ECONOMICS What’s With the “D” Word?

The New Zealand Herald reported concerns about it early in July (in an article under the heading “Deflation heads agenda for world’s top bankers”). The Otago Daily Times was alert to similar sinister trends (under the heading “Deflation threatens to spread around the world).”

In the same week, Britain’s The Economist published measure of the global dread and declared deflation to be “rampant”. The evidence: its D-word index (a count of stories in the Financial Times and the Wall Street Journal that include the word “deflation”) surged in the second quarter of the year to its highest level since the 1930s. An accompanying graph illustrated the point. The trend line was shooting sharply upwards.

United States Federal Reserve chairman Alan Greenspan is at least partly responsible for this development. He was among those to cluck concerns about deflation in mid-year, and as the ODT article noted, when Mr Greenspan talks deflation, “the rest of the world sits up and takes notice”.

Actually, Mr Greenspan said deflation was potentially serious threat, but he was confident the central bank had plenty of ammunition in its monetary-policy arsenal to beat it back.

His confidence was mirrored in the text of its decision when the Federal Open Market Committee in June lowered its target for the federal funds rate by 25 basis points to one percent.

Meanwhile, Argentina had gone down with dose of it; some European countries had caught it and others were on the verge of becoming infected; and poor old Japan has suffered from it and its sluggish effects for more than 10 years.

In Germany, Europe’s largest economy, the annual rate of inflation slowed for the third straight month in May to just 0.7 percent, down from one percent in April, 1.2 percent in March and 1.3 percent in February. Beware. European Central Bank chief economist Otmar Issing reckons inflation rates below one percent come close to the “danger zone” of deflation.

So why should anyone worry? If the price of your favourite chocolate bar comes down, surely you can buy more of them with the same dollar.

Well, deflation is commonly regarded as general fall in prices – not fall in any component of general price index, such as oil, lamb chops or computers, but decline in the price index itself. bad case of it can lead not only to widespread price declines, from goods and services to real-estate and stocks, but also to bankruptcies, foreclosures, job losses and pay cuts.

The United States’ last serious deflation occurred during the Great Depression. New Zealand analysts haven’t been as nervous about the deflationary threat as their foreign counterparts. The last available figures at time of writing showed the consumers price index ticked over at 2.5 percent in the year to March, down from 2.6 percent year earlier. The Reserve Bank in June was forecasting it would fall “significantly” in the near term. Much of this decline would reflect the effect of the strengthening Kiwi dollar on prices for goods and services in the tradeables sector.

But there was nothing in the bank’s crystal ball to show annual inflation falling, as distinct from rising at slower pace. Its projections showed the annual rate averaging 1.75 percent in the second half of this year and the first half of next year before nudging back to average two percent in the second half of next year.

As American analyst Hal R Varian points out, deflation itself isn’t necessarily bad – what matters is the cause of the deflation. Falling prices can arise from too much supply or too little demand, and having too much supply can often be good thing. Having too little demand, however, is almost always bad.

Therefore we must keep close eye on the US. If it follows Japan’s example and can’t clamber out of the recessionary ditch for several years, the global economy will be in danger, too.

Avinash Persaud, Gresham Professor of Commerce and global head of research at State Street, gives cause for believing this won’t happen. The risks hinge on the willingness and ability of domestic policy-makers to avert deflation, he argues, while reminding us that deflation leads to transfer of resources from debtors to creditors. The more powerful the debtors, the greater will be the political resolve to avoid deflation; the more powerful the creditors, the weaker the resolve. “If you are creditor, voting for inflation is like turkeys voting for Christmas,” says Persaud.

On an international basis, the US is running net debt position of around 25 percent of GDP versus the rest of the world, whereas Japan is running net surplus of around 35 percent of GDP. Thus there are strong political pressures on the US to keep out of the deflationary mire.

Bob Edlin is regular contributor to Management.

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