Sunday, March 08, 2009

The Dangers of Deflation

With the world in the grip of the worst financial crisis since The Great Depression, one should definitely consider pertinent issues relating to the broad economy, in addition to evaluating one's personal wealth. Though much of what had transpired so far could not be reliably predicted, and the way forward looks uncertain and murky, there have been several topics which have been highlighted in the media and in financial circles in recent months so as to warrant significant attention. Most of these topics cover issues ranging from the bursting of the US Housing Bubble as well as the ruthless and relentless disintegration of once vaunted financial institutions in America and Britain. Another issue which immediately comes to mind may not sound like a big deal at first but has many important ramifications: Deflation.

Deflation is defined as a persistent slide in prices over an extended period of time, and is the exact opposite to inflation, in which purchasing power in eroded. In the case of deflation, purchasing power of the dollar is increased over time as the prices of goods and services become lower, and consumers enjoy lower costs and expenses as everything from transport costs to electricity tariffs are lowered. Sounds like a very joyous occasion and a reason to celebrate right ? However, there are many dark aspects of deflation which have been put forward by economists to explain why deflation is anything but good for the economy, and the most pertinent example is that of Japan in the 1990's (also termed as the "lost decade").

To immediately illustrate my point, Japan had undergone the bursting of their real estate bubble in the late 1980's, and subsequently their stock market (the Nikkei) crashed from a high to its present level of around 7,000+ (a 25-year low). What was more damaging was not the immediate fallout from the real estate and equities crash, but that of persistent deflation lasting about 10+ years which caused many companies to fail and pushed the savings rate of Japanese up, thus exacting a heavy toll on the economy. Government efforts to inject liquidity and put cash in the hands of the final consumer did little to halt the slide of prices, and this had a detrimental effect on the Japanese Economy which spluttered along like a terminally ill patient on life support for more than a decade ! Let's examine the process of what I term the "Deflationary Spiral" and explore why it is so damaging to economies, and what can be done to prevent a similar occurrence in Singapore. *Note: This scenario is unlikely to occur in the USA at present due to the massive injection of liquidity through the printing of US dollars, thus raising the prospects of devaluation of the US Dollar and increasing inflation in the years to come as the purchasing power of the US Dollar drops.

The logic of deflation is that once people start to realize that prices are falling, they tend to hold back their purchases of goods and services as they believe things will get progressively cheaper. This has the effect of causing companies to lower the prices of their goods, while at the same time firms get hit by a double whammy of falling demand. The end result is that factories and manufacturing plants get hit by low utilization where production plants lay idle. Whatever inventory the Company has can only be sold at prices which are constantly falling as a result of deflation. The predictable result from the low utilization, falling demand and lower prices is of course, retrenchments and layoffs as companies seek to aggressively cut costs in order to maintain profitability and conserve cash balances.

As a result of these mass layoffs, people will lose their purchasing power ability as their source of income dries up. Families then seek to re-budget and decide to cut back even more on spending on discretionary items. Those families which were not directly affected by the layoffs would similarly tighten their belts in anticipation of bad times as they may expect pay freezes or pay cuts, or they may do so for fear of getting into a cash crunch themselves should the previously unthinkable happen. All of these generate a negative feedback loop which reinforces falling prices as more and more people hold back purchases and spending, forcing businesses to further cut prices to induce people to buy their products - and so the vicious cycle is perpetuated. Businesses are also likely to halt or put off plans for expansion, cutting back on capex and pulling back from M&A deals as liquidity dries up amid slumping sales, so this will put added pressure on the economy as the money supply contracts.

So it would seem that there is no solution to this vicious cycle of falling prices, falling demand and forced savings. Call it the "Paradox of Thrift" if you will, but the irony is that saving more actually penalizes the economy rather than helping it to grow at a steady clip, as the GDP equation consists of consumption, investments and Government spending. So how do economies break free from this cycle and restore growth - in order words, making people spend again !

Governments have a major role to play in breaking deflationary cycles, and they do this by adopting fiscal spending measures such as tax breaks for businesses to reduce costs, lowering rentals on government property to ease expenses; while for the individual, they may put money directly into the hands of consumers (e.g. rebates, GST Credits) to encourage more spending. Consumers need to feel that now is a good time to put their money to use and thus increase their spending, so as to break the cycle of deflation. At the same time, businesses, once assisted, can stop cutting jobs and thus prevent the problem from escalating by ensuring individuals have enough income to put food on the table.

To summarize, the dangers of deflation cannot be over-emphasized, as Japan is one classic example of what could happen if deflation was allowed to fester over an extended period. The damage to the economy could be long-lasting and irreparable; thus I hope the Singapore Government is able to tackle this problem before it rears its ugly head. A good start has been made through the Resilience Package, and more off-Budget measures are set to be introduced in the coming months as the economy, and inflation, head downhill.


dsea said...

excellent write up

a few other comments

1) asian economy always rely on export to developed countries esp USA. We now really need the large economy like china to start consuming.

2) Japanese pump priming had been rather misguided due to heavy vested interest of the constuction companies. They build excellent highways to nowhere....concretise their riverbanks....placed massive (and ugly looking tetrapointed) wavebreaker and they actually laden the pork barrel to build large concert halls in small towns...

musicwhiz said...

Thanks DSEA,

Yes I agree with you. China's domestic consumption alone will be enough to power their economy and keep it chugging, but the Chinese have to go back to consuming and stop stashing cash away - a tough proposition in the short-term !

As for Japan, they are a textbook example of what a country should NOT do in terms of fiscal spending. As you mentioned, building stuff which no one uses is akin to wasting public resources and eventually does not help the flagging economy either.


auseco said...

i wish to point out that deflation is the result of a healthy economy growing in productivity over time, with a sound money basis.
i used to be a staunch believer of keynesian and monetarist economic thinking until i stumped across Austrian economics.
please devote your utmost attention and effort to this website
You can try to read and study the books by henry hazlitt, murray rothbard and ludwig von mises for a start.
Your conception of the workings of the economic and financial world will be transformed after you have studiously studied and gained the knowledge from their books, just like me. Takes quite a lot of effort and time, like learning a new subject all over. But, it was well worth eveything.
Wishing you all the best.

musicwhiz said...

Hi auseco,

Thanks for the information. This is a new concept to me, and I will read up more on what you recommended.

Wish you all the best too.