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Will Britain succumb to Japanese disease?
The spectre of deflation is haunting central bankers around the globe Faisal Islam Sunday August 18, 2002 The Observer In Waco, Texas, at President Bush's 'economic forum', the pom-poms were missing but the cheerleaders did their job nonetheless. The markets may have applauded last Wednesday's mass certification of company accounts by chief executives, but central banks around the world were refusing to budge, or announcing their reasons for doing nothing. The Bank of England, in published minutes, announced that it discussed cutting rates, but held back for fear of panicking the markets. The Federal Reserve decided to hold fire, but said it stood ready to cut if economic conditions deteriorated. But bankers on both sides of the Atlantic are keeping a careful eye on Japan - still suffering a deflationary spiral of falling prices and a rotten financial system after a decade. The much-feared 'double-dip' recession in the United States and Europe would actually be one of the more benign outcomes for the world economy compared with the really scary scenario: the world's largest economies following Japan into a sustained period of stagnation, compounded by deflation - subverting the ability of monetary policy to help boost the economy. Stephen King, chief economist at HSBC, has no illusions: 'The environment we are painting is one in which deflation provides the greatest single risk to ongoing economic stability.' He points to warning lights that are 'flashing red', such as the persistent weakness of equities and rise in corporate bond spreads. Money supply growth is still strong despite low price inflation. King puts this down to an increase in the demand for money to hold on to rather than to spend. A sharp decline in the 'velocity of money' - the extent to which the same notes and coins are circulated - supports this view. In deflationary times, holding on to cash is a sensible financial strategy. Here, the Bank of England's 'symmetrical' mandate gives equal weight to avoiding inflation and deflation. The European Central Bank, long accused of inheriting a 'deflationary bias' from the German Bundesbank, recently announced that its target of positive inflation, less than 2 per cent, should also be deemed 'symmetrical'. Deflation is essentially the painful march down a hill after an asset price bubble. As such, it is more of a worry for the US post-dotcom economy than for the UK or Europe. Mervyn King, the Deputy Governor of the Bank of England, calls this 'debt deflation', where the burden of nominal debt grows as prices fall leaving an even bigger burden of debt this kickstarts a cycle of lower demand and even lower prices. 'The phenomenon of debt deflation is one that all of us are conscious of as a conceptual problem, but no one thinks it is an immediate problem for the UK, and part of our task is to ensure it remains that way,' said King at the launch of this month's Bank Inflation Report. Price statistics are not showing overall deflation just yet. In the US the GDP deflator, a broad measure of price trends, shows that the price of all the goods and services produced in the economy rose at an annualised rate of 1.2 per cent in the second quarter of this year. 'This is somewhat below the 3.1 per cent average annualised rate since 1930, but it by no means suggests the [US] economy is on the verge of deflationary slump,' says Peter Dixon of Commerzbank. Last week, the monthly retail price index in the UK showed that inflation had gone up from 1.5 to 2 per cent, still well below the Bank of England's target of 2.5 per cent. Over the last half-decade, British inflation has been the lowest it has been at any time since the Fifties. But the overall figures mask important divergences within different sectors. In the US and in the UK healthy inflation in the service sector coexists with deflation in goods prices. On the Federal Reserve's favoured measure, second quarter services, prices were up 4.6 per cent while durable goods slumped 2.9 per cent. In the UK, figures released last week showed goods prices down 1.7 per cent and services prices up 4.5 per cent. Globalisation helps to explain this. Goods can be traded more readily than services, and are therefore more sensitive to international price competition. In ultra-competitive markets, companies completely lack pricing power. Only last week it was announced that already embattled mobile phone companies, weighed down with mountains of debt, were to face even more competition from 'Three', a new entrant in the UK. But this is not the reason that Japan fell into its deflationary spiral in 1991. In the Far East the markets marked out a path of over-investment, excess capacity and unserviceable debt to speculation and exuberant valuations in property markets that slumped. But, hey presto, the bears in the West say that the hangover from the 'infectious greed' era of the late Nineties, both psychological and economic, may amount to the same thing. 'This recession is being driven by excess capacity,' said Charlie Minter, a US manager of a successful 'bear' fund. He believes there is an unalterable cycle that follows, involving devaluation, protectionism and tariffs. 'This is not going to be a good period of deflation as we unwind all the greed from the biggest financial mania of all time,' he says. But there are a few who think the problem is the familiar one of inflation, rather than its opposite. Last week, in an interview with Central Banking magazine, Milton Friedman, the Nobel prize- winner in economics and sage to Margaret Thatcher, dismissed the prospect of deflation. 'We are storing up inflationary pressure, and I think there is little doubt that we shall see in the US an increase in inflation over the next several years,' he said. The Federal Reserve is taking it very seriously. Although the state of the US banking system is in no way comparable with the malaise in Japan, broad macro economic similarities have prompted the Fed to take a closer look. A Fed paper exploring the lessons about policy when inflation and interest rates are close to zero concluded that the Bank of Japan did not reflate the economy quickly enough by slashing back rates in the early Nineties. This may have informed the Federal Reserve's aggressive series of rate cuts over the past 18 months. In January, the Fed also discussed hypothetical scenarios requiring the use of 'unconventional methods' of monetary policy. Chairman of the Fed, Alan Greenspan, the newest honorary Knight of the British Empire, has been cautiously looking in both directions. The small extent of deflation seen in the US economy so far, has been more the result of forces of competition, a reflection of a healthy US economy. For the UK, the threat remains slightly more than conceptual. There have been no published Bank of England or Treasury studies into debt deflation. At our very low levels of inflation, it would not take much for deflation to appear. The biggest risk is in asset prices, and Britain's own version of the dotcom bubble - the housing market. 'The biggest risk is from housing, a market where prices have been increasing by 10 times the rate of inflation. It contributes seven tenths of the rise in inflation. If that was negative rather than positive, you'd get deflation straight away,' says Danny Gabay, UK economist at JP Morgan. So the best way to stave off Japanese style debt deflation is to stop the emergence of asset price bubbles before they get out of control. But as Governor Mieno, of the Bank of Japan, once said: 'Pricking the bubble is the easy part. Controlling the fall is the problem.' The Bank has marshalled impressive evidence that the exceptional rise in house prices is not a bubble and therefore there is nothing to pop. But it does expect house price inflation to slow to just above the rate of overall inflation. The Bank for International Settlements, the central banker's banker, has called for a new shift in monetary policy thinking to take greater account of such asset market issues. At a time when economists are asking the extent of 'Sir' Alan Greenspan's complicity in building up the dotcom bubble, central bankers should be wary of donning those pom-poms. There's a fine line between building confidence and hyperactive cheerleading. |
