Fighting Deflation

Maltastar 

The Japanese economy has been locked in a deflation of falling prices for nearly three years now. Germany’s economy has also run out of growth and seems set to go into negative mode. The US economy has slowed down considerably and although the Federal Reserve Bank has adopted a strongly accommodating monetary policy, aggressively reducing interest rates to record lows for more than 40 years, there emerge no clear signs of revival and the Fed is said to be considering driving interest rates to new post-war lows.

The Stock Markets of the world are showing their concern about the prospect of deflation by moving in and out of bear market rallies with almost annoying regularity. Any economic indicator which points to a revival in confidence and consumption demand, is soon followed by others showing the exact opposite.

What is being done to avoid the prospect of deflation? But to start with is deflation bad and should economic managers try to avoid it?

“There are two types of deflation. One is benign, one oppressive.”

There are two types of deflation. One is benign, one oppressive.

Benign deflation is not at all wrong. It happens when prices fall because there is a surge in productivity due to some technological innovation and in spite of healthy growth in consumer demand the supply side efficiencies outstrip the demand and push prices down.

Such benign deflation is very rare and often it happens only in particular segments of the economy affected by the technological innovation and not across the whole price spectrum. Often as prices fall in a particular economic segment due to such innovation, e.g. mobile telephony prices., two particular phenomena start working to ensure that the price falls do not get transported to the economy as a whole.

Firstly it brings into the market new participants whose income can access the lower prices levels of the innovation sector. Producers are therefore not squeezed by the falling margins as they can make up by volume what they lose through margin drops. Furthermore as consumers benefit from additional purchasing power due to price falls in the particular sector, they increase their spending on other sectors of the economy, e.g. leisure and sports, pushing up prices in that sector thus leaving the overall price levels of the economy generally unchanged.

“Oppressive deflation occurs when there is a fall in demand creating supply overcapacity that drives prices down”

 

Oppressive deflation is a much more serious and painful matter altogether. Oppressive deflation occurs when there is a fall in demand creating supply overcapacity that drives prices down. If the phenomenon persists it would build its own momentum as consumers defer consumption waiting for prices to fall, causing more overcapacity leading to employment layoffs and further reduction in demand starting another round in the spiral of falling prices.

It is for this reason that Central Banks throughout the world have responded by lowering interest rate to record lows. Falling prices, soft demand and production over-capacity put the minds of monetary authorities at rest that inflation is no longer an issue. The issue is now averting deflation.

Reduction in interest rate levels over the last two and a half years seems to have been pretty ineffective in stimulating demand. It brings to mind Lord Keynes theory that trying to created demand through lax monetary policy is like pushing on a string.

“The US seems to have adopted a unilateral and deliberate policy of stimulating internal demand by lowering the value of the USD on the exchange market”

Generally it is more aggressive fiscal policy that can be trusted to work better for the purpose of stimulating demand. Tax cuts or additional government spending can be much more effective in putting money in people’s pocket tempting them to increase consumption to stimulate economic demand.

In America this has been possible given that the economic growth of the late nineties had produced big budget surpluses giving ample room for manoeuvring fiscal policy to create demand. It has not proven effective so far as the consumer has been shocked by the threat of terrorist attacks and the prospects of America being engaged in active warfare throughout the world and this has not yet persuaded the consumer to start spending his increased riches whilst feeling insecure about the future. There is also a lot of criticism that the fiscal stimulus adopted in the US, i.e. removal of tax at source on corporate dividends, is putting purchasing power in the hands of those whose normal demands are already well met and are therefore unlikely to spend the additional purchasing power they are being favoured with.

In Europe the situation is more complicated. Germany is already grappling with significant budget deficit deviations from the Euro Growth and Stability Pact and has very limited room for manoeuvring fiscal policy to stimulate demand. To make it worse the ECB, having responsibility for the whole Euro area (12 countries) and not just Germany has not been aggressive enough for Germany’s tastes in reducing interest rates which low as they nominally are, in the context of very low inflation, are still high in real terms.

And complications know no end for Germany. The US seems to have adopted a unilateral and deliberate policy of stimulating internal demand by lowering the value of the USD on the exchange market. A drop of 22% in the space of two months was described by the Treasury Secretary as ‘quite modest’ putting pressure on Euro exporters to the US markets to remain competitive or risk losing orders compounding the internal problems.
Japan seems to have lost all tools to fight deflation with interest rates at zero and fiscal deficit too high to permit any significant stimulus Japan has been studying the unthinkable.

Knowing from classic economic books that the easiest way to create inflation is by printing new money, voices in Japan are being listened to more attentively, also because of the absence of other alternatives, that the way to break the chronic deflations is for the Central Bank to start printing money and giving them to the population to whet the appetite for increased consumption. Seems logical. But can difficult problems be addressed by such simple solutions?