched by a recession and who could thereby help to curb it. In a downturn, unemployed people and failing businesses will obviously have less money to contribute to the economy. But deflationary psychology affects people and businesses who do have money to spend; it makes them not want to spend it.

And even for those of us who understand the harmful effects of our collective actions, it is very difficult to go against our individual interests. That especially applies if you need to borrow money to make a purchase or investment.

Deflation hurts

Here's an example: the latest data show that Canadian house prices are falling. There is no expectation that Canadian housing values are going to crash like they did in the U.S. following the subprime disaster, but nonetheless, do you want to be the person who takes out a mortgage on a home that will be worth less in six months?

Mortgages in a falling market are an example of the danger of leverage during deflation. Leverage is the advantage you get by borrowing to buy an investment that's gaining in value. Initially during a home mortgage, you may only own 10 per cent of your house, but if the price rises by $50,000, you pocket all the benefit. But in a falling market, everything reverses. When the price falls $50,000, the whole loss comes out of your 10 per cent. And that may be all of it.

Perhaps the most damaging thing to an economy is that businesses start to think the same way. Why borrow to grow a business that will be worth less in the future? Unlike during inflationary times, the business will have to pay the interest on the loan and swallow the entire loss.

Deflation may not have arrived yet, even in the U.S. And it may not be coming at all. Deflationary psychology isn't the same as full-fledged deflation. True and poisonous deflation is a general decline in prices over months or years, where every spending decision is best delayed.

Prices are always changing in a dynamic marketplace. It was not deflationary to put off buying a Beanie Baby on eBay during the height of the craze.

But if deflation does come, and prices do start creeping ever downward, I'd like to offer the government a solution. Unlike the U.S. government, which handed out stimulus cheques that have now been spent or used to pay down debt, Canada should not just hand out money. Instead, it should use a tactic from retail to get the people who have money spending it: the time-limited discount offer. Twenty per cent off, but spend it now, before it's too late.