| The
Truth about the Deflation Threat
(Archive 2002)
Sections of Many Economies Already Deflating
Hong Kong Composite Consumer
Price Index - Source: HK government
At the 2003 World Economic Forum meetings in Davos
there was much talk about the possibilities of deflation: a real
and growing threat to a number of economies, despite the fact that
most governments have been obsessed with reducing inflation. Indeed
entire government economic policy has often been focussed on just
one main factor: killing inflation. Why?
Soaring inflation rates have been blamed for many
national crises and even for causing wars. Time and again we have
seen countries with out-of-control cost of living rises: strikes,
industrial action and high wage demands all feeding into higher
production costs, encouraging a spiral of further upward pressures
on consumer prices. Inflation is often blamed for destroying the
value of savings, and making people poor.
The US has been deflating in 40% of goods
and services
But the reality has been deflation across many
industry sectors. Take the US economy. Prices for 40 percent
of all the goods and services in the Labor Department's consumer
price index (CPI) showed year-over-year declines in September 2002,
according to research by Merrill Lynch's chief Canadian economist
David Rosenberg. Corporations in the deflating sectors below form
25% of the stocks in Standard and Poor's 500 index.
But many governments are being far too slow to
recognise the great dangers of low inflation, where a single economic
blow can push an entire nation over the edge into deflation, with
falling cash values of every asset and every investment.
Deflation means a complete mental rethink and is beyond
the understanding of most people today who were raised in inflationary
times. The real question is an emotional one: how will ordinary
people behave if they think prices are going to fall year on year
for more than a very short period?
And how will investors in the market behave? If they start pricing
in an expectation of deflation across most sectors, rather than
just 40% today, it will have a significant effect on valuations
and reduce appetite even more for buying stocks.
In the past most consumers have relied on inflation
to help them repay debts - particularly house loans. Inflation of
5% means a mortgage is only half what it was in real terms in a
decade.
But what happens in deflation?
When prices fall, the value of cash rises. Anyone with money has
an advantage and those with debts lose. If I have a mortgage of
$250,000 this year, and deflation runs at 5% a year, it means in
real terms my loan will double in size over a decade. Most worryingly,
in deflation, my loan (which was only 70% of the value of my home)
will become so huge that even if I sell my home, I will be left
with large debts.
We have all seen deflation before in one key area:
computers and digtal technology where deflation has been eating
away at price levels for three decades or more. But this is different.
It is one thing to write off an investment in a computer system
over three years, but another to find that one of your greatest
assets, your own home, is worth only a small fraction of what it
was twenty years ago, and that prices of every other asset you own
are also expected to go on falling.
Of course if you have cash in hand, the temptation
is to spend nothing, and invest in nothing. What is the point of
buying when you know that in six months time the chances are you
could buy more? So money gets left as cash under the bed, or in
a bank account (if you are prepared to risk the bank going bust
because so many loans were secured against assets, now worth almost
nothing). Spending falls, feeding a further frenzy of price cutting,
downward pressure on salaries, bonus cutting, and so on. But it
is easier to pay people less and get away with it when they know
they need less to live on this year than last year.
Interest rates fall to zero, because no one in
their right minds wants to borrow large amounts of an asset (cash)
which is going to inflate with time. Indeed the only asset for ordinary
men and women that grows in value in a deflationary economy is cash,
and cash is what you find they hang onto. Just look at Japan which
has experienced deflation for years with terrible consequencies.
But how serious is the risk of deflation hitting
other economies?
What happens when interest rates fall to
zero
The main tool that governments use to control inflation is interest
rates, but this tool has lost its power in many nations because
rates are already so low that there is hardly any room left to cut
further before the cost of borrowing falls to zero. With the reduction
of US interest rates to just 1.25% on 6 November 2002, alarm bells
should be ringing. Another terrorist shock, a war in Iraq that goes
badly wrong, or some other national calamity... it is not hard to
imagine a scenario where further rate cuts become necessary.
Think about it from the ordinary man or woman in the street's point
of view. If interest rates are zero, I can go out and get a huge
loan and it costs me nothing at all. Of course the loan must one
day be repaid, but when? The bank soon realises I am over extended
and cannot repay, but is in no hurry because the loan repayments
will be worth more to them in the future, if they give me longer
to find the money. They are not losing a penny in interest because
the interest rate is zero. In fact every day the bank waits, the
more the make, because the price of money is rising as the price
of everything else falls - that is the reality of deflation.
Old economics relied on inflation running at a
safe modest level - not too high and not too low. It taught us that
raising the cost of borrowing also raises the returns to savers,
and sucks money out of the economy so less is around to be spent
by consumers, goods hang around before being sold and market prices
are constrained. Lowering interest rates encourages people to spend
without worrying, more cash chases goods for sale, prices rise.
But the old model needs review.
Unfortunately there are a number of drivers of
deflation which are accererating, so it will be easy for governments
to find rates lower turn out lower than they expected. That's why
it is essential to keep a margin for error and to take radical steps
to prevent inflation falling from - say - an absolute minimum of
2.5% or even 3% a year.
Deflation Drivers
1. Globalization: every time a
job moves from a high income country to a low income country, the
price of production falls, and the potential for price cutting increases,
while maintaining profits and market share. We are currently witnessing
rapid and accelerating changes in industry and services. Even less
developed countries like Mexico are finding large chunks of their
manufacturing capacity moving to places such as China. India is
taking a significant share of software development, with entire
teams being made redundant in the UK and the US, replaced by teams
twice the size at a fraction of the cost in places like Hyderabad
and Bangalore.
2. Technology innovation: every
time a new production process is developed, using less people and
less resources, prices fall. In the past technology purchases formed
only a small part of our lives, but the techno-economy continues
to grown dramatically, despite the hype and gloom of investors.
And the indirect spin-offs are becoming greater every day. Take
for example food technology and processing, where new automated
packaging and distribution systems have contributed to falling food
prices for over a decade, or new farming methods with increased
yields, or the impact of online business to business relationships
and just-in-time delivery systems.
3. Economic cycles and global shocks
Every economy goes through ups and downs and events outside
any government's control also have impact. Take for example major
terror attacks or turmoils in the Middle East affecting oil prices,
which have recently fluctuated widely and may continue to do so.
When oil prices rise, there is inflationary pressure. Governments
respond by factoring this into decisions to raise interest rates
and inflation falls towards a base level. But if that minimum is
too low, what happens if there is another major correction and for
a while oil prices fall very significantly? The answer is an added
risk of overshooting and causing deflation.
Acting to prevent further deflation
So then, as we have seen, sectors in many economies
are already deflating. What can governments do now to prevent overall
deflation, or to correct national deflation once it starts?
Firstly they can cut interest rates more aggressively while they
are still able, if inflation is below 2.5% or likely to be so. The
slowness of the ECB (European Central Bank) to act was bizarre through
2002 and early 2003, with particularly serious results for Germany,
faced with soaring unemployment and recession.
Secondly they can suspend or revoke tax rises for a limited period.
Thirdly they can increase expenditure. Both these options of course
affect government debt and are sustainable only in the short term
without profound consequencies.
In summary then, expect many deflationary pressures
to continue in major sectors of the economy for the next decade,
with potential risks to stability in some countries where inflation
has been allowed to fall too low. Governments should be expected
to act now to stimulate inflation, aiming to maintain a minimum
of 2.5% to 3.0% inflation throughout economic cycles, giving room
for adjustments and economic shocks in both directions.
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