Dangers of Deflation Defined
As we have already seen, the American economy is increasingly global and effects of a downturn in one area of the world can immediately affect the value of American stocks at home. Throughout the first half of the year, it was widely speculated that Federal Reserve Chairman Alan Greenspan would choose to raise interest rates in the U.S. to cool down the economy a bit and prevent inflation from creeping in. By late September, though, he was coming under increasing pressure to lower interest rates to fend off deflationary pressures. What happened?
As economic trouble spots flare up around the globe, the earnings estimates of American firms who do business abroad begin to flatten. Without these international consumers to buy their products, there are fewer sales, which means that inventories pile up. When there is more supply than demand, prices go down. Lower prices would normally cause demand to pick up, but in an uncertain economy people tend to postpone purchases. We see this tendency in the American economy with computer products where consumers believe that the prices will go down if they wait another six months, so they decide to hold off. This tendency causes further gluts in the market, which eventually leads manufacturers to slow production. They lay off workers, causing domestic consumption to fall further since there is less money to buy goods. These effects ripple throughout the economy and create a deflationary spiral that can lead to a recession or even a depression.
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