I've been hearing the term deflation being bandied about by TV news pundits with Japan being used as the popular example of this phenomenon for the past few months. The claim is that if the trend of price drops in the U.S. continues then we will be headed for deflation. When I first saw these stories I wondered what exactly is wrong with falling prices? Well…

Everywhere you look assets are worth less than they were a year ago. Gas prices are lower, house prices are lower, and stock portfolios are lower. At first I considered this a net positive. According to Zillow my house is now worth 10% less than what we paid for it almost two years ago and my 401(k) lost about 35% during the 2008 calendar year. However I treated this as a "correction" since these were in effect paper losses since I bought my house to live in not to flip it and I'm not planning to spend out of my 401(k) until retirement. On the other hand lower gas prices and cheaper consumer goods at Christmas time had a real and positive effect on my bottom line.

In addition, despite the media's claim that people were hoarding we planned to ignore the hype and help the local economy by continuing our plans to have our bathroom remodeled and get a new car later in the year (my wife has her eye on the Ford Flex).

As each week passes I've been less sure of our plans to "help the local economy" and last week's announcement by my employer to eliminate 5,000 jobs within the next 18 months began to make the plans seem downright irresponsible. At this point we've decided to hold off on the purchases and are debating the safest way to hold on the money and still retain value. My behavior sounded familiar and I looked up Wikipedia for information about deflation in Japan it was interesting to see the parallels

Systemic reasons for deflation in Japan can be said to include:

• Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.

• Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks have delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks make even more loans to these companies that are used to service the debt they already have. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by The Economist) as methods to speed this process and thus end the deflation.

• Insolvent banks: Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.

• Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.

• Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

The crazy thing is that this sounds like a description of the United States of America today. That's when I understood that the threat of a deflationary spiral is very real. If people like me start hoarding cash then businesses get less customers which causes them to lower prices in return. With lower prices, they make less money and thus need to cut costs so they have layoffs. Now the local situation is worse giving people even more conviction in holding on to their cash and so on. The bit about imported goods kicking the butts of locally produced items in the marketplace is also especially apt given the recent drama about the automobile bailout. 

Anyway, it looks like we are at the start of a deflationary spiral. The interesting question is whether there is anything anyone can do to stop it before it fully gets underway.