B/c when deflation hits contracts have been pegged to pre-deflation dollars, while the goods/services used to raise money to make those payments is now paid in deflated buckaroos. To wit, the loan, mortgage, whatever has now becomes bigger. A h### of a lot bigger.
Thus:
-- You own Acme Widgets. Your widgets sells for $1.00 each. It cost you, oh, let's say 91¢ -- for raw materials wages, maintenance, utilities, taxes, etc.-- to make each widget. The remaining 8¢ is obscene profit.
-- You borrow $1,000 from the bank to buy and install a machine that will stamp your widgets with just-too-cute-for-words pictures of puppies on them.
-- All told you'll pay the bank back, oh, let's say $1,010 for the loan. Theoretically you need to sell 1,010 widgets to pay off this loan.
-- Then one day you wake up and find deflation has struck. The price of everything has been chopped by 50% -- bam!
-- Your widgets are now selling for 50¢ each. But the money you borrowed (the $1,010) is based on widgets selling for $1 each.
-- So now instead of needing to sell 1,010 widgets to pay off your debt, you need to sell 2,020 widgets -- double what you originally budgeted.
-- Worse, every widget you make you lose money.
Remember?
$1.00 widget, selling price
- .92 fixed cost to make same
-------
$0.08 profit
Well, with this deflation its now:
$0.50 widget, selling price
$0.92 fixed cost to make
-------
$0.48 in the hole...well, more like 50¢ in the hole since you (also) won't be making you obscene profit of 8¢.
So every widget you make you lose money, but you gotta pay back that bank loan some how! Rise the price? No dice. The public just ain't gonna spend $2.00+ for widgets, even widgets with just-too-cute-for-words pictures of puppies on them. B/c chances are they just found themselves with 50% less pay, same as you.
Thank you for your response. You're quite right that a sudden, unexpected deflation can have the nasty consequences you mentioned; however, a predictable, steady deflation of a few percentage points per year is something businesses can prepare for and it can be factored into interest rates.
The stock of extracted gold has been growing at a steady rate of around 2% annually. Suppose the economy grows at 4% per year; this leaves us with a deflation rate of 2%. This means if a bank wants to achieve a real interest rate of 5%, it should ask for a nominal rate of 3%. Simple enough, isn't it?
Predictability is actually a great benefit that the gold standard has and a Fed-determined money supply doesn't have. The Fed has the power to inflate or deflate the dollar by any amount it pleases--even 50%, if they get very evil! Such dramatic and unforeseeable swings are impossible under the gold standard, since it is based on a physical good and on the forces of supply and demand, rather than on the decisions of a single man.
I'd much rather have a steady deflation of 2% than give such power to any one person!