I am in the process of launching a new 12 step program (along the lines of Alcoholics Anonymous) called Deflation Anonymous. The aim of the program is to help Wall Street analysts and mainstream journalists overcome their terror of the word “deflation” – and their denial that the US economy has entered a deflationary spiral.

During the first 12 months of the economic downturn, the mainstream media refused to use the word at all. In the last 8-9  months, they have had no choice, especially since major corporations – such as Kroger foods, Costco, and Walmart have publicly blamed “deflation" for a drop in corporate earnings last year.

In the last 24 hours I have heard the “D” word four times – in reference to a 2% decline in New Zealand grocery prices (over one year), “deflation” in the Chinese real estate market, “deflation worries” causing yesterday’s 1% drop in the Dow Jones and now a split in the Federal Reserve on whether we actually have “deflation” or are only “verging” on it. The latter really surprised me. It seems the Fed should have anticipated they would create deflation when they reduced the money supply by 9.6% (with ten percent less money in circulation, people have ten percent less money to spend and retailers have to reduce prices to move their products).

The US media still studiously avoids the word without qualifying it. They hedge by referring to “deflation worries,” a “deflation threat,” or “verging on deflation.”

My absolute favorite, though, is “deflation recognition phase,” which Internet commentators have used a lot this week. This makes me very optimistic the condition can be cured – thus my new 12 step program.

Why is Wall Street So Terrified of Deflation?

In essence deflation is negative inflation, a steady decline in retail and producer prices (oh yes, both the producer price index and the consumer price index have fallen every month for three months). The term deflationary spiral refers to a chain reaction in which lower prices and profits force employers to lay off workers and reduce wages, which further reduces consumer demand because people have no money, which leads to even more layoffs and wage cuts.

Economists who advocate aggressive anti-deflation measures usually point to the Great Depression and to Japan. Many theorists blame the Great Depression on ten percent overall contraction in prices and wages. And people might be surprised to learn that Japan – the world’s second largest economy – has been in a deflationary spiral for thirty years.

Deflation has resulted in a lower standard of living for most Japanese. Most workers have experienced wage cuts. However the government of Japan has pursued a deliberate policy of keeping unemployment low. Everyone works and earns lower wages. However their money keeps earning more because of falling prices (in many cases the price remains constant but the size of the soda can or candy bar keeps getting bigger).

The Problem of Massive Corporate Indebtedness

Based on the Japanese experience, I have the impression that deflation will be moderately painful for average Americans. Where the real suffering will occur is in banks and other corporations (and individuals) which are massively in debt. The dollar amount of a one million dollar debt remains constant, even though that million dollars is much harder to come by (owing to decreased revenues, profits and access to credit) and even though the relative value of that million dollars has substantially more buying power.

I have a feeling individual Americans will simply walk away from their debts when they become unemployed or their wages drop substantially (as they walked away from their subprime mortgages when the value of their homes plummeted). It is much harder for corporations. And after decades of cheap credit increased the wealth and stock prices of corporate America, many companies carry massive debts they can only repay with a US dollar that continually declines in value owing to inflation.

In a deflationary spiral, many of these companies will either go bankrupt – or come to the federal government for more bail-outs.