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04th
February 2012
Worrying
Prospect
 Deflation
that reflects a slump in demand and excess capacity
is always dangerous. Falling prices can cause
consumers to put off purchases, leading to a
downward spiral of weak demand and further price
falls. That outcome is particularly pernicious
in economies with high levels of debt, as Japan
painfully discovered in the 1990s. The real
value of the debt burden grows as prices fall—precisely
the opposite of what a country needs when it
is weighed down by excessive debts already.
The rich world’s economies are already
suffering from a mild case of this “debt-deflation”.
The combination of falling house prices and
credit contraction is forcing debtors to cut
spending and sell assets, which in turn pushes
house prices and other asset markets down further.
, An economist, famously pointed out in 1933
that such a vicious downward spiral can drag
the overall economy into a slump. A general
fall in consumer prices would make matters even
worse. Since central banks cannot cut nominal
interest rates below zero, deflation raises
real interest rates, slowing the economy further
and raising the real value of debts. Private-sector
debts are now much larger than they were in
the 1930s, so a modern depression could be even
nastier. But there are four reasons why a deflationary
spiral should be still a remote risk—and
a risk that policymakers can avoid.
First, although food and fuel prices are volatile,
most prices do not drop so easily. In most rich
countries core inflation is still a long way
from zero. That will not change quickly. In
Japan deflation did not set in until four years
after that country’s financial bubble
burst.
Second, central bankers—at least outside
America—have plenty of monetary ammunition
left. At 4.25%, the ECB’s policy rate
still leaves plenty of scope for downward adjustment.
Third, American policymakers, at least, have
understood that public money is necessary to
counter a spiral of debt-deflation. They are
now spraying taxpayers’ money at the financial
crisis like firemen with hoses. This will help
slow the deleveraging.
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Lastly, and less happily,
several years of rising oil prices may have
slowed the rich world’s underlying economic
speed limit, by reducing the productivity
of energy-guzzling machinery and raising transportation
costs. Economic weakness may therefore be
less disinflationary than it used to be.
All in all, then, the rich world’s policymakers
have plenty of tools with which to beat off
deflation. But just as the bubble was inflated
by the interaction of monetary policy in the
rich and the emerging world, so today’s
macroeconomic outlook will be influenced by
decisions made outside America, Japan and
Europe.
So far, emerging economies have been playing
a positive role. If, as still seems likely,
the biggest among them slow but do not slump,
then some sort of floor will be put under
commodity prices and robust consumers in the
emerging world will prop up exports from fragile
debt-laden rich countries.
But the emerging markets’ resilience
cannot be taken for granted. They suffered
their own version of the cycle that inflicted
on the rich world: surplus savings flowed
in, stoking asset prices. Now many stockmarkets
and currencies have plunged as the pendulum
has swung back again. Investors worry about
continuing high inflation (in emerging Asia)
and lower commodity prices (in Latin America).
Countries, especially in eastern Europe, that
built up current-account deficits when cheap
money made these easy to finance now look
vulnerable. But the biggest economies, notably
China’s, appear robust. And if the world
economy darkens further, China will emerge
as the likeliest saviour.
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