[PEN-L:32528] deflation? redux

["Ian Murray" <seamus2001@xxxxxxxxx>]

The great deflate debate

Larry Elliott
Monday November 25, 2002
The Guardian

It's often said that Britain lives in a world of its own, and that
assessment looked totally apt at the end of last week. In the UK it was
suddenly the1970s redux; firefighters huddled round the brazier, Labour
ministers flapping around ineffectually and a chancellor warning of a
contagion of inflationary pay demands.

Yet while the talk here is of a new winter of discontent, of picket lines
and the public sector pay bill, elsewhere different parallels are being
drawn - both more recent and more distant. Economists seeking to explain the
current state of the world economy are looking at the mid-19th century, the
1930s and the early 1990s.

Why? Because Britain's local concern with inflation is at odds with fears
that a much bigger threat to the global economy deflation spreading from
Japan to the United States and Europe. The Federal Reserve and the
Organisation for Economic Cooperation and Development are already talking of
what should be done to thwart the onset of falling prices.

Focusing on deflation requires a change in thinking for policy makers. Most
have spent their careers grappling with inflation, with higher interest
rates used to kill off periodic bouts of overheating. They are now faced
with a very different global economy to that of the mid-1970s or the
late-1980s.

The first noticeable difference is that inflation is now much lower than
25 - or even 10 - years ago. Higher interest rates have had something to do
with this, but the trend away from protected national markets, strong trade
unions and anti-competitive oligopolies and towards global markets, weak
unions, and tougher regulation to prevent monopoly pricing has probably been
more crucial.

Policy potency


The boom in the US at the end of the 1990s thus took place in a new
environment. Despite the longest post-war expansion, inflation kept on
falling because capacity grew at an even faster rate than the economy
overall. America's bust was much more like the collapse of a business cycle
in the 19th century, when periods of debt-fuelled over-investment led to
long periods of stagnation or retrenchment as the boom's excesses were
purged. Lower interest rates helped, but were not a complete cure.

As a result, the quite substantial easing of economic policy over the past
couple of years has not had the potency it had in the past. US interest
rates have come down by 5.25 percentage points, those in the eurozone by 1.5
percentage points and those in Britain by 2.0 percentage points. Yet all
three economies have been stuttering along this year and, according to the
OECD, will not grow much faster in 2003.

It would be wrong to conclude from this that macro-economic policies do not
work. Had policy not been eased, the position would be now far more serious.
The model here is early 1990s Japan. The Fed and OECD view is that the
government failed to act quickly and decisively enough after the collapse of
the asset bubble of the late 1980s and allowed deflation to take hold.

In a paper released this year, the Fed drew two big conclusions: the
Japanese authorities had been too slow to see the risk of deflation, and
that it is better to be safe than sorry. The message was that if there was a
whiff of deflation, the Fed would act and act big. All of which explains why
the Fed cut interest rates this month, and why it would be prepared to back
up further cuts in the cost of borrowing with more unconventional means of
stimulating the economy - perhaps by printing more cash, buying treasury
bills or intervening in the foreign exchange market to lower the value of
the dollar.

Should it do so, it would have the full support of the OECD, which made its
views on deflation clear in its half-yearly health check on the global
economy released last week. It too drew two lessons from Japan. "The first
is that the costs associated with possible policy errors are asymmetric:
they are far higher when erring on the conservative side than when loosening
too much... This asymmetry then justifies a policy posture biased towards
expansion, involving decisive cuts early in the downturn and a deferral of
rate hikes until a recovery is well under way, as 'insurance' against
downside risks. Such a stance is also seen as helping meet the second
concern - that of preserving a sound financial system, thereby allowing
monetary policy to operate effectively."

Hang on, I hear some of you say, the Fed and the OECD are getting het up
about nothing. Inflation is still in positive territory and the global
economy is growing. Is there really a risk of deflation? And even if there
is, would it be so terrible? The answers are yes and yes.

The starting point for any analysis is that inflation is already low. In
countries such as China and Singapore, prices are already falling, and in
the G7 inflation is running at little more than 1%. Inflation falls when
economies are operating below trend - when there is a gap between actual and
potential output. The OECD is expecting that every G7 country apart from
Canada will have an output gap next year, leading to downward pressure on
inflation.

There are also plenty of early warning signals of deflationary pressure. In
the US, inflation as measured by the consumer price index is running at 2%
but half of the goods and services that make up the index are falling in
price. Ian Harwood, global head of economics and strategy at Dresdner
Kleinwort Wasserstein, last week said that Japan was in a similar position
in the 1990s, where prices of goods started falling four years before
outright deflation set in.

The country most imminently at risk of deflation is Germany. DKW say that
there is historically a close link between the output gap and the change in
the inflation rate in the euro area. "Based on an unchanged exchange rate,
we see euro area inflation falling to around 1% by the end of next year and
only 0.5% in 2004. Given the dispersion of national inflation rates inside
monetary union, that spells major deflation risk for Germany and France."

Poor profitability


America is not immune either. Three years after the peak of the hi-tech
bubble, the US remains saddled with a glut of capacity and the corporate
sector's profitability is poor. Profits are what makes capitalism tick: they
determine how much companies invest and how many people they hire. The state
of corporate profitability in the US is not good news for the global economy
and will intensify deflationary pressure.

Mr Harwood identified five reasons why deflation is a problem: wages fall
more slowly than prices, thereby squeezing profits still further;
expectations of further price declines mean spending is postponed, creating
a deflationary spiral; rising bankruptcies hit banks and their willingness
to lend; falling prices mean rising real interest rates - even if the latter
are reduced to zero; and a falling price level raises the real burden of
debt.

It is the last that could be the real killer. Modern western economies have
been built on an ever rising quantity of debt. In the 1970s and 1980s,
borrowers could rely on rising prices to inflate away the real value of
their debts; now for the first time since the depression of the 1930s there
is the looming threat of debt deflation, where the burden of debt grows
bigger rather than smaller.

In terms of policy, the risk of debt deflation will mean that economic
policies remain looser for longer than anybody was expecting even three
months ago. The Fed will cut rates to below 1%, and rates in the eurozone
could hit 2% next year. Fiscal policy will be eased everywhere. Even then,
inflation will remain low and recovery will be hesitant. Policy makers are
not about to repeat the mistakes of the 1930s (at least, let's hope not),
but if the global economy fails to respond to the stimulus, they don't have
an awful lot left to offer.

larry.elliott@xxxxxxxxxxxxxx