Definition of deflation:
A decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation can also be brought about by direct contractions in spending, either in the form of a reduction in government spending, personal spending or investment spending. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. opposite of inflation.
Source: http://www.investorwords.com/1376/deflation.html
Source: http://www.investorwords.com/1376/deflation.html
Deflation is not an option
WHAT ARE WE TO DO
by TAN SRI LIN SEE YAN
Hi from Xiamen University. Like most large Chinese cities, Xiamen is crowded and summer is not its best month. This week, the city hosts the Asia Financial Management Association international conference.
Away from the maddening crowd, the university campus offers respite to reflect on the frightening prospect of deflation, which can readily evolve from the impact of deep global recession and lower commodity prices.
I am often asked: “What’s so wrong about deflation?” Falling prices (as opposed to inflation) should be positive since it raises the purchasing power of the ringgit. That’s clearly a simplistic and very naive micro-view.
Some perspective is useful. The current US recession is past 17 months old (already the longest since World War II). It is expected to be still there in the next six months, the Fed Chairman’s “green shoots” notwithstanding. After all, GDP in the United States had contracted in excess of 6% per annum in each of the past two quarters, the worst 6-month performance in 50 years.
To be sure, as of now, although the outlook in the United States and China seems to be better, prospects in most of Euro-zone (including Britain and Germany) and in Japan have not brightened much.
The International Monetary Fund’s (IMF) update this week predicted a “long and severe recession” for Asia’s wealthier but export-oriented economies. Prospects for an imminent rebound are weak.
Realistically, latest data show a mixed picture – in the United States, conditions begin to look up on the back of tentative signs of firmer household spending – the beginning of some signs of stabilisation in the housing market, and in what appears to be a sharp inventory correction.
Optimists point to the recent surge in stock markets around the world as a clear signal since this is regarded by many as a lead indicator of things to come. This is a myth. After all, these markets did not see the meltdown coming last year.
Nobel laureate Paul Samuelson says it best: “The stock markets predicted at least 12 of the last two recoveries, and nine of the last five recessions.” Even the US Fed admitted this week that activity “is likely to remain weak for a time.”
But there are “headwinds” – US private investment remains weak and conditions in commercial real estate are poor; unemployment could reach 9% very soon and will rise further before it gets better; the banking system still needs fixing and bank loans remain tight (IMF recent estimates put losses in the financial sector at US$4.1 trillion).
The US private sector debt remains high (112% of GDP in 1976, 295% in 2008) while the financial debt picture is no better (rose from 16% to 121% over the same period); and private savings (up to 4.2% currently) can rise further as households begin to restore lost wealth (to match net worth at mid-2007, they have to save or make capital gains of US$13 trillion; matching the mid-2005 net worth will still require US$6.6 trillion).
Green Shoots – Just Out of Freefall
The brutal truth is: “less-worse” is not recovery. The world is not out of the woods yet; no clear signs of stabilisation.
Sure, as the Fed Chairman testified this week, the economic outlook has “improved moderately as the US recession appears to be losing steam”, in the face of some positive “tentative signs.” But he also warned that even when the United States recovers, growth will remain below its long-run potential for some time.
In my view, the optimistic consensus forecast positive growth by the third quarter of 2009, +2% in the fourth quarter of 2009, and about 2% in year 2010 is not realistic.
The financial system is far from healthy; private deleveraging has about just begun; and the rebalancing of global demand has barely started. Even the Fed Chairman concedes that “financial markets are still fragile and there will not be sustainable recovery without stabilisation of the financial system and credit markets; and much more needs to be done to make further progress on this front”.
Frankly, the reality is this: No one really knows what the year-end is going to bring. There is just too much uncertainty. I think Columbia’s Professor Nouriel Roubini’s outlook makes good practical sense: -2% by the fourth quarter of 2009 and +0.5% in year 2010; i.e. “even if we are technically out of a recession, we are going to feel like we are in a recession.”
The IMF’s recent update reflects similar views. What then has changed in the last few months? Two things – the risk of a L-shaped near-depression is reduced; and for the first time, we now begin to see positive risks in the global economic outlook as well as many negative risks (including something new – a possible H1N1 flu pandemic). Indeed, the whole situation remains rather confusing.
But make no mistake. The risk of deflation is still there, with the odds falling, I think, to 15%-20% after the aggressive US and Chinese stimuli programmes and the co-ordinated actions with many others. After all, even the US Fed Chairman admitted this week that “we expect the recovery will only gradually gain momentum and that economic slack will diminish slowly.”
The Fed is also focused “like a laser beam on an exit strategy, to keep inflation low.” For 2009 as a whole, the consensus is for consumer prices to fall in the United States and Japan (close to zero now in both), while inflation in Euro-zone will be flat. For Organisation for Economic Co-operation and Development nations, consumer prices rose 0.9% for year ended March 2009 – the lowest in 38 years.
Reflecting the global recession, most countries in East Asia expects inflation to fall to historic low levels (including in China, South Korea, Taiwan, Thailand, Singapore and Malaysia); even high inflation nations like Indonesia and Philippines will experience significant price declines.
This is not surprising, given the collapse of industrial production, sharp fall in commodity prices, rising unemployment and low utilisation of the existing capacity.
In the United States, Euro-zone and Japan, there are real concerns of deflation with potentially serious consequences for especially economies with over-indebted borrowers. The risks include:
● raising already large excess capacity (stimuli on infrastructure in particular will add further to this excess);
● rising unemployment and huge wealth losses can ironically work to raise savings;
● falling demand and profits, rising risk aversion and tight credit in the face of mounting fiscal deficits and soaring debt with dire impact on incomes and consumption; and
● flight from riskier borrowers can result in a vicious downward spiral of weakening foreign direct investment flows, falling output and deteriorating asset quality. This global recession is unlike any the world has ever seen. It creates uncertainty at every turn. Indeed, its exceptional and unpredictable dynamics raise doubts about the outcome of recovery when it does come.
What is disturbing is the dynamics of the price discovery process, given uncertainties surrounding the timing of return to normalcy (i.e. sustainable fiscal clarity, viable market interest rates, and solvent financial system and credit market).
For Japan, its recent experience in achieving such normalcy is scary. Indeed, the prospect of another “lost decade” is frightening. Whatever eventually happens in the United States on whose final demand the world has come to depend, is critical.
In the worst case scenario, the real risks hinge on a shallow and hesitant economic turnaround in the face of insufficient progress at:
● deleveraging
● rebalancing global demand, and
● inducing private-led revival, at a time when the financial system and credit market remain far from healthy.
Deflation can take off in such an environment to the detriment of a solid recovery. In such an environment, the recent stock market “surge” can well become a “dead cat bounce”, heading south once again before too long.
Deflation Woes
Most of us, especially those who are old enough in the mid ‘70s, know what inflation is and how destructive it can be. Some may even have painful memories.
Deflation is something new in Asia – only happened in Japan. For a decade after the stock market and real estate bust in 1990, Japan bumped along at just 0.5% growth per annum, in the face of a deflation (including in wages) that so very slowly brought down unemployment that the period was dubbed “the lost decade”. For the younger generation, both phenomena are abstracts.
Persistent falling prices and the expectation that they will continue to fall reflects a broken economy. In today’s context, it can be serious enough to destabilise the recession and derail any prospect of early recovery in a number of critical ways:
● First, deflation raises the real rate of interest i.e. the nominal rate adjusted for inflation. In practice, with inflation, the real rate is less than the nominal rate; with deflation, the real rate is higher than the nominal rate. In the United States, since short-term rates are already close to zero, there is no room to bring nominal rates down further to offset the higher real rate.
So, deflation simply raises the real yield on cash; thus, encouraging more saving (a virtue, surely) which is precisely what you don’t need in recessionary times. Hence, the paradox of thrift (Keynes). Moreover, higher real rates discourage credit-based purchases by consumers and businesses. This weakens demand, leading to further falls in prices which exacerbates the recession.
● Second, deflation increases the real value of debt. In the same way, inflation helps debtors by driving down their real value. If the price level falls significantly, borrowers will really feel a double whammy – real debt servicing will rise relative to income (as wages fall with deflation); and deflation also brings with it a higher loan-to-value for home owners as house values fall. This can lead to loan defaults.
Similarly, rising real debt weakens business balance sheets and affects their access to more credit. It encourages businesses to deleverage to clean-up their balance sheets. This, of course, makes business sense. But, if all businesses did the same, we will have a financial crisis on our hands – hence, the paradox of deleveraging (Krugman).
● Third, deflation will bring with it, the paradox of falling wages (a-la Krugman). To save jobs in a recession (a good thing), workers are prepared to accept lower wages. If all businesses did this, no one gains any competitive advantage. But falling wages worsen the recession since falling incomes adversely affect household and business debt, raises mortgage payments in real terms, and dampen their propensity to spend, with disastrous impact on recession in the face of rising real interest rates.
As indicated earlier, falling wages in Japan brought about the “lost decade” – wages fell by more than 1% a year from 1997 to 2003.
● Fourth, deflation also brings damaging effects on the expectations of consumers and businesses. Essentially, with deflation the psychological impact of expecting prices to fall some more. This can well bring on a potential downward spiral of declining prices to further weaken confidence, making real recovery that much more difficult.
Crucial to breaking the downward cycle is changing expectations, among shoppers and businesses alike, that prices will keep tumbling.
Perhaps, the Japanese experience can offer an invaluable lesson. As of now, the prospective behaviour of consumers and businesses remains deeply uncertain. The dynamics of the range of risks to be managed are as complex as they are global.
As indicated earlier, it is possible that the United States, Euro-zone and even today’s Japan could find themselves in the situation of Japan in the mid-1990s – i.e. unable to power a sustainable strong recovery and requiring further stimuli.
It is clear that stabilising the recession is not good enough. A really strong recovery is needed. This could mean stronger stimulus, stronger action to restore confidence in the financial system and credit market, and stronger job creation measures. By learning from Japan’s mistakes, the United States and Euro-zone can avoid a dismal decade.
● Former banker Dr Lin See-Yan is a Harvard-educated economist who now spends time promoting the public interest. Feedback is welcome. Please e-mail to starbizweek@thestar.com.my.
WHAT ARE WE TO DO
by TAN SRI LIN SEE YAN
Hi from Xiamen University. Like most large Chinese cities, Xiamen is crowded and summer is not its best month. This week, the city hosts the Asia Financial Management Association international conference.
Away from the maddening crowd, the university campus offers respite to reflect on the frightening prospect of deflation, which can readily evolve from the impact of deep global recession and lower commodity prices.
I am often asked: “What’s so wrong about deflation?” Falling prices (as opposed to inflation) should be positive since it raises the purchasing power of the ringgit. That’s clearly a simplistic and very naive micro-view.
Some perspective is useful. The current US recession is past 17 months old (already the longest since World War II). It is expected to be still there in the next six months, the Fed Chairman’s “green shoots” notwithstanding. After all, GDP in the United States had contracted in excess of 6% per annum in each of the past two quarters, the worst 6-month performance in 50 years.
To be sure, as of now, although the outlook in the United States and China seems to be better, prospects in most of Euro-zone (including Britain and Germany) and in Japan have not brightened much.
The International Monetary Fund’s (IMF) update this week predicted a “long and severe recession” for Asia’s wealthier but export-oriented economies. Prospects for an imminent rebound are weak.
Realistically, latest data show a mixed picture – in the United States, conditions begin to look up on the back of tentative signs of firmer household spending – the beginning of some signs of stabilisation in the housing market, and in what appears to be a sharp inventory correction.
Optimists point to the recent surge in stock markets around the world as a clear signal since this is regarded by many as a lead indicator of things to come. This is a myth. After all, these markets did not see the meltdown coming last year.
Nobel laureate Paul Samuelson says it best: “The stock markets predicted at least 12 of the last two recoveries, and nine of the last five recessions.” Even the US Fed admitted this week that activity “is likely to remain weak for a time.”
But there are “headwinds” – US private investment remains weak and conditions in commercial real estate are poor; unemployment could reach 9% very soon and will rise further before it gets better; the banking system still needs fixing and bank loans remain tight (IMF recent estimates put losses in the financial sector at US$4.1 trillion).
The US private sector debt remains high (112% of GDP in 1976, 295% in 2008) while the financial debt picture is no better (rose from 16% to 121% over the same period); and private savings (up to 4.2% currently) can rise further as households begin to restore lost wealth (to match net worth at mid-2007, they have to save or make capital gains of US$13 trillion; matching the mid-2005 net worth will still require US$6.6 trillion).
Green Shoots – Just Out of Freefall
The brutal truth is: “less-worse” is not recovery. The world is not out of the woods yet; no clear signs of stabilisation.
Sure, as the Fed Chairman testified this week, the economic outlook has “improved moderately as the US recession appears to be losing steam”, in the face of some positive “tentative signs.” But he also warned that even when the United States recovers, growth will remain below its long-run potential for some time.
In my view, the optimistic consensus forecast positive growth by the third quarter of 2009, +2% in the fourth quarter of 2009, and about 2% in year 2010 is not realistic.
The financial system is far from healthy; private deleveraging has about just begun; and the rebalancing of global demand has barely started. Even the Fed Chairman concedes that “financial markets are still fragile and there will not be sustainable recovery without stabilisation of the financial system and credit markets; and much more needs to be done to make further progress on this front”.
Frankly, the reality is this: No one really knows what the year-end is going to bring. There is just too much uncertainty. I think Columbia’s Professor Nouriel Roubini’s outlook makes good practical sense: -2% by the fourth quarter of 2009 and +0.5% in year 2010; i.e. “even if we are technically out of a recession, we are going to feel like we are in a recession.”
The IMF’s recent update reflects similar views. What then has changed in the last few months? Two things – the risk of a L-shaped near-depression is reduced; and for the first time, we now begin to see positive risks in the global economic outlook as well as many negative risks (including something new – a possible H1N1 flu pandemic). Indeed, the whole situation remains rather confusing.
But make no mistake. The risk of deflation is still there, with the odds falling, I think, to 15%-20% after the aggressive US and Chinese stimuli programmes and the co-ordinated actions with many others. After all, even the US Fed Chairman admitted this week that “we expect the recovery will only gradually gain momentum and that economic slack will diminish slowly.”
The Fed is also focused “like a laser beam on an exit strategy, to keep inflation low.” For 2009 as a whole, the consensus is for consumer prices to fall in the United States and Japan (close to zero now in both), while inflation in Euro-zone will be flat. For Organisation for Economic Co-operation and Development nations, consumer prices rose 0.9% for year ended March 2009 – the lowest in 38 years.
Reflecting the global recession, most countries in East Asia expects inflation to fall to historic low levels (including in China, South Korea, Taiwan, Thailand, Singapore and Malaysia); even high inflation nations like Indonesia and Philippines will experience significant price declines.
This is not surprising, given the collapse of industrial production, sharp fall in commodity prices, rising unemployment and low utilisation of the existing capacity.
In the United States, Euro-zone and Japan, there are real concerns of deflation with potentially serious consequences for especially economies with over-indebted borrowers. The risks include:
● raising already large excess capacity (stimuli on infrastructure in particular will add further to this excess);
● rising unemployment and huge wealth losses can ironically work to raise savings;
● falling demand and profits, rising risk aversion and tight credit in the face of mounting fiscal deficits and soaring debt with dire impact on incomes and consumption; and
● flight from riskier borrowers can result in a vicious downward spiral of weakening foreign direct investment flows, falling output and deteriorating asset quality. This global recession is unlike any the world has ever seen. It creates uncertainty at every turn. Indeed, its exceptional and unpredictable dynamics raise doubts about the outcome of recovery when it does come.
What is disturbing is the dynamics of the price discovery process, given uncertainties surrounding the timing of return to normalcy (i.e. sustainable fiscal clarity, viable market interest rates, and solvent financial system and credit market).
For Japan, its recent experience in achieving such normalcy is scary. Indeed, the prospect of another “lost decade” is frightening. Whatever eventually happens in the United States on whose final demand the world has come to depend, is critical.
In the worst case scenario, the real risks hinge on a shallow and hesitant economic turnaround in the face of insufficient progress at:
● deleveraging
● rebalancing global demand, and
● inducing private-led revival, at a time when the financial system and credit market remain far from healthy.
Deflation can take off in such an environment to the detriment of a solid recovery. In such an environment, the recent stock market “surge” can well become a “dead cat bounce”, heading south once again before too long.
Deflation Woes
Most of us, especially those who are old enough in the mid ‘70s, know what inflation is and how destructive it can be. Some may even have painful memories.
Deflation is something new in Asia – only happened in Japan. For a decade after the stock market and real estate bust in 1990, Japan bumped along at just 0.5% growth per annum, in the face of a deflation (including in wages) that so very slowly brought down unemployment that the period was dubbed “the lost decade”. For the younger generation, both phenomena are abstracts.
Persistent falling prices and the expectation that they will continue to fall reflects a broken economy. In today’s context, it can be serious enough to destabilise the recession and derail any prospect of early recovery in a number of critical ways:
● First, deflation raises the real rate of interest i.e. the nominal rate adjusted for inflation. In practice, with inflation, the real rate is less than the nominal rate; with deflation, the real rate is higher than the nominal rate. In the United States, since short-term rates are already close to zero, there is no room to bring nominal rates down further to offset the higher real rate.
So, deflation simply raises the real yield on cash; thus, encouraging more saving (a virtue, surely) which is precisely what you don’t need in recessionary times. Hence, the paradox of thrift (Keynes). Moreover, higher real rates discourage credit-based purchases by consumers and businesses. This weakens demand, leading to further falls in prices which exacerbates the recession.
● Second, deflation increases the real value of debt. In the same way, inflation helps debtors by driving down their real value. If the price level falls significantly, borrowers will really feel a double whammy – real debt servicing will rise relative to income (as wages fall with deflation); and deflation also brings with it a higher loan-to-value for home owners as house values fall. This can lead to loan defaults.
Similarly, rising real debt weakens business balance sheets and affects their access to more credit. It encourages businesses to deleverage to clean-up their balance sheets. This, of course, makes business sense. But, if all businesses did the same, we will have a financial crisis on our hands – hence, the paradox of deleveraging (Krugman).
● Third, deflation will bring with it, the paradox of falling wages (a-la Krugman). To save jobs in a recession (a good thing), workers are prepared to accept lower wages. If all businesses did this, no one gains any competitive advantage. But falling wages worsen the recession since falling incomes adversely affect household and business debt, raises mortgage payments in real terms, and dampen their propensity to spend, with disastrous impact on recession in the face of rising real interest rates.
As indicated earlier, falling wages in Japan brought about the “lost decade” – wages fell by more than 1% a year from 1997 to 2003.
● Fourth, deflation also brings damaging effects on the expectations of consumers and businesses. Essentially, with deflation the psychological impact of expecting prices to fall some more. This can well bring on a potential downward spiral of declining prices to further weaken confidence, making real recovery that much more difficult.
Crucial to breaking the downward cycle is changing expectations, among shoppers and businesses alike, that prices will keep tumbling.
Perhaps, the Japanese experience can offer an invaluable lesson. As of now, the prospective behaviour of consumers and businesses remains deeply uncertain. The dynamics of the range of risks to be managed are as complex as they are global.
As indicated earlier, it is possible that the United States, Euro-zone and even today’s Japan could find themselves in the situation of Japan in the mid-1990s – i.e. unable to power a sustainable strong recovery and requiring further stimuli.
It is clear that stabilising the recession is not good enough. A really strong recovery is needed. This could mean stronger stimulus, stronger action to restore confidence in the financial system and credit market, and stronger job creation measures. By learning from Japan’s mistakes, the United States and Euro-zone can avoid a dismal decade.
● Former banker Dr Lin See-Yan is a Harvard-educated economist who now spends time promoting the public interest. Feedback is welcome. Please e-mail to starbizweek@thestar.com.my.