|Economist.com/October 12, 2002
FINANCE & ECONOMICS
Of debt, deflation and denial
FOR decades inflation was the bogeyman in rich countries. But now some
economists reckon that deflation, or falling prices, may be a more serious
threat--in America and Europe as well as Japan. That would be decidedly
awkward, given the surge in borrowing by firms and households in recent
years. Particularly worrying is the rise in borrowing by American households
to finance purchases of houses, cars or luxury goods. Deflation would swell
the real burden of these debts, forcing consumers to cut their spending.
Policymakers in America and Europe have been quick to dismiss any fears of
possible deflation. Bond markets, on the other hand, reckon that the risk is
mounting: bond yields have fallen to historical lows. Many products, from
clothes to cars, are certainly cheaper than they were a year ago. But
full-blown deflation requires a persistent fall in the overall price level.
The recent fall in the prices of durable goods has been offset by rising
prices of services; so outside Japan, average prices continue to rise,
albeit at the slowest pace for decades. As measured by the GDP deflator, the
best economy-wide gauge, America's inflation rate has fallen to 1.1%, its
lowest for 40 years. Its consumer-price index has risen by 1.8% over the
past 12 months, but prices have fallen in half of its 16 main product
categories--the biggest proportion since the current series started.
The world is still awash with excess capacity, in industries from telecoms
and cars to airlines and banking. Until this is eliminated, downward
pressure on inflation will persist. A good measure is the output gap, the
level of actual minus potential GDP. Historically there has been a close
relationship in most countries between the size of the output gap and
changes in the inflation rate. When the output gap is negative (ie, actual
output is below potential), inflation usually declines. The OECD estimates
that America's GDP is about 1% below its potential. If growth remains at or
below its trend rate of around 3% over the next two years, the negative
output gap will persist into 2004, pushing inflation even lower. It would
not take much to tip into deflation.
Optimists argue that deflation is much less likely today than in the 1930s
because services now account for a bigger slice of the economy. The prices
of services tend to be more resistant to dropping than the prices of goods
because they are more labour-intensive, and wages rarely fall. However,
Stephen Roach, an economist at Morgan Stanley, observes that service-sector
inflation is now much weaker than usual. The rate of increase in the
services component of America's GDP deflator fell from 3% in the year to the
fourth quarter of 2000 to 2.2% in the second quarter of this year. In the
previous six recessions, service-sector inflation actually increased over
the comparable period.
Although Mr Roach reckons that deflation is a serious risk, economists at
Salomon Smith Barney argue that fears of it are vastly overdone. Incompetent
monetary policies were largely to blame for deflation in America in the
1930s and in Japan today. Outside Japan, they argue, no central bank would
tolerate a persistent decline in prices. A recent paper by economists at the
Federal Reserve draws lessons from Japan's deflation and concludes that,
when inflation is unusually low, central banks must be especially alert to
the risk of deflation and cut rates by more than is normally justified by
inflation and growth rates.
The Fed is at least aware of the risks. However, not all central banks may
be either willing or able to learn from Japan's mistakes. Germany probably
faces a higher risk of deflation than America. The ECB's interest rate of
3.25% is broadly appropriate for the euro area as a whole, given its
inflation rate (2.2%), the size of the output gap, and the bank's chosen
inflation target of "less than 2%". But the ECB seems unlikely to cut
interest rates until inflation dips below 2%. And its inflation target is
arguably too low. Research by the IMF and the Fed suggests that, if central
banks aim for inflation below 2%, the risk of deflation rises markedly. If
the ECB had an inflation target with a mid-point (rather than a ceiling) of
2%, it could now trim interest rates.
Even then, however, rates would still be too high for Germany. Since it is
the highest-cost producer within the euro area, a fixed exchange rate tends
to cause price convergence by forcing inflation to be lower in Germany than
in the rest of the euro area. Germany's core rate of inflation (excluding
food and energy) has averaged 0.6 percentage points below the euro-area
average over the past three years; it is now a full point lower, at 1.1%.
Since interest rates are the same across the whole of the euro area, this
implies that real rates will be higher in Germany and growth consequently
slower. Germany's output gap, at an estimated 2.5% of GDP, is the second
biggest after Japan among the G7 countries, and it is likely to widen.
Deutsche Bank recently cut its growth forecast for Germany to only 0.1% for
this year and 0.6% in 2003.
Back-of-the-envelope calculations suggest that, if the old Bundesbank were
setting interest rates to suit Germany alone, they would now be below 2%.
Worse still, not only is Germany unable to cut interest rates, but the EU's
stability and growth pact also obstructs any fiscal easing. Nor can it
devalue its currency. Stripped of all its macroeconomic policy weapons,
Germany now runs a serious risk of following Japan into deflation.
Friend or foe?
Deflation is not necessarily bad. If falling prices are caused by faster
productivity growth, as happened in the late 19th century, then it can go
hand in hand with robust growth. On the other hand, if deflation reflects a
slump in demand and excess capacity, it can be dangerous, as it was in the
1930s, triggering a downward spiral of demand and prices.
Today, both the good and bad sorts of deflation are at work. Some prices are
falling because of productivity gains, thanks to information technology. But
the weakness of profits suggests that most deflation is now bad, not good.
Deflation is particularly harmful when an economy is awash with debt. Total
private-sector debt is now much higher than when deflation was last
experienced in the 1930s. Falling prices not only increase the real burden
of debt, they also make it impossible for a central bank to deliver negative
real interest rates, because nominal rates cannot go below zero.
If deflation causes real debts to swell, debtors may have to cut spending
and sell assets to meet their payments. This can unleash a vicious spiral of
falling incomes, asset prices and rising real debt. Irving Fisher, an
American economist, described this process in a famous article in 1933
entitled "The Debt-Deflation Theory of Great Depressions". He described how
attempts by individuals to reduce their debt burden by cutting costs could
paradoxically cause their debt burden to swell. Unable to increase prices to
boost profits, firms have to cut costs, either by reducing labour costs and
hence household income or by buying less from other firms. This is sensible
for an individual firm, but it reduces demand in the economy, thwarting the
desired improvement in profit, leading to another round of cuts and putting
further downward pressure on prices.
America's corporate sector is already suffering deflation, with the price
deflator of non-financial businesses falling in the past year for the first
time since the second world war. Many firms that borrowed heavily in the
late 1990s, expecting rapid revenue growth to finance their debts, are now
in trouble. Ed McKelvey, an economist at Goldman Sachs, worries that
corporate-sector deflation could create wider deflation if firms try to
slash labour costs.
When Japan was the only country with deflation, one sure cure might have
been a big devaluation of the yen to push up inflation. But for the world as
a whole, this is not an option. Global deflation could be even harder to
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