Which would you rather have: prices going up or prices going down? Be careful how you answer. Bill English and Alan Bollard are listening.
There is much talk in Europe and the United States of deflation if governments act too soon to reduce or reverse their fiscal stimuluses by cutting spending and/or raising taxes, even though many are on a road to seriously high debt.
Deflation, in this context, is a spiral of lower prices encouraging consumers to delay purchases, causing profits to contract, jobs to be lost, demand to fall further, prices to drop again and so on. Investors, who are critical to ending the spiral, give up.
That happened in the 1930s depression. Governments are said to have accentuated the spiral by cutting spending. Since then rich-country governments have leaned against recessions, or tried to — as here in 2008 and 2009 and for the coming fiscal year.
But stimulus sometimes fails. In Japan for two decades since its financial and house bubble burst economic growth has been stalled, despite near-zero interest rates and huge fiscal stimuluses.
These spectres have spooked Ben Bernanke, head of the United States’ central bank, who made his academic reputation analysing the 1930s depression. So, too, New York Times Nobel Prize economist-columnist Paul Krugman, who wrote on May 20 the United States was “looking more and more like Japan… Low inflation, or worse yet, deflation, tends to perpetuate an economic slump, because it encourages people to hoard cash rather than spend, which keeps the economy depressed, which leads to more deflation.”
A week later, when the United States’ “core” inflation fell to 0.9 per cent, Krugman blogged: “It’s not hard to see Japan-style deflation emerging if the economy stays weak.”
Krugman is a bit left of centre — “liberal” in American jargon. Financial Times super-guru Martin Wolf is right of centre, a vigorous defender of markets and capitalism. On June 8 he worried that a consensus forming for fiscal “consolidation” (cutting spending and/or raising taxes) might replicate Japan’s experience.
“Another economic shock could shift these economies” — Germany (inflation 0.3 per cent) and the United States — “into deflation, with all the attendant difficulties of trying to make monetary policy bite in a world of post-bubble deleveraging,” he wrote. The Economist magazine, usually a fiscal hawk, concurred.
Now note a warning by John Key last month of a possible “double-dip” world recession or new global shock, implying Bill English’s modest fiscal restraint is insurance. Greece’s default on debts in all but name (and still likely in fact, some economists here say) was driving fear through financial markets and governments.
Next heed Krugman’s warning against learning lessons from the wrong history. Wolf said the 1990s success of debt-busting fiscal tightening by Sweden and Canada depended on export surges but “there is no world economy big enough to offset renewed contraction in Europe and the United States”. Krugman worried that the low euro’s boon to German and other European exporters will beggar the United States.
But are the 1930s and Japan the appropriate histories? Japan’s ingrained savings culture is not the North Atlantic countries’ (and our) ingrained borrow-and-spend-up culture. Rich countries’ huge budget deficits and steeply climbing debt are lightyears from 1930s fiscal parsimony. China (now having to fight rising inflation) was poor then.
Here is another history: digitisation, globalisation and low-wage China’s entry into global manufacturing lowered costs in the 1990s and early 2000s but central bankers kept consumer prices rising. Money supply ballooned, asset bubbles grew, unregulated bankers did brilliant things with debt and we got the great financial crash.
Here deflation talk is academic. Government debt is relatively low. The Reserve Bank keeps inflation mostly in the top half of its 1-3 per cent target band. Here consumers need to spend less, not more.
The risk, as Bollard said in a tough speech last week, is of a sudden stop in foreign lending to our banks because of “unsustainable” astronomical private debt and chronic, large external deficits. So, save more and spend less on imported consumer items. English loudly agrees.
But English’s October GST increase instantly wipes 2.2 per cent off your savings. And the 2.5 per cent inflation (net of the GST rise) which Bollard projects through to 2012 would, if it ran on for 10 years, wipe more than a fifth off your nest-egg’s real value. To keep up you need high interest rates.
Of course, it works in reverse for borrowers. And borrowers include firms which must be confident to invest if the economy is to grow sustainably and build general prosperity.
And if the rich world has a bout of deflation and stops spending, our exports will slow, general prosperity will stall and interest on savings will fall.
So which would you rather have: prices going up or prices going down?