Dirk Ehnts — Deflation in Spain

econoblog101
Deflation in Spain
Dirk Ehnts | Berlin School for Economics and Law

So, the problem of deflation has now manifested itself in the fourth largest eurozone economy. Why is deflation bad? Imagine a balance sheet of a business. The business takes out a loan on January 1st, then buys inputs and produces. At the end of the year, output is sold at current prices. With deflation, these prices will have come down. That way, a business buys dear and sells cheap, which obviously eats into profits and is not a sustainable way to run a business at all. How will that business react? Since profits are shrinking it might be tempted to curb supply, thus setting more workers free. This will lead to a fallacy of composition if all business react that way. Nominal income for the workers will have fallen, so that there is even less demand than before, so that the fall in supply will not lead to rising prices. A downward spiral of falling prices, wages and incomes can result. This is the most destructive set up an economy can show on the financial side. It needs to be avoided.