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US in denial over deflation trend

By Neville Bennett

Friday 27th June 2003

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US Federal Reserve vice-chairman Roger Ferguson last month said the risk of deflation was "remote" and that "the US has too many good things going for it to make a forecast of deflation credible."

Nevertheless, several Fed statements have rated deflation a risk and Mr Ferguson went on to admit a need "to guard against further declines" in prices.

So the US is in denial. Deflation is a reality in Japan, Germany and Hong Kong. It is not asserted here that the US is about to plunge into deflation. It remains a possible scenario the US is trying desperately to avoid.

The US is pursuing a "funny money" policy. The Fed has cut interest rates more times than I can count. It has driven down short-term interest rates to record lows. The market has driven the 10-year bond to 45-year lows.

The dollar is unsupported, and is falling against most currencies. Perhaps this policy will inflate the economy. Perhaps it will avoid Japan's fate. Japan has tried every measure to inflate its economy but faces inexorable decline.

So let's have a look at the "d" word. It is obviously the terrible word hiding in the American closet. It is a word in which we have little management knowledge.

Before going further, it is necessary to pay tribute to capitalism's brilliant ability to produce cheaper goods. Prices will fall as a natural process of capitalism's pressures and productivity delivery.

Capitalism puts inexorable pressure on prices of goods (alas not on the prices of services such as lawyers' fees). The IMF calculates real commodity prices have declined 0.6% a year since the turn of the century.

Deflation is a risk because prices are falling in many societies, especially China and Japan. But equity markets are still way below their peaks and there are repeated disappointments over the pace of economic recovery.

Oil prices have been at a dangerous level for many months and a $US30 a barrel price equivalent has always created recessions in the past. Despite repeated interest rate cuts, business is unwilling to expand its activities and invest significantly in new capital investment while much over-capacity exists.

Deflation is costly. It severely reduces output and employment. It is punitive to debtors, though many people think low interest rates are good for debtors and hard for creditors.

Creditors have to be careful in their asset allocation, as many real estate and equity assets decline in value in deflationary times. The banking sector becomes weak and a fragmented system, such as that of the US, falls under enormous stress. (Remember the huge losses in savings and loans in a mild recession in the 1980s?)

Japan's experience has shown deflation is as vicious now as it has ever been. After the 1990 stock market crash, equity, real estate and business values plummeted, and many loans and overdrafts ceased to perform. Banks were immediately hurt by a reduced cash flow and soon they were in difficulties.

Banks are always vulnerable because they are innately highly leveraged. They have a small capital base and usually make loans about 12 times the magnitude of their capital. When the loans they make do not perform, the asset base shrivels like plastic in a fire.

Banks try to guard against excessive losses by securing loans against collateral. The Japanese experience was that collateral was over-valued when stock quickly halved in value and land 80%. The Japanese banks went into shock with a huge book of non-performing loans. They lost the courage to make new loans.

Business was hard pressed to obtain working capital. It lost the confidence to invest. For a long time business lacked the confidence to approach the stock market to raise new capital. A general downturn followed despite a good export performance.

The downturn in deflation is further exacerbated by two factors. First, as activity runs down, there is a rise in unemployment and in incomes generally. Spending slows and growth rates wither.

Second, consumers become much more careful in their spending habits. Shopping ceases to be fun. Consumers become cannier because their confidence is lower and they also feel the goods they must have may be cheaper in the future.

The collapse of demand and prices naturally promotes business failures, and these spill over into other sectors. Businesses can fall like dominoes.

If this scenario seems remote, then refer to a chastening major study by the IMF (see link below). It observes that inflation rates are often overstated because consumers buy discounted goods, or substitute cheap apples for expensive oranges.

Given these statistical anomalies, a CPI of 1% may be 0%. In 2002, some 22% of countries have inflation or inflation of less than 1%.

Moreover, producer prices are declining. Over a third of countries have deflation or minimal inflation in producer prices. This already affects a stunning 47.3% of the industrialised economies and 30% are already in deflation. The rate of deflation's advance is terrifying.

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