Since the late 1970s, the defeat of inflation has been the number one priority of governments and reserve banks. Now that has radically changed.
Recently, US Federal Reserve Chairman Alan Greenspan declared that the number one priority is to stop deflation.
Two International Monetary Fund reports have also said that deflation was now the dominant problem facing the world economy. Germany has declared stopping the slide into deflation as its number one priority.
Inflation is a measure of rising prices. Deflation is a measure of falling prices.
Consumer goods may become cheaper, but deflation also means falling profits and falling prices of assets like houses, land, capital equipment, jobs and wages.
Like inflation, deflation can be self-reinforcing. Consumers may defer spending. Why buy now when goods will be cheaper in the near future?
Inflation reduces debt burden of assets like home mortgages. Asset deflation sees an increase in the value of debt like mortgages and company borrowings.
Hence, deflation can be benign or dangerous.
Benign deflation occurred for some time in the US in the latter part of the nineteenth century. Electrification, new machines and technologies ushered in the age of low cost, mass produced goods. Company profits stayed healthy and the economy remained strong.
More insidious, systemic deflation was experienced during the 1930s. The huge debt and losses of companies from the inflated stock market of the 1920s resulted in companies cutting investment and employment. Consumers cut expenditure. Falling demand saw companies further cut employment. The economy spiralled downwards. The pattern of bankruptcy and retrenchment caused a depression.
Deflation is difficult to counter. Reserve banks can cut interest rates almost to zero, and governments can cut taxes, putting more cash in into consumers pockets. However, businesses won’t borrow if profits are falling and if the value of their debts are increasing. They are caught in what is called a “debt trap”. Consumers use tax cuts, not to spend, but to pay off the rising value of their mortgages.
Hence, while governments and reserve banks may try and rev the economic engine, the wheels just spin without gaining traction.
Today there is substantial overcapacity in many manufacturing industries, causing heavy discounting. As a result, US car companies are offering zero interest financing for five years to shift stock.
The average profit on the sale of a General Motors car has dropped from $US1,200 four years ago to $US300 today. Now the car market is saturated and sales are flat.
Is the world facing benign deflation or systemic deflation? Nobody knows. Hence the concern over where the world economy is headed after a century of almost unbroken inflation.
The risk of deflation in the EU stems from Germany, where inflation has been very low and prices are now falling. Germany makes up 30% of the economy of the EU.
The US economy has been flat and is likely to stay flat or in recession for several years, due to the enormous debt the economy is carrying in the wake of the bursting in 2001 of the largest stock market bubble in history.
The Federal Reserve has cut interest rates 13 times since then to 1.0%, the lowest rate since the 1950s.
While US companies have off loaded some debt over the past two years, households have been increasing their debt, taking advantage of the record low interest rates for home buying.
The value of new mortgages has risen 2,800% in three years.
In fact, the US continues to go deeper into debt. It has a rapidly growing foreign debt, such that Americans now spend $US105 for every $US100 they earn.
Household debt is rising. When households eventually decide that they have reached their debt limit, they are likely to cut spending in favour of paying off debt, stifling any economic recovery.
Japan has been in deflation for several years. However, it is not clear how much of this is due to the falling prices of domestic goods, which would cut profits of Japanese companies, or how much is due to Japan’s industry restructuring. Japan has re-tooled its industries several times since 1945.
This time it is switching from production of many manufactured goods to the production of the machine tools used to produce manufactured goods.
These machine tools are sold to China. In return, Japan is buying back from China, at a large discount, the high quality manufactured goods it used to produce itself at much higher costs.
This deflation of imported products, that are not in competition with domestic industry, allows the Japanese to buy more for their yen, raising their living standards without needing pay rises.
While it is not clear how much it is hurting Japan, deflation still poses an uncertain threat to the world economy.
For example, the falling value of the US dollar should be a stimulus to US exports, thereby boosting company profits and curb its rapidly growing foreign debt.
But cheaper US exports will force US competitors in the EU to lower prices. Germany is already on the brink of deflation.
In this way a falling US dollar would export deflation.
So what is the US doing about the risk of deflation?
The Federal Reserve has slashed interest rates such that home loans are now as low as 3.8%. Also, President Bush has cut taxes. As a result, in less than two years the US budget has gone from a planned surplus of $US200 billion to a deficit of $US300 billion.
Their hope is to keep consumers spending big on housing and consumption goods long enough for US companies to write down their debts from the 1990s stock market excesses, and until they can take up the excess capacity of their under-utilised industries.
The key is to stop unemployment rising and so to keep consumers confident and spending big time.
US economist and adviser to Alan Greenspan, Allan Meltzer, says that he has advised the Federal Reserve Chairman that historically there is little chance of systemic deflation in the USA.
Following a meeting with Alan Greenspan, Meltzer told the Australian Financial Review “that in all the history I examined, there are only two cases where deflation was a major problem. Japan now, and the US in 1929-33. And we are not going to come close now …
“There has never been a case of a country with a high money-supply growth, a depreciating currency and a rising budget deficit having a problem with deflation. Ever.”
This may be true; but these are hardly the policy prescriptions for a healthy economy.
The fact is that these policies are likely to take the US further into debt at a time when there is record debt due to the bursting of the largest stock market bubble in history.
It is by no means clear that these policies can turn deflation into inflation.
US economists put the chance of world wide deflation at about 40%. So why the concerns about deflation? The answer: “uncertainty”.
First, Greenspan has indicated that nobody really understands enough about how the modern global economy and its highly-complex, unstable financial system really works.
Second, nobody predicted deflation in Japan – nor do they properly understand its causes. Greenspan does not want that sort of surprise facing him in the US.
Third, US companies and households are carrying unprecedented levels of debt. Inflation would erode the value of that debt, but deflation would see that debt burden rise, rendering ineffective the usual economic stimulants like tax cuts and interest rates reduced almost to zero.
The policies the US is pursing may be necessary to try and head of deflation, but they also serve a political purpose.
Next year George Bush Jnr faces another US presidential election. His father was highly popular after successfully prosecuting the Gulf War following Iraq’s invasion of Kuwait, yet he lost the next election because of an economic recession.
George Bush Jnr wants strong growth in the US economy in the run up to the 2004 election. He will be struggling to achieve this.
The result of the huge stock market bubble and easy credit for 20 years is that the world now is staring at the possibility of deflation. This is unchartered waters.
- Pat Byrne