While
we in India have been battling high inflation, some other countries are
doing the opposite : battling low inflation or no inflation. What's
there to battle if prices are falling? Why do economists dread deflation
more than inflation? What happens when a country goes into a
deflationary spiral? Read on as we try and explore answers to some of
these questions.
In India, for as long as we can
remember, we have lived in inflationary times. Sometimes, inflation
becomes too much for the common man to handle (let's not forget that
onion prices have toppled governments in the past) and other times, it
is within endurance zone. In the last couple of years, inflation has
clearly moved out from endurance zone to suffering zone.
For an average
Indian therefore, the thought of prices coming down rather than going
up would be a welcome relief. What if food prices kept coming down each
year rather than going up? What if land and house prices kept coming
down each year rather than going up? Wouldn't it be wonderful for the
consumer? Wouldn't his purchasing power keep increasing with each
passing year, rather than getting eroded by inflation? If falling
prices can give so much relief to the common man, why then do economists
dread deflation more than inflation?
What is the difference between deflation and dis-inflation?
Textbooks define deflation as a
decrease in the general price level of goods and services. Deflation
should not be confused with dis-inflation, which is a situation where
the rate of inflation falls down, but prices still rise, albeit at a
slower level. So, when a country's inflation rate falls from 10% to 2%,
it means that price rise is still happening, but at a slower pace of 2%
p.a. rather than running at 10% p.a. When the inflation rate continues
to drop down further and then gets into negative territory, the country
moves from dis-inflation to deflation - which means prices actually
start falling rather than rising slowly.
What is a deflationary spiral?
Falling prices get economists worried
no end, as it immediately raises worries of a dreaded deflationary
spiral. Think of yourself as a consumer : as long as there are
inflationary expectations, there is an incentive to buy now rather than
later, as later is likely to cost you more than today. So, if you were
thinking of buying or replacing a TV or a laptop or a car or anything
other than essentials which could either be bought now or a few months
down the road, there is no price incentive to postpone the decision.
But, if you see a trend of falling prices, you automatically have an
incentive to postpone the purchase as you think you will get it cheaper
sometime later. Now, think of yourself as an investor. If you see land
and house prices falling, would you rush to purchase or wait for a
further fall so that you can buy it cheaper? And, one year later, when
it house prices have fallen as you anticipated and the outlook remains
the same, would you then postpone the investment in your 2nd house
further down the road, in the hope of getting it even cheaper?
When an economy moves from a boom
cycle to a recession, demand falls off - or rather excessive demand
first falls off. If demand continues to fall, prices fall at some point
of time. If prices continue to fall and nothing is done about it in
terms of steps to revive demand, producers as well as investors start
defaulting on their debts. If prices fall below cost of production,
producers are unable to service their debts. Their debts in real terms
actually become more burdensome to pay off. That's because their income
generating capacity (in absolute terms) has gone down due to lower
prices but their debts remain the same - they don't go down. Investors
who invested in houses, land and stocks are unable to pay off their
debts as the assets they purchased are now worth much less than the debt
they took on to buy them. As business profits shrink, wages get cut.
As some businesses go bankrupt, layoffs increase. Lower wages and
layoffs reduce demand further as disposable income in the hands of
consumers reduces. This lower demand in turn further depresses prices -
and the cycle repeats. This vicious cycle is known as a deflationary
spiral, which is depicted below.
Continuously falling prices therefore
cause more pain to the common man rather than providing him relief.
Dis-inflation is usually a welcome sign, but Central Banks of countries
are ever vigilant to try and ensure that dis-inflation does not get to a
deflationary situation. It is important for consumers to believe that
prices will go up - though slowly. Deflationary expectations can make
deflation a reality. It is for this reason that Governments in
developed countries rushed to provide all kinds of incentives to
consumers after the 2008 meltdown, to spur consumption. The US
Government for example gave cash incentives for people to replace their
old cars with new ones and to buy new houses. This was in addition to
the ultra-low interest rates, which are anyway supposed to spur
consumption and investment. US and European governments rushed to
ensure that the 2008 recession doesn't turn out into a long term
deflationary spiral, as memories of Japan's deflationary spiral continue
to be fresh in every economist's mind.
The Japanese deflationary spiral
Several reasons have been put forth
for why Japan's economic bubble burst and why it went into deflation,
and more analysis will perhaps produce even more theories. Sky high
wages that made manufacturing uncompetitive, an ageing population that
consumes less, inflexible producers who didn't adapt well enough to
change, obnoxiously high real estate and stock prices that just had to
come down - there are many reasons why Japan's troubles started back in
1990, and continue till date - a full 24 years later. Lets see what
impact deflation has had in Japan over this period of time.
Japan moved from dis-inflation
between 1991 to 1994 into deflation thereafter for a very long period of
time, until 2009, barring an isolated couple of years in 1998-99. It
tried coming out of deflation briefly in 2009, only to slump back into
deflation in 2010 and beyond. That's over 20 years that the average
Japanese consumer has seen prices coming down each year rather than
going up. The incentive to consume and invest, built out of
inflationary expectations, has simply not been there for 2 decades now.
Japan's GDP has consequently taken
quite a beating - its down in nominal terms now to levels far below than
what it saw 20 years ago.
The misery for the average Japanese
investor is well captured in the graph above. The stock market index
went down some 70% over a 20 year period from 1990 to 2010 and land
prices declined every year for 20 years. Land in 2010 was 60% cheaper
than what it was priced at, in 1990. What then, would be the urge to
invest in domestic land and stocks for an average Japanese investor?
If the Japanese investor has felt
pain, the Japanese common man felt even more pain - wages have been only
coming down over the last 20 years rather than going up. Falling
wages, falling land prices, falling prices of everything - for 20 years :
how many average Indians will even relate to this?
Is Europe heading into deflation?
We've seen the pain that the Japanese
deflationary spiral has inflicted. Some economists now worry that
Europe may be heading into deflation. Consumer price inflation in Europe
is now at 0.7% - well below the inflation target of 2%. Some experts
worry that it doesn't take much for 0.7% to fall below 0%. In any case,
prolonged periods of ultra low inflation can anyway reduce the urge to
consume now - and increase the propensity to postpone - which would be
bad news for already weak demand. Economies like Japan and most parts
of Europe are developed - which means pent up demand for basic goods and
services (like what we see in developing countries like India) is not
there. Spurring consumers to spend more, in this context, takes more
effort. It however takes perhaps less effort to spur investors to
invest and maintain asset prices at comfortable levels - an effort that
all Central Banks have undertaken in the last 5 years - and the results
are there for all of us to see.
The silver lining is that European
Governments and the ECB - who have all seen the Japanese debacle playing
out in slow motion, are doing everything in their command to prevent
deflation and its nasty consequences.
