A reader asked a question about this after my Stephen King post from last Friday.  I think the best place for an answer is here.

In most circumstances, what counts is real GDP, not nominal.  That latter is, after all, just real GDP + inflation.  However, what comes to mind when people start to look for instances where nominal GDP shrinks is the Great Depression   …or maybe Japan during the series of Lost Decades it has been experiencing since 1990.

A potentially huge economic problem during a period of declining nominal GDP is that virtually all borrowing contracts–bonds or bank debt–are written in nominal terms.    In many places, labor contracts are also framed the same way, with an x% increase in wages yearly over the term of the agreement.

The revenues that businesses generate to meet these obligations are a function of unit volumes and price changes.  If real GDP is falling by, say, 3% and prices rising by only 1%, overall revenues are contracting.  Given that operating costs are typically fixed over the short term, this means firms in the aggregate will have less income to meet debt repayments and salary obligations.  For highly operationally or financially leveraged companies, even small declines in revenues can be deadly.

If, on the other hand, volumes are down by 3% and prices are rising by 4%, then revenue growth will still be positive.  On the margin, at least, this means fewer layoffs and fewer insolvencies to act as an economic drag during a time  when governments are trying to stimulate demand.

The situation where nominal prices are actually falling–which we’re not talking about here– is far worse.  Consumer soon learn that waiting a month, or two or three, before buying will mean a lower price.  So they just stop buying.  Given that consumers make up the bulk of economic growth in developed economies, they can ill afford to get the idea in consumers’ heads that purchasing anything today is a bad idea.