Savers and spenders

As the financial media continue to speculate about the possibility of deflation in the OECD countries, one interesting feature is emerging.

The country already in the throes of deflation is of course Japan, where consumer prices have dropped 7 per cent since 1995, or roughly 1 per cent per annum.

The next candidate for a general price fall seems to be Germany where inflation is at 0.7 per cent and is likely to fall further. The economy least likely among the big three to experience deflation, by common consent, seems to be the United States.

It is interesting that Japan and Germany, in that order, are famously frugal and their savings get reflected in their traditional surpluses on the current account; in contrast, the US is notoriously spendthrift with a deficit on current account fairly close to 5 per cent of GDP in the current year.

Clearly, spenders have an edge over savers in avoiding deflation! In a way, deflation is 'good' for those with savings as the fall in prices enhances the spending power of their savings. In contrast, most debts are repayable in nominal money and, in general, deflation makes debt servicing more difficult.

Perhaps the most balanced commentary on the prospects of deflation has appeared in the annual report of the Bank for International Settlements, released last week.

A few comments are worth quoting: "Given low inflation, ample spare capacity and the prospect of growth below potential in major advanced industrial countries, some commentators worry more about deflation - defined as a decline in the aggregate price level - than inflation.

"The first, obvious point is that when inflation is very low, deflation is arithmetically not far away...

"Since the Japanese experience clearly shows that deflation can become entrenched, despite very loose macroeconomic policies, an assessment of possible deflationary forces currently affecting other countries needs to be undertaken.

"Prices for manufactured goods in international markets have indeed fallen significantly since the mid-1990s in SDR terms. Attention has focussed on China, given that its share of world trade has more than doubled in the past decade. However, China still accounts for only around 5 per cent of World Trade."

The central bank most alive to the dangers of deflation has been the US Federal Reserve. More than a year back it published a research paper titled, 'Preventing Deflation: Lessons from Japan's Experience in the 1990s', which came to somewhat different conclusions than the BIS.

The paper argues that the Japanese authorities "did not take out sufficient insurance against downside risks through a precautionary further loosening of monetary policy", and that "had the Bank of Japan (BoJ) lowered short-term interest rates by a further 200 basis points at any time between 1991 and early 1995, deflation could indeed have been avoided."

(To be sure, I remain a strong agnostic about such precise determinism of effects from causes!) One does not know whether the lessons from the Japanese experience influenced the Fed, but since the beginning of 2001, amongst the major central banks, it has been the most aggressive pursuer of looser money supply and lower interest rates.

The rate change announced on June 25 was the 13th cut in the Fed funds rate engineered over the last 30 months, bringing the rate down from 6.5 per cent to 1 per cent.

In contrast, the European Central Bank has been far more reticent in cutting interest rates - to be sure, the ECB argues that at 2 per cent, the short-term rates are at their lowest post-war level. The Bank of Japan of course has no room left with interest rates already at 0 per cent.

The recent behaviour of the major equity and bond markets also throws some light on the prospects of deflation. Even as the Fed cut the rate last month, bond yields in the US treasury market went up.

And, this has been paralleled by the European, particularly German, British and Japanese bond markets, all of which are factoring higher yields than a couple of weeks back, perhaps evidencing that the cycle of interest rate fall in the major economies has bottomed out.

(This could well be the situation in India as well, as, in contrast to the previous few weeks, the inflation number published last Monday evidenced a rise.) Moreover, equity prices in the US, EU and Japan have rebounded sharply over the last couple of months.

(This too has a parallel in India.) While GDP growth is not incompatible with a falling general price level, i.e. deflation, it is clearly difficult for corporate profitability to grow in the face of falling prices.

If equity markets are to be believed, deflation is not much of a worry. (Incidentally, in the US, equity prices are high by the P/E yardstick, but low by other measures like the dividend yield.)

If the spectre of deflation vanishes in Europe and the US, the talk of inflation targeting as the policy objective of central banks, could well die down.

The difference between inflation targeting and the traditional objective of monetary policy, namely controlling inflation, is that, when inflation is too low the central bank would be responsible for pumping in money and making sure that it does not fall to unacceptable levels.

Whether monetary policy can be so fine- tuned is of course questionable. It is also worth remembering that central banks are as much manipulators of expectations, as of money supply and interest rates.

If the deflation debate has thrown out the contrast between savers and spenders, it also has evidenced some interesting differences between the US and the European Union.

For one thing, the cheaper dollar comes in handy in avoiding deflation; in contrast, the appreciation of the euro comes at an awkward time for the Eurozone economy where growth is likely to be less than 1 per cent in the current year.

Again, if fiscal deficits in the Eurozone are limited by the Growth and Stability Pact, the US has moved from a fiscal surplus of 1.4 per cent of GDP in 2000 to a deficit of 4.6 per cent in the current year, a truly massive shift.

If the European Central Bank has a limited objective namely inflation control, the Fed's objectives also include economic growth and full employment.

Again, given the difference in welfare systems, a slowdown leads to higher unemployment in the EU - but lower wages in the US. (To be sure, currently, unemployment is at a nine-year high, but barely half of Germany's.)

One other point is worth noting - labour mobility in the EU is limited by language and cultural differences.

But this apart, the comparatively positive growth prospects in the US may well help Bush Junior to complete another of his father's uncompleted tasks, and win the re-election next year - despite his downgrading of  "serious economic policymaking"; following an 'irresponsible' fiscal policy; and a 'chaotic' international economic policy, as the Financial Times editorialised on May 19.

The big imponderables are a possible collapse of the dollar and/or the housing market, leading to loss of consumer confidence.

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