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Deprogramming the Deflation Cult

While a complete failure of demand would be bad, deflation in and of itself can coexist with growth.

Considering everything you've read about deflation, you'd think it was the worst thing to happen to the economy since the oil embargo. But is that really true?

Contrary to popular opinion, some experts believe that mild deflation isn't always bad. In fact, deflation can coincide with a strong economy and is even beneficial for some people, particularly those on fixed incomes.

"Deflation, like inflation, is not generally considered a good thing. Price stability is preferable to either, but a little bit of each can be tolerable," said Stuart Hoffman, senior vice president and chief economist at PNC Bank.

Whip Deflation Now

In recent months, concerns have mounted that the economy is about to enter a period of broadly declining prices, in which corporate profits are eroded and companies are forced to reduce wages and lay off workers.

Experts point to declines in various measures of inflation, outright deflation in consumer goods and the most recent interest rate cut by the

Federal Reserve

as signs that the U.S. may be moving in the direction of Japan, which has stagnated for years as prices have continued to fall.

"Deflation is one of equities' most formidable foes," wrote J.P. Morgan equity analyst Carlos Asilis in a recent research note.

Asilis says deflation "wreaks havoc on

companies and households holding fragile balance sheets as deflation raises liabilities in real terms." Unlike inflation, which makes debt easier to pay off over time as the value of money decreases, deflation makes it harder to pay back loans.

Still, interest rates do tend to be low during these periods, meaning consumers can refinance their debt.

Tightening Up

Analysts say deflation reduces spending as consumers delay purchases on the expectation that prices will be lower in a few weeks or months. That, in turn, undermines investment and results in a general economic slump. They point to the U.S. in the 1930s and Japan post-1990 as examples of how devastating the deflationary spiral can be.

Still, Fed governor Ben Bernanke noted Thursday that Japan is not struggling simply because of price declines -- which he said are easy to reverse -- but rather because of a poor banking system and policy mistakes.

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In fact, deflation doesn't have to be so destructive. Throughout U.S. history and in other countries around the globe, there have been periods of mild deflation that have coincided with respectable economic growth.

In China, for example, exports are booming and the economy is expected to grow by more than 7.3% this year even though prices have turned down. Although critics contend the government's data are skewed and that bad debt and unemployment are a problem there, many economists outside of China believe the economy is generally thriving.

Jazz Age

In the U.S., there are several examples of deflation happily co-existing with decent growth. In the 1920s, profits -- outside of farming -- flourished despite a combination of falling and stable prices.

Profits also were strong throughout the 1950s, a period of essentially flat prices. As recently as 1997, the producer price index fell 1.2%, and yet the economy grew above its long-term trend rate, rising 3.8%. Although consumer prices rose 1.7% that year, some have suggested that the rate of inflation was overstated.

"Typically, the economy and the stock market as a barometer don't mind mild deflation or mild inflation; they just don't like extremes of either," said Dan Ascani, an independent investment analyst.

Michael Lehmann, a professor of economics at the University of San Francisco, said deflation can emerge for different reasons and with different results.

"If you have a deflationary period such as the one between 1929 and 1933, that deflation is due to a collapse in aggregate demand, that's very bad," he said. "If you have the kind of deflation that occurred between 1865 and 1896, that was due to the very rapid growth in supply. Either one is enough to cause prices to fall, but one is healthy, the other is not."

From 1880 until 1896, the wholesale price level in the U.S. fell by about 30%, or by 1.75% per year, but real income rose by about 85%, or around 5% per year, according to Joseph Salerno, professor of economics at Pace University.

Passed Along

James Devine, a professor of economics at Loyola Marymount University, said that as long as wages continue to climb, a small amount of deflation isn't necessarily a problem. "If we see falling prices without wages falling, it wouldn't be bad," he said. "It might be unpleasant for those with extreme debts, but I don't think it would be an automatic disaster."

How could wages continue to rise with prices on the decline? Analysts say that is possible because deflation doesn't necessarily result in lower profitability.

"It's not at all clear to me that deflation automatically means small profit margins and inflation means large profit margins," Lehmann said.

Although the prices of goods sold generally fall in periods of deflation, the price of raw materials that go into those goods also falls, thus reducing expenses.

Increases in productivity also can help offset weak prices. Prior to the stock market crash in 2000, prices of IT products had declined every year and yet corporate profits remained strong in the tech sector. That was largely due to technological advances, which allowed those companies to be more productive, enabling them to pass on the benefits to customers.

"As a country, we're much more used to a low level of inflation," Hoffman said. "But deflation doesn't have to be a terrible thing."