
Deflation explained
Date: Sunday, August 17 @ 23:52:09 CDT
Topic: Rest of World
Guardian (UK) feature on "What is Deflation?"
With US inflation at its lowest level for years, coupled with persistently weak growth, the threat of deflation is stalking the American economy. Mark Tran explains
Monday May 19 2003
The Guardian
What is deflation?
Deflation is defined as a sustained decline in price levels, or as the Collins English Dictionary has it: "A reduction in the level of total spending and economic activity resulting in lower levels of output, employment, investment, trade, profits and prices."
What is wrong with falling prices?
In some cases, this is beneficial. Productivity gains in the last century allowed businesses to make more goods more cheaply, lowering the price of those goods and improving everybody's standard of living.
So when is deflation a problem?
Deflation becomes damaging when people postpone spending in the anticipation of cheaper prices. When consumers postpone or no longer spend, businesses cannot sell their goods, make profits or pay off their debts, leading them to cut production and workers.
This leads to lower demand for goods, which leads to even lower prices. Historical experience has shown that once deflation sets in, it is incredibly hard to shake it off, as Japan is discovering.
What happened in Japan?
Japan has been in the grip of deflation since the mid-1990s, when asset prices - property and shares - collapsed after the boom of the 1980s.
But the most notorious period of deflation occurred in the US in the great depression of the 1930s, when a fall in prices was coupled with a sustained fall in gross domestic product.
Is the US worried about deflation?
Increasingly so. In May, the US Federal Reserve made a sharp departure from its fight against inflation over the last 30 years, saying it was worried about an "unwelcome substantial fall in inflation".
Even before that, in June 2002, the Fed published a study about deflation in Japan and how monetary policy could have prevented it.
What did the Fed say?
The study said Japan should have cut interest rates more aggressively between 1991 and 1995. "Too much stimulus can be taken back later through a corrective tightening of policies," the study said.
"However, if too little stimulus is provided and the economy moves into deflation, the future ability of monetary policy to pull the economy out of its slump can be substantially undermined."
Is deflation a problem in Europe?
It is a relatively distant prospect in most countries with one important exception - Germany, the eurozone's most important economy. If Japan, the US and Germany - the world's three largest economies - enter a deflationary spiral, then the global economy will indeed be in trouble.
The International Monetary Fund has issued a blunt warning that Germany, which has remarkably low inflation, could soon see falling prices.
What about the UK?
The Bank of England points out that deflation is as much a preoccupation
as inflation because of its "symmetrical target" of 2.5% inflation. This means that the bank's monetary policy committee has to take into account deviation either above or below 2.5%. If there is deviation of greater than 1% either way, the governor of the bank has to write a letter of explanation
to the chancellor.
What can be done to stop deflation?
The Fed has already tried the option of cutting interest rates. In the most aggressive easing of monetary policy in its history, the US central bank has slashed rates to a 48-year low of 1.25%. But recovery has been weak, and economists increasingly talk of the need for unconventional measures.
Such as?
One of the harmful effects of deflation is that it increases the value of real debt. With a little inflation in the system, borrowers see their debt eroded over time.
Someone who borrows £100, when inflation is 2.5% (the UK target), can
assume that in 10 years the amount will be only 78% of its original value when adjusted for inflation.
But if inflation is zero, lenders are better off as their savings have not been eroded. By contrast, borrowers are worse off as inflation has not eroded their debts. In such a climate, companies with debt will struggle.
One way for governments to help these companies is to simply bail them out
and pass on the costs to the taxpayer. Other measures include the creation
of inflationary expectations such as printing money and/or cutting taxes.
What is meant by exporting deflation?
The dollar has fallen sharply following broad hints from the US Treasury
Secretary, John Snow, that America has ditched its traditional strong dollar policy.
The greenback is trading at four-year lows against the euro and virtually at its all-time low of $1.18, which it reached just after the single currency made its debut in January 1999.
A low dollar is good for US exports and means higher US growth. But a weak
dollar will hurt European exports. In effect, by driving down the dollar, the US is literally passing the buck. In this case, it seems it's landed with the Europeans.
Copyright Guardian Newspapers Limited
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