While the United States is fighting inflation, China—the world’s second-largest economy—seems to have the opposite problem: deflation.

In July, consumer prices fell in China for the first time in two years. Several economic issues have hit China since lifting COVID-19 restrictions. There has been a drop in exports and the real estate market has been in a downturn.

China’s economy has dipped into deflationary territory.

But what exactly is deflation and why are people worried about it?

William Dickens, distinguished professor of economics and social policy at Northeastern University, explains that while the opposite of inflation may sound good, deflation is a problem you don’t want to have…

Responses have been edited for clarity and brevity.

What is deflation?

Deflation is the opposite of inflation. We say an economy is in deflation when the general price level is falling. The general price level is measured by one or more indices like the familiar Consumer Price Index.

Is deflation different from the lowering of inflation?

Disinflation (falling inflation) is the slowing down of price increases. Deflation is falling prices.

Falling inflation is normally viewed as a good thing. Most of the world’s central banks like to keep inflation around 2%—lower than what most countries are currently experiencing. However, inflation rates less than 2% are avoided because of the danger that the economy will fall into deflation.

You might think falling prices were a good thing, but you have to remember that wages are a price as well. During deflation, wages and prices fall so purchasing power doesn’t increase.

However, if you have a lot of debt, falling wages mean people have to work longer to pay off debt. It also means that people have less real purchasing power so this leads to declining consumer demand which puts further downward pressure on prices and wages.

Falling prices also mean that firms have to sell more goods to pay off their debt. Often they can’t and are forced into bankruptcy. This causes more unemployment and again lowers purchasing power and demand.

This very vicious circle hit Japan in the 1990s, causing more than a decade of economic decline and then stagnation. China is a very heavily indebted country with a very weak banking system. Deflation could be disastrous.

Why is deflation happening in China?

First, it may not be. One month of falling prices can be a statistical fluke. But conditions in China are ripe for deflation. Inflation has been very low and both foreign and domestic demand has been weak. Domestic demand is weak because the economy hasn’t recovered from China’s disastrous COVID policies. Foreign demand is falling because Western nations want to disengage their economies from China out of fear of major economic problems should China attempt to bring Taiwan under mainland control by force or should Chinese claims on waters in the South China Sea lead to confrontation. Russia’s invasion of Ukraine has been a lesson to the world about how unpredictable authoritarian governments can be.

Will this affect the U.S. economy?

If China enters a full blown period of deflation, it is possible that there will be some blowback on the U.S. and world economies. The U.S. will be less affected than other countries because we don’t export much to China, so a collapse in Chinese demand would have little immediate impact on the U.S. Third-world exporters of raw materials and food will be most affected. Many of those same countries are saddled with crippling debt to China. This may lead to some defaults in the developing world.

More concerning are the possible global financial impacts—particularly a financial panic. I will speculate that that won’t happen. China is a net lender to the world. Its debt is mainly held internally. I doubt that any major Western banks would have trouble dealing with a Chinese default, which could follow an economic collapse. I worry more about Western banks’ exposure to the debt of those developing countries that are likely to suffer from lower Chinese demand.

What are you looking for to see if China does, in fact, fall into deflation?

Another month or two of falling prices and it will be hard to call it a fluke. The follow-on effects will take time and I suspect that the government will try to paper over and cover up the problem. Being an authoritarian state, they have more tools at their disposal than a Western government would.  

Are you worried?

Not yet. And to the extent I am, it is more about wag-the-dog problems than purely economic ones. 

Cyrus Moulton is a Northeastern Global News reporter. Email him at c.moulton@northeastern.edu. Follow him on Twitter @MoultonCyrus.