If all the economists in the world gave their opinion as to
whether the developed world was moving into deflation or would soon
regain normal rates of inflation, they would be divided at about 50:50
I'd guess. However, if you asked them whether they thought that deflation
was a Bad Thing, then 99% of them would certainly answer yes. Or, more
likely, YES!
I have certainly assumed this. In fact, I wrote a few days ago on FW that
it was 'obviously' impossible for there to be an interest rate of minus
1%, never mind minus 2% or more. Well . . . I've had to revise my
view. It would seem that there's no reason why a negative interest should
not be maintained -- and even that it would not be greatly damaging so
long it didn't spiral downwards too far (just as inflation is dangerous
if it spirals upwards too far). The fellow who's changed my mind is Prof
Rostowski in a truly radical article in today's FT.
For FWers who are interested in economics the following is well worth
reading:
<<<<
THE MYTHS OF A DEFLATIONARY SPIRAL
Jacek Rostowski
According to some analysts, deflation is about to devour the world
economy unless inflationary policies are implemented urgently. Quite
apart from the fact that we are still far from deflation happening
(inflation in the UK is 3 per cent and in the eurozone 1.9 per cent), the
idea that deflation must inevitably trigger a self-sustaining depression
is simply mistaken.
There are five ways in which deflation is supposed to plunge the world
into a spiral of economic contraction. First, once deflation has started,
falling prices will make people put off spending, causing prices to fall
further. Second, with prices falling and the value of debt fixed in
nominal terms, the real indebtedness of households and firms will grow,
acting as a drag on the market, as in Japan since 1990. Third, nominal
interest rates cannot fall below zero because companies and households
always have the choice of holding cash, which gives a zero return. Banks
cannot therefore offer interest rates below zero to depositors so cannot
charge negative nominal interest rates on loans. The demand for loans
will fall, shrinking the banking sector and the economy with it. Fourth,
because nominal interest rates cannot turn negative, central banks will
be powerless to offset the effects of defla tion. Finally, with prices
falling and nominal interest rates stuck at zero, real interest rates
will keep increasing, turning the deflationary screw.
In fact, all of these supposed effects either do not matter much, or are
the result of inflation being lower than expected, or happen because
institutions have not yet adjusted to a potentially deflationary world.
They are not the inevitable result of falling prices.
For example, we have experienced falling nominal prices in computers and
telecommunications for decades, and although we may think twice before
buying that new computer, we buy it in the end. We are not put off those
long-distance phone calls at all. That is because it is quite difficult
to put off the consumption of many services. And with services accounting
for three-quarters of many advanced economies, most activity will be
protected from significant delays in purchases.
Real indebtedness rises not only with falling prices, but also as
borrowers misjudge future inflation. This is one of the main recessionary
forces at a time of falling inflation. Neither is it true that interest
rates cannot fall below zero. Companies cannot hold billions of dollars
in cash for security reasons. The costs of warehousing cash and making
cash payments are likely to be higher than the negative nominal interest
rate that banks would want to charge for taking deposits and making bank
transfers. In an economy such as America's where cash accounts for less
than 2 per cent of gross domestic product, cash warehousing capacity is
very low, so that its price could well be sufficient to accommodate
negative deposit rates of several per cent a year.
If banks are paid for holding deposits, they will be willing to pay out
interest on loans, as long as this interest is lower than the
interest they receive on deposits to cover their costs (including credit
risk). Bonds and bills can just as easily bear negative interest rates.
You simply get less money back at maturity than you paid. Thus, a slide
into a mild annual deflation of 1 to 3 per cent need not be much to fear.
Indeed, much of the world went through such a period during the last
three decades of the 19th century, the golden age of the gold
standard.
Some economists warn that the US is already in deflation because price
indices underestimate quality improvements and therefore overestimate
price increases by 1-2 per cent. But they forget that this also implies
that output growth is underestimated by 1-2 per cent. Four to five per
cent growth with zero to -1 per cent inflation does not sound that bad
for the US this year.
After four decades of inflationary bias, some central banks have not
adjusted to the threat of deflation. For example, the ban on the European
Central Bank financing government deficits would need to be changed, if
interest rates could not be driven far enough below zero, to pump cash
into the economy. Fortunately, the US Federal Reserve and the Bank of
England are not subject to this restriction.
Finally, it is possible to impose negative interest rates even on cash.
Governments could impose a penalty on cash used for tax payments. Since
cash derives its value from government's willingness to accept it at par
in settlement of tax obligations, such a penalty would depreciate cash
compared with electronic payments.
So, with negative nominal interest rates possible, a deflationary spiral
need not happen as prices fall. Of course, deflation is no more desirable
than inflation. And a sharp plunge into deflation as in the Great
Depression, when prices fell by 10 per cent a year, would be disastrous.
But occasional deflation should not be an excuse for abandoning the low
inflation we have achieved at such a high cost over the last 20 years.
True price stability would change people's attitude towards saving and
lay secure foundations for growth. We must not throw this prize away for
fear of an imaginary threat.
The writer is professor of economics at the Central European
University, Budapest and a trustee of the CASE Foundation, Warsaw
>>>>
Financial Times; Jun 03, 2003
Keith Hudson, 6 Upper Camden Place, Bath, England
