|
|
Finance - The dreaded D word |
The chairman of the US Federal Reserve Alan Greenspan has been dancing around the dreaded “D” word for some time now.
He won’t use it explicitly because, it seems, he believes if he does, it might actually make the event happen and possibly make it worse if it does. The word of course is deflation.
Japan has got it; so has China. Taiwan has succumbed and so has Germany. Other countries, including the United States, are at risk.
Deflation occurs when prices across the whole economy start to fall. It is different to a fall in prices of specific goods such as computers and mobile phones where they fall because of technical advances in the manufacturing processes. Deflation occurs when the price of goods and services all fall.
Usually it is measured by the Consumer Price Index or something similar.
Now most people of course can see little wrong with a burst of deflation. It does after all make their pay packets go further. But as the International Monetary Fund (IMF) concluded in a recent study, deflation is seldom benign.
A lot depends of course on how severe it is and how long it lasts. Perhaps more importantly, it is the expectations of consumers and business that can be most disruptive.
If deflationary expectations take hold, and this can happen quickly, then behaviour can change dramatically.
If consumers for example believe that prices will continue to fall they will save more and spend less in the expectation that they will be able to buy cheaper in the future. Demand then falls and pressure is placed on producers to cut prices even more.
Manufacturers who see downward pressure on prices in the future will look at their profitability. They will try to cut costs and they will be less expansionary. If wages are ‘sticky’ and do not fall in response to the falling prices, then unemployment will rise.
Deflation also causes a redistribution of income from debtors to creditors because the real value of loans increases. Deflation is also usually associated with falling asset prices such as shares and property. This makes the banks nervous about lending because their collateral is affected. It can then become a vicious deflationary spiral.
The last time this happened in a big way was during the Great Depression when prices fell in the US by 24 per cent between 1929 and 1933. The effect on growth and unemployment was catastrophic.
This new focus on deflation is rather ironic. Central banks around the world have been fighting inflation for the last 40 years and have taken every cyclical downturn in the economy to hammer inflationary expectations. Some would say they have been too successful.
The big problem faced by central banks in dealing with deflation is that they rapidly run out of weapons to fight it. Once interest rates reach zero, or close to zero, there is little they can do. The classic example in Japan where interest rates have been virtually zero now for several years and nothing much has happened. Hence the IMF recommends central banks take action to prevent deflation rather than cure it.
So how does it happen? Deflation can be caused by a big slump in demand or by a big increase in supply of goods and services. A fall in demand can occur after a major shock to the economy.
The big fall in share prices over the last three years, the geo-political uncertainties, excess capacity in many industries and in some countries such as Japan and Germany, and stress on the banking sector, have greatly increased the risks of it happening now. Fortunately big rises in house prices throughout the western world have helped repair household balance sheets and have kept consumer confidence from collapsing.
At the same time there are supply pressures. China for example has a huge under-utilised labour force that can be used to crank out more and more consumer products without putting pressure on wages and prices.
Alan Greenspan reportedly is privately concerned that another shock to the US economy could tip the balance of risks in favour of deflation. A fall in house prices or another share market shock could do it. The problem is that with globalisation, no one is too sure just how everything works.
The IMF however is optimistic. It believes that the risk of generalised deflation across the world is slight if appropriate pre-emptive action is taken. It sees floating exchange rates as a great plus and blames the gold standard and fixed exchange rates early last century for the Great Depression. It believes exchange rates will adjust to correct imbalances.
Nevertheless the risks are there with one of the biggest dangers being a big correction in house prices.
The IMF puts the chance of deflation in Belgium, Finland, Norway, Portugal, Singapore, Sweden and Switzerland as moderate. The risks in the US and the UK are low with Australia and New Zealand in the minimal risk category.
But if the US caught a bout of deflation we would all take to our beds.
|
|
|
|
