As the economy grinds its gears to recovery, it might by showing some elements of deflation as a result of the slow rise in employment levels. Deflation results from consumers not spending and/or conserving their cash which could lead to production surpluses and falling prices. Unemployment is a primary factor to consumer spending reduction but in a recession and early stages of recovery people who have jobs are not so quick to spend because they are not sure how long they will stay employed. When spending is down and there is surplus, prices are likely to fall. But even with low prices, there may not be enough takers, leading to further price reductions.

When the economy is tight, it does not matter if goods are cheap, consumers are scared and hold on to their money. The challenge would to eliminate the surplus and push prices up. In short, increase demand. To ensure that prices remain stable and stump creeping deflation, it is necessary to create the conditions that would encourage people to spend. Fiscal stimulus measures and tax cuts support continued consumer spending while the Feds monetary policy aims at supporting investment and job growth.

Regardless of what compromises are made to avoid the looming fiscal cliff and hold down deflation , there will be some degree of government spending cuts and tax rollbacks early in 2013. It would indeed be bad timing and the wobbly recovery would slow down again in spite of the access to investment capital through QE3. Job growth is likely sputter once more as investor caution postpones new business initiatives. The hope that QE3 will bankroll increased output and create an advantage for US exports in the short term will be delayed. The reduced trade deficit to strengthen the dollar may not be realized till much later.

The possible ensuing scenario begs some examination of US-EU interconnectedness as nervousness about Europe continues to impact the US economy and its growth outlook. The US is the largest trading partner for EU goods. A new US recession would mean a major drop in EU exports leading to further economic shrinkage in Europe. New austerity measures in an already battered Greek economy is giving new breath to political unrest that has several flashpoints across Europe. Reduced EU revenues threaten the bailouts for Greece and Spain and political/economic stability in the region.

The EU is also the largest outlet for US exports. Economic contraction in the Eurozone will affect the US ability to earn revenues from goods exported to Europe. The German economy, the strongest in the EU, is already showing signs of a slowdown which could be partially attributed to lower US demand. With supply and demand down on both sides of the Atlantic, the stage is set for deflation (zero growth) of global proportions. The issues relating to the US fiscal cliff need to be navigated free of partisan politics for strategizing so that the recovery will not be reversed and economic growth remains steady.

Very low economic growth leads to deflation and a stalled economy. Worst case scenario is that low demand and low supply will see prices fall so dangerously low that businesses will be forced to close their doors, triggering a new unemployment spiral and a recession deeper than before. The injection of money into the system as in the case of QE3 could increase inflation. But low levels of inflation are necessary to keep supply and demand at optimal points in order to sustain recovery and keep deflation at bay.

Advertisements