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Last Updated: Tuesday, 3 June, 2003, 22:38 GMT 23:38 UK
Should we worry about deflation?

By Evan Davis
BBC economics editor

Economists and politicians in industrialised countries around the world are united in worrying about deflation. But is it a bogeyman or a real danger?

Deflation. It seems to be the word of the month. And it's a word on the minds of the central banks meeting this week to set interest rates.

It's apparently no longer rising prices we have to worry about. It's falling prices. In the -flation stakes, we've moved from in- to de- .

At least, that's the current concern.

Central banks can stimulate the economy by printing money and dropping it from helicopters if that's what they think the economy needs

And it is more than a theoretical risk. Japan has had it for years, along with other parts of Asia like Hong Kong. China has been in and out.

But the real worry is that Germany will suffer it - with inflation at 1%. The recent rise in the value of the euro will put downward pressure on import prices in the country, making deflation more likely.

Even more scary, is the fear of the US succumbing, given that deflation often follows the collapse of a bubble.

A self-fulfilling prophecy?

Falling prices are good only in the short run

But how bad is the prospect?

Well, the view of "deflation as nightmare" sees it as the outcome of a collapse in spending and demand in the economy.

It is what Japan has suffered; it is what the 1930s depression was about. And what is terrifying about it, is that it can be self-fulfilling.

If I as a shopper expect prices next year to be lower than they are now, I may choose to save, not spend, in anticipation of getting things more cheaply.

By saving, I make life tougher for producers, who thus have to cut their prices even more. We get stuck in a vicious circle.

Hoping to avoid deflation

The normal route out of such recessions is for central banks to cut interest rates.

Unfortunately, rates can't go below zero.

Yet, if prices are falling at 3%, a zero interest rate is actually quite high when adjusted for prices. So monetary policy is said to be impotent.

And a related problem with deflation is that people who have debts find the burden of those debts rising with time.

A 100,000 mortgage looks more daunting when prices and wages fall by 3% a year, than when prices rise by 3% a year.

No wonder people are so worried about it.

Let's drop money from helicopters

Yet, before getting too alarmed, there are two reasons to be cheerful.

First, monetary policy does not have to work through lower interest rates.

In this case, falling prices may not represent a self-perpetuating cycle of economic despair

Most central banks can stimulate the economy in other ways if they want to - they can print money and drop it from helicopters if that's what they think the economy needs.

So stimulating demand is not always challenging (and not always as challenging as the policy paralysis that afflicts Japan makes it seem).

There's too much 'stuff' out there

Secondly, not all deflation is about recessions at all.

Sometimes, prices can fall not because demand is too low, but because supply is too high.

And that might be the state we're in at the moment.

The engagement of the Chinese in the global economy, the investment boom of the late 1990s, new technology which has raised productivity in manufacturing sectors - all these are adding to the supply of "stuff" in the world.

They are all creating the over-capacity that lead to falling prices, and the core deflationary environment.

But in this case, falling prices do not represent a self-perpetuating cycle of economic despair, they simply represent the market telling consumers to buy more, because it is available.

Debt or deflation?

Now if you take this view of the current deflationary tendency, you are less worried about it.

pound sterling in rubbish bin
Will deflation rubbish our economies?

Moreover, you might even want to let it happen.

After all, if we do have the production capacity out there, we need to let consumers buy more.

And there are two ways to stimulate consumer spending. One is to keep prices rising, by cutting interest rates, stimulating borrowing and spending, and getting consumers to buy more goods with their increased debt.

The other method is to let prices fall, let deflation do its work - and encourage people to buy more things, because they can afford more.

Which is the better route?

Tough choices for central banks

It's not obvious to me that enticing consumers into debt is better than enticing them into the shops through deflation. The argument between these two options is a subtle one.

Yet, if we panic about the danger of falling prices as some people are inclined to do now, and if we treat deflation as though it is like falling off the side of a cliff, we may induce central banks to cut rates too far now.

That will encourage consumers to borrow too much. And that may have unstable consequences when the consumer boom eventually has to end.

The goal for the European Central Bank and the Bank of England then, in pondering their rate cutting options this week, is whether the threat of deflation makes more consumer borrowing desirable.

For the ECB, the answer seems to be "yes", as demand on the continent is too low, and consumers are not overdrawn.

For the BoE, that argument seems far more doubtful.

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21 Mar 03  |  Business
Japan still dogged by deflation
26 Jul 02  |  Business

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