When prices are constantly increasing, it is easy to say: "wouldn’t it be nice if prices would just fall as often as they go up?" I’ll tell you why the answer is "no," and discuss some business concepts directly dealing with this question.
In a perfect capitalist system (without government intervention), there are two inputs and two outputs:
While the economics apply equally to business and consumers, let’s just rephrase the question as if given by a consumer: "If I could buy for less, would I do so if it meant that I might also have to undergo a cut in my wages?" Obviously, it depends on the wage cut, but there may be some other significant reasons why you wouldn’t want to do so:
Falling prices result in:
- Cut business profits, causing businesses to contract, cutting purchases and jobs and even wages
- R&D and Marketing usually getting cut up front, cutting additional jobs and new product development
- benefiting only consumers still willing and able to pay
- Stopping buyers from purchasing, thinking prices will still fall further
- Causing capital to shrink and banks to stop loaning money
I remember gas at 29.9 cents per gallon. I made $2 per hour then. But the bigger question is: if I could only buy what was available then, would I still want to do it today?
- No super antibiotic drugs
- No internet, satellite, cable or cell phones
- Gas guzzling cars
- And on and on…..
So how do we avoid all the bad that comes with deflation? The answer is that we shoot for slight, but controlled, inflation. Why:
Because, Slight Inflation:
- Increases incentive to hire, buy and produce more
- Causes optimism among providers and consumers
- Encourages borrowing and lending
- Causes consumers and businesses to buy, buy, buy
What can cause an economy to move from deflation to inflation? There is only one thing: optimism. This type of optimism is created in only one way: by the leaders of a country telling people that the worst is over and that they can now proceed in a "business as usual" mode.
So what would happen if a country’s leaders don’t respond with the appropriate call to optimism? Well, there is a method by which a capitalist society will correct itself. Here’s what happens. Remember the two inputs? You’ve probably heard that to some degree, they are interchangeable. It’s true, to some degree, labor can replace capital. If wages drop enough, we start hiring and do what has to be done by hand. No new machine gets purchased, with the labor thereby replacing the capital. People start having some money again, but very few things to buy, which then drives inflation, since supply lags behind demand. Third world countries have followed this route often. And therein lies the problem: while the system will generally correct itself if government fails to lead us out of deflation, government will then usually fail to control inflation, and the whole cycle repeats itself!