Doyle answers: >... Assets like real estate, commodities like oil go down in price because of over production and other pricing mechanisms (like over building) which can not be worked out of the system any other way force the system whether country, or global exchange to lower the prices to sell. That general lowering of prices to make things once again profitable is a deflation. With an economic slowdown it becomes a depression. Recessions are an example of inflations of prices while business activity goes down.<
Deflation = a general fall in prices (the opposite of inflation).
The key problems with deflation can be seen by looking at assets and liabilities. Suppose you lend me $1 million and I buy a bunch of oil, which I put in my tank in hopes of selling it at a higher price. (Neither of us expect deflation.) I have a debt of $1M (and also the oil) and you have an asset of $1M.
Falling prices mean that the purchasing power of that $1M rises (it can buy more goods and services), which raises the value of your assets. However, it also raises the purchasing power of my debts at the same time that it lowers the price of my oil (as Doyle notes). Oil and other commodities usually see large price swings, so they'd be hit hard by a general fall in prices. But a general deflation would also likely hit my wages, which don't fall as steeply as oil prices.
Falling prices, in sum, make what were "good loans" (from the bank's viewpoint) become "bad loans." With my obligations to you rising relative to the value of my assets, it is likely more difficult for me to pay off the principle and interest on your loan to me (especially given the fall in my wages). I may not be able to live up to my obligations and so I end up bankrupt. (Or I repudiate my debts to you, as Russian did recently.)
With the bankruptcy, you've lost an asset. Or if you can claim the oil, that asset is of much lower value than it was at the time of the loan. I'm being told to jump through all sorts of hoops by the bankruptcy court (or by the IMF, if I'm a country). The latter typically involves cutting back on spending: debtors can't be choosers.
You (the lender) are less likely to lend to me or anyone else after this experience. I am less likely to borrow or spend. This encourages a recession. (Note that a recession would result only if the price cuts hit large numbers of individuals.) A recession means that a lot of people lose jobs, which makes it even harder to pay off their debts.
On top of this, as Doug points out, falling prices throw a spanner into capitalists' efforts to plan. They buy raw materials and hire labor-power hoping to sell the product at one price but it turns out that when they actually do sell, the price is lower. This hurts profits, which are more volatile than wages. Of course, they punish their employees by laying a bunch off.
The recession leads to further price declines, more deflation. It can become a vicious circle (as in Irving Fischer's debt-deflation theory of depressions). Falling prices cause falling spending causing falling prices, until the financial system and the real economy melt down. There's a depression.
If the price declines are expected ahead of time, all of this is less of a problem. But usually when people are talking about the threat of deflation, they are saying that we weren't expecting deflation when a lot of debt obligations were contracted, so the deflation we now expect is a big issue. But even expected deflation is a problem: expected price rises mean that borrowers will be paying off their loans in dollars that are worth more (a higher expected real interest rate). This encourages them to hold back on borrowing and spending, unless the lenders are willing to cut the nominal interest rate. In a place like Japan, however, there's little or no room for cutting nominal rates since the nominal rate cannot be below zero (banks never pay you to borrow their money).
A final note: when countries in East Asia or Russia devalue their currencies, it's much like deflation. Their products suddenly become less expensive in dollar terms. Usually deflation hits commodities more than manufactured goods or wages, but with devaluations, the dollar prices of the latter fall a lot. Russia is mostly exporting commodities (e.g., gold) these days, so its deflation contributes to the commodity deflation. East Asian devaluation encourages the deflation to spread to manufacturing. (Because so many countries have devalued, few of them get any benefit in terms of increased volume of exports demanded. This can encourage further devaluations.)
Another final note: I don't want to say that global deflation will automatically drag down the US economy. (Nothing is inevitable.) After all, cheap imports and competition from cheap exports help avoid inflation in the US. This in turn discourages the Fed from inducing a recession; if the US economy continues to prosper, it provides increased demand for the rest of the world's goods, which helps moderate the deflation cycle outside the US. In fact, they may even work to fight a recession, both nationally and globally. I've expressed skepticism about the ability of the Fed and the other central banks to do so, but it's not impossible.
Jim Devine jdevine at popmail.lmu.edu & http://clawww.lmu.edu/Departments/ECON/jdevine.html