Deflation Can It Be Prevented?

Deflation Can It Be Prevented?

 

Josef Sima:Deflation is a term used to denote situations of a general decline in prices, a falling price level. For most of the history, such deflation coincided with prosperous times. However, 20^th century changed that perception. Prices have been systematically on the rise-inflation has become a part of our life, (e.g., prices in the US multiplied between the years 1900 and 2000 approximately 25 times, as opposed to 50% decrease between, 1800 and 1900.) Rather than a sign of prosperity, deflation is today often - though mistakenly -taken to be the cause of crises and economic breakdowns. In the following text, I will explain what economic forces can cause prices to fall and bring some light to the consequences of `anti-deflationary policies'.

It might be useful to start tackling the issues of deflation by noting that deflation (and inflation) originally meant a great decrease (increase) in the supply of money, rather than its inexorable consequence - the general tendency towards a fall (rise) in prices- which is what it means today. This shift in meaning may easily cause confusion: e.g., in a rapidly growing economy with an increasing money supply but decreasing price level, our predecessors would - using the original definition - speak of inflation, whereas, today, we would describe it as deflation. Let us see now, in what situations prices typically fall.

 

Deflation as a Result of Economic Growth

This kind of deflation is a natural state of a dynamically developing economy. As a result of growing productivity, more and more goods are produced in the economy and, consequently, producers have to compete over existing money units, against which they supply their products. Assuming a given quantity of money, it follows that the value of money will go up, which means that more goods can be bought for a unit of money. Prices will have a tendency to fall. Money will keep acting as the medium of exchange and the resulting prices will precisely mirror market participants' preferences and underlying resource scarcity patterns. Therefore, the economy will not waste resources, which is a precondition for further growth. As rational economic calculation is possible under these conditions (prices correctly reflect the relevant market `data'), there is no reason to expect any obstacles for successful economic development. Such a development is a typical one for periods between several inflationary episodes in history generally initiated by states for the sake of waging wars. In the US, between 1880 and 1896, we can, for example, see a decline of wholesale prices by some 30% (which amounts to an annual fall of 1.75%), whereas real income went up by some 85% (which is 5% annually). Even today, despite the continual inflation orchestrated by central banks, there are sectors experiencing a boom within a `deflationary' environment (decline of their products' prices)- the most flagrant example being the electronics industry (computers, video and DVD-players, TV-sets, cell-phones, etc.). What is of interest to producers is the spread between buying and selling prices, i.e., input-output spreads that give rise to profits. Changes in some `price index', which captures the changes of overall prices, are of no real importance to them.

 

Deflation As a Result of Hoarding

 

For many people, hoarding embodies a veritable bogey as it causes money to `disappear' from the economy. What hoarding means, however, is that some people for certain reasons, (such as uncertainty about their pensions) decide to increase their cash holdings. In this situation, it is only natural that selling the existing stock of goods for less money units will be possible only if the purchasing power of the money unit increases - the higher demand for money units pushes their price, in terms of goods, up. This adjustment is, strictly speaking, a productive activity - some people decided voluntarily not to exchange their money for so many goods offered as before, because they value holding cash more than the goods they could obtain for that amount of cash. The result is deflation, i.e., a new structure of prices corresponding to the new market situation that emerges in the same way as any new price pattern accommodating any change in people's behavior, (e.g., a change in fashion).

 

Bank Credit Deflation

 

We will now explore the third situation causing prices to fall. In modern history, we can find several instances in which people, typically as a result of previous inflation and subsequent financial crises, started to withdraw their demand deposits from banksen masse. As they withdraw their money (or in the past redeemed gold), banks are driven into liquidity problems that may ultimately lead to their bankruptcy. This intensifies the crises, as more and more clients lose confidence in the overall health of the banking sector and therefore come to their banks and demand that the deposits on their accounts be paid off. Banks attempt to accumulate their reserves in order to become able to fulfill their obligations. The accumulation of reserves (historically gold) leads towards a decrease in money supply, resulting in an increase in the value of money - prices fall, deflation is underway. Before World War I, central banks themselves several times initiated such a deflation to prevent the breakdown of the banking system. Deflationary periods of that kind were typically very short and swift, and so was the elimination of unavoidable results of previous inflations.

 

Confiscatory deflation

 

Whereas the previous kinds of deflations were market-driven, now confiscatory deflation is orchestrated by the state authorities by preventing people from using their cash in an attempt to solve the `imbalance' in the money market created by a preceding inflation. The case of Argentina from the first years of the 21^st century can be listed as an example. Supply of money shrank and prices went down.

As we have seen, deflation can be one of the result of economic problems, such as banking sector collapse. Under normal circumstances, however, if new money is not pumped into the economy it is a reflection of economic growth - a certain quantity of money chases more goods-and allocation of resources is guided by consumers' preferences. The pattern of income corresponds to the productivity of market participants, rather then being influenced by politically induced monetary shocks. On the other hand, the attempts to increase the money supply to fight deflation often lead to redistribution (as it equals taxing the cash-holdings) , discoordination and hence waste of resources (as price signals get wrong).

Shobha Ahuja:From 2003 to early 2008, the world witnessed the most marked commodity price boom of the past century. The prices of oil, metals, food grains, and other commodities rose sharply, and over a sustained period. But the global economic crisis has reversed the commodity price boom in the late 2008 with commodity prices, notably the oil prices, falling sharply in the last six months. Besides, there is a sharp decline in metal and food prices as most countries have started experiencing excess (supply) capacity and a contraction in demand. These price declines have dampened growth prospects for a number of commodity-exporting economies. According to IMF projections, headline inflation is expected to decline from 3.5% in 2008 to a record low 0.25% in 2009 in the advanced economies, before edging up to 0.75% in 2010.

India, too, is facing the prospect of negative inflation, as measured by the Wholesale Price Index (WPI). However, the paradox is that the Consumer Price Index (CPI), which measures inflation at the retail level, is still at double digit level. And there are a range of products within the WPI which are still rising. High food prices are still a cause for concern. Hence, at present, the fall in WPI is seen as a corrective mechanism from the high prices ruling in 2007-08 and the specter of falling prices is not so much a threat to our growth prospect.

Indeed, our growth story is intact, even though it is weaker than last year, there is demand in the economy and investments are still taking place. However, if prices continue to fall, a prospect which we do not anticipate to hold for long , then it could be a setback to growth

Caught in Deflationary Spiral?

With the deterioration taking place in the global economy, the prospect of outright deflation - and all the risks that it entails - is a clear and present danger. The prospect of deflation in countries like US, Europe and Japan is very much real, given the recession in their economy. The prospect of falling demand and possibly falling prices is something that is catching the attention of policy makers the world over. Hence, the phenomena should not be dismissed as a statistical quirk.

In the current scenario, prices are falling, not because of improved productivity, but because of fall in demand. The fall in demand and prices is adversely affecting the bottom line of companies and the manufacturing sector is not finding any incentive to increase production. If deflation sustains for a long period of time, it will lead to lower production and investment as industry would not invest in capacity addition. A fall in demand would result in lower wages and unemployment, which, in turn, would lead to further decreases in prices, causing a deflationary spiral. However, in India, the southward drift of inflation, which is now closer to zero, is more as a result of high base effect apart from falling oil and commodity prices. No wonder, policy makers have termed the phenomenon as disinflation, rather than deflation. Hence, near zero inflation is temporary and is anticipated to again show an upward trend once the statistical bias accruing from the high base effect, which compares present inflation levels from that prevailing during the same period last year, wears off.

WPI vs. CPI

The phenomenon of measuring inflation on the basis of WPI is unique to India. All major countries across the world measure inflation on the basis of CPI or the Producer Price Index (PPI). Hence, this question pertains more to India than to the rest of the world.

The plunge in WPI was mainly driven by the fall in prices of industrial commodities and raw materials. The near zero inflation rate is largely the result of the dramatic decline in energy and commodity prices over the past year. For example, oil prices fell from the high $109 in September 2008 to a low of $37.4 in 2009. However, the WPI takes prices at ex factory level and is made up of a large number of primary, intermediate and manufactured items. Excise duty, marketing costs and rebates are not reflected in WPI. For that matter, much of items which form the household consumption basket have a low weight in WPI. CPI measures inflation experienced by consumers at retail outlets. The weights assigned to items taken for measuring inflation are different. CPI assigns higher weight for items which are consumed by households. For example, the weight attached to food and beverages, etc., account for nearly 48% in CPI, but around 28% in WPI. Likewise, fuel has a weight of 6% in CPI but over 14% in WPI. However, a decline in WPI would most likely be captured by CPI in times to come when the impact of price fall percolates down to the retail level.

To reconcile the WPI and CPI and to have a cogent measure of inflation, it is imperative that we move towards a new measure of inflation given by PPI. This is presently being contemplated by the government.

Options Before the Central Banks

• Sufficient injections of money will ultimately reverse deflation.
• Increased government spending in areas, such as infrastructure and housing.
• Global monetary and fiscal policies can provide substantial support.
• Fiscal policies and rationalization of taxes which would lower production costs of industry and spur demand.

Less than a year ago, inflation was a major concern for many of world's economies. Now its opposite, deflation, is emerging as the latest threat, which could make the global recession worse if it takes hold.