Listener 28 June, 2003.

Keywords: Macroeconomics & Money;

Even the International Monetary Fund is beginning to talk about the possibility of world deflation, that is the general level of prices falling over the medium term. Although the tendency over the last thousand years has been for inflation (rising prices), deflation with slightly falling prices has happened: notably in England during the twelfth and fifteenth centuries, from 1660 to 1730, and during the life of Queen Victoria. There have also been sharp price falls for short periods – most memorably in the 1930’s depression. (My source is David Hackett Fischer’s splendid The Great Wave: Price Revolutions and the Rhythm of History.)

Deflation is different from ‘disinflation’ as when the rate of inflation falls from, say, 15 percent p.a. to 2 per cent p.a. as it did in the late 1980s and early 1990s. Disinflation causes much hardship, but at its end prices may still be rising. Deflation would be equivalent to an inflation of minus 2 percent p.a., with prices generally decreasing. It raises quite different issues, although the fundamental one remains. How do we adjust to the new circumstances? In this case, how different is deflation we may experience from the inflation we are used to?

You might think that deflation is a good thing since each year your money will be more valuable. But the likelihood is that wages will be adjusted down too, and any debt (such as the mortgage on your house) will become more onerous. (The price of your house could even fall below the value of the mortgage.) If you depend on interest for income (those paying your pension do), the cash flow decreases because interest rates fall close to zero.

It is the very low interest rates which worry economists, because the monetary authorities cannot lower interest rates any further and monetary policy can become impotent. Interest rates cannot go below zero because people would hold their savings in money rather than interest bearing bonds.

The Japanese economy is already experiencing deflation, and is notorious for the ineffectiveness of monetary policy. Indeed fiscal policy – the balance between government taxing and spending – has not worked very well there either, and Japan has had ongoing stagnation since 1990. There is a view that some other major economies – notably Germany – may also be sinking into a deflationary spiral. But will the whole world?

One possible deflation scenario would be rapid technological change enabling firms to lower their prices (as is already happening in much of the computing industry). This requires real wages and other remuneration to rise more slowly than productivity. But although there has been enormous technological leaps in some industries, it has not occurred everywhere in the economy. In any case, it seems unlikely that workers in the advancing industries will be so quiescent, especially as there tends to be labour shortages of them.

The more likely source of deflation would be if the millennium recession were to tip into a millennium depression. High levels of underutilised capacity and unemployment would put severe downward pressures on prices (as firms competitively cut prices) and firms would force pay cuts on workers, generating a deflationary cycle. Any significant world deflation is likely to be a consequence of a very sick world economy. It is a symptom of a deeper economic malaise (while the mistakes we make learning to adjust to falling prices will exacerbate it).

Is the world economy that sick? I am not sure. The counter argument observes the US is cutting taxes and will end up with enormous budget deficits. So although its base interest rates are so low that US monetary policy may becoming ineffective, it is argued that fiscal policy is stimulating. Moreover, the US macroeconomic stance seems to be generating a depreciation of the US dollar, which will raise their import prices and could stimulate US inflation. The resulting higher US prices would surely impact on the world economy, and spur world inflation.

I am sorry to be so uncertain, but we are in unknown seas. The charts from the Reagan fiscal expansion of the 1980s may be misleading, while the Japanese ones are foreboding. It is easy to claim there are differences between Japan and the US. International commentators often conclude something like ‘the US business balance sheets could not be as rorted as the Japanese ones, could they?’ with the implication that perhaps they are.

It may be that for some commentators ‘deflation’ is a codeword for the assessment that the US (and perhaps European) business balance sheets are in the same Japanese mess. Even so, there are differences between the situation of the world’s largest economy and that of its third largest (the EU being second). The US is, after all, the banker of the world, and deflation is a monetary phenomenon. It could be even worse.