Friday, September 05, 2003
The deflation fear that won't go away
Posted by David Smith at 09:30 PM
Category: David Smith' s magazine articles

It is now some time since financial markets began to contemplate a life beyond inflation, or put another way a world of deflation or falling prices. By now, though, those worries should have gone away.

It is two years, after all, since America succumbed to what was, with hindsight, a very shallow recession. And, while the global economy also met the standard recession definition (2% growth compared with a 4% norm and a virtual standstill in world trade), things were by no means as bad as they could have been.

And yet, in the recovery phase, the deflation doubts remain. The global recovery is certainly not strong enough to produce a revival in inflation. And if we are not careful, it seems, it may be soggy enough to allow deflation to take hold.

The reasons for this are familiar enough. America, while in little danger of a “double-dip” recession is growing at a slower rate than the post-recession norm, or at least the norm that applied until the early 1990s.This recovery, perhaps alarmingly for George Bush junior, is rather similar to the one presided over by his father, with disastrous electoral consequences.

Europe, meanwhile, is stubbornly refusing to play its part in the global recovery. Reluctant euroland consumers and confidence-sapped businesses have pushed growth below 1% this year, with little reason to be much more optimistic about prospects for 2004.

Japan, for once, has been surprising on the upside, with growth coming through a little stronger than expected. Nobody yet believes, however, that the world’s second biggest economy is out of its prolonged depression.

In Britain, for once, the picture is relatively healthy. The economy sailed through the world recession of 2001 and has continued to grow, albeit relatively slowly. No economy is immune to what’s happening elsewhere, though, particularly Britain with a somnolent euroland on its doorstep. Growth in the first quarter, at just 0.1%, was the slowest for 10 years.

The proof of economic weakness, and the associated deflation fear, is in what policymakers have been doing. Central banks have continued to cut, at a time in the cycle when they would normally be thinking of raising rates. Thus, the Federal Reserve under Alan Greenspan has cut to just 1%, and the Bank of England under Mervyn King to only 3.5%. In both cases rates are at their lowest level since the 1950s. The European Central Bank has joined in the act, reducing rates to 2%. The Bank of Japan, with rates already at zero, has had to resort to alternative measures for boosting liquidity in the economy.

So how serious is the deflation risk? In Japan, of course, we have a living example of the phenomenon at work. Consumer prices have been falling for the past 4-5 years; property and share prices since the bursting of the “bubble” economy a decade ago.

One of the most thoughtful contributions on the subject of deflation came a few months ago from Ben Bernanke, the former Princeton professor who is now a Fed governor. He distinguished between price falls in individual sectors, which may be due to productivity gains or other factors, and price falls across the economy – deflation.

As he put it: “Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.

“Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending - namely, recession, rising unemployment, and financial stress.” In America during the great depression prices fell by about 10% a year during the 1930-33 period.

Bernanke made several points to justify his view that America was unlikely to succumb to deflation in the modern era. In Japan, as he pointed out, deflation came as a surprise in spite of the bursting of the bubble economy. In contrast, the Fed, like other central banks, is well aware of the danger and has acted to head it off.

He also pointed to the dynamism of the US economy, its flexible nature providing “a remarkable ability to absorb shocks of all kinds, to recover and to grow”. A similar view applies among policymakers in Britain. The Bank of England, for example, sees little risk of deflation. Its inflation forecasts have a negligible probability of it happening over the next two years.

The European Central Bank, it should be said, takes a similar view even though inflation in Germany, Europe’s biggest economy, is under 1% and falling. The common theme among central banks is that they have further room to cut interest rates (although not very much) and that if that is not enough they can resort to unconventional means of boosting liquidity – metaphorically if not literally like Milton Friedman’s helicopter drop of money.

What if they are wrong? Deflation worriers point to the downward pressure on prices resulting from new global capacity, notably in China, like Japan an economy experiencing falling prices. They also point to very low inflation rates worldwide, suggesting it would not take too much to tip many more countries over into deflation.

The difficulty about deflation, of course, is that it is the economic equivalent of a quagmire. Once in it is hard to fight your way out. For all the talk of unconventional measures, if we see US and European interest rates drop to zero we will know we’re in trouble.

There’s another view – there always is among economists. It is that the current obsession with deflation, and the determination to head it off, can only have one result – the return of inflation. Government bond markets picked up a little whiff of that worry earlier in the summer.

More likely, policymakers will just about manage to negotiate a course that avoids deflation without rekindling inflation. Even a few years ago, the idea that we would be worried about the return of 1930s-style falling prices would have seemed fanciful. But deflation is a worry that won’t quickly go away.

From Professional Investor, September 2003

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