Monday, December 29, 2008

Is Deflation Good Or Bad?

Economics always create wonders out of nowhere! It was not long ago, when everyone on the street was talking about the danger of inflation, particularly oil price peaked to $147 per barrel on July 11th. Somehow, just months after that economic scene have totally changed. Inflationary pressure is no longer on the radar when oil price fell below $40. Now, it’s the D-factor & I’m referring to deflation

What is inflation-deflation?

Inflation is the sustained increase in general price level. Meanwhile, deflation means a fall in general price level. It’s just the other way round. Price level is falling fast in UK now, led by slump in housing market. Economists predicted that the real impact of deflation will be fully felt next year

You may argue, isn’t a good thing when everyone can buy things cheaply? Well, my answer is YES & NO. Yes, if it lasted for months. No, if it lasted for years like in Japan. In short, inflation & deflation are both equally dangerous to economic health

Before we proceed, I would like to show an important calculation here. Say, nominal interest rates 0% (like in US now) & inflation is 5%, so real interest rates = 0% - 5% = -5%. Therefore it serves no point saving your money in bank account. But in period of deflation, say inflation is -5%, therefore real interest rates = 0% - (-5%) = 5% had increased

Why deflation is bad?

(1) Defer in spending. Deflation creates a disincentive for people to spend now. This is because people expect the price to further fall in the near future. Why buy a house now, when probably one can buy it at 10% cheaper next 3 months? When everyone thinks the same, the economy will contract faster, driving the price level lower. Then, again people will wait rather than spend, since they saw further space for the price to rock bottom. This is particularly true in UK & US since the economic growth is consumption-led. In this period, savings will also increase. This is consistent with scenario in Japan. The ‘long-lost decade’ experienced in 1990s to 2000s shows how danger deflation is. This is also the period where the Japanese stack up their savings to the extent of the US’ GDP

(2) Borrowing is expensive. As shown in the calculation above, deflation causes a rise in real interest rate when the nominal interest rate remain constant (0%). As such, it means costs of borrowing have increased. Households will reduce their consumption on huge items on credit such as plasma TV, cars, houses etc. Meanwhile, firms will cut their spending significantly on acquisition of capital goods, building of new factories etc. It makes economic sense for firms to do so. First, there is great uncertainty as to when they can breakeven. Second, there could be a shift in customers’ mindset, therefore changing the consumption pattern

(3) Increasing debt.
In the period of rising inflation which is normally followed by rise in wages, the real value of mortgage will be progressively reduced. A monthly mortgage payment of $ 600 will become attractive since it becomes smaller as a % of our income. However, with deflation & period of falling income, the value $ 600 as % of our income grew larger. This means increasing burden, fall in disposable income which lead to fall in consumption & contraction in GDP. The same applies for firms

(4) Higher wages cost for firms. Depending on how this is argued. In current period, workers especially those backed by unions will seek to prevent a cut in the nominal wages. It has 2 impacts which are equally bad. First, firms that are unable to maintain at such wages will resort to sack workers, thus creating real wage unemployment. Second, firms may not be able to sack many of those workers to reduce operating costs significantly if they are backed by strong unions. As such, their profit margins will become thinner or even make losses. GM, Chrysler & Ford typically face such problem. Their workers are backed by strong union called UAW (United Auto Workers)

(5) Falling share prices. In period of deflation, where real economy contracts at such speed it is norm to see company making smaller profits or even make losses. At such they may need to cut dividends payout to shareholders. This caused a bad valuation upon the firm. More people will be dumping its shares. Heavy selling will drag the price lower. This explains why Dow Jones & FTSE fell in the recent months, although there could be other factors. This may pose a greater threat to US economy than UK, since only a fraction of Britons actually store their wealth in shares

(6) Undermine the ability of monetary policy. Monetary policy has always been an ‘effective’ tool to boost spending into the economy & to control price level. Since the outbreak of contagious deflation, its effectiveness has come to an end. Despite the aggressive stance taken by the Fed to cut rates from 5.25% (September 2007) to now 0%, it doesn’t seem to work at all. The same goes for MPC. Interest rates had went down from the peak of 5.75% (September 2007) to 2% in December 08, but fail to prevent the housing market slump in UK. For States, we said that the monetary policy has run out of ammo!

Good thing about deflation

(1) Narrowing income inequality. Income gap has always been large in both UK & US. In the period of economic contraction, usually those executives with fat pay checks will be the first to go, as firms are reducing costs. But no doubt this argument also depends on which industry we are referring to. This could be more applicable to financial sectors in both UK & US. Wall Street wizards are now poorer. Share brokers really go broke due to thin transactions in financial market

(2) Bargain hunting. It often happens at the turn of all business cycle. For those who accurately time the market, will enter & buy good shares at ‘discount’ prices. The same goes for property market. If plans work out, normally those middle income people will turn themselves into high-income bracket once the market fully recovers. High share & property prices mean greater wealth, which will steer the economy. The only problem is, no one can actually time the market, not even Wall Street gurus

(3) Build up savings. From the calculation above, it is obvious that deflation can actually increase the real value of savings. It would be appropriate for Americans & Britons to consider building up their financial position once again. From the PPF argument, increase in savings can be channeled for investment which will shift the curve outward in future. Also, banks will have more cash to lend out & they will reduce their exposure to money markets just like before

(4) Good opportunity to expand through mergers. In the current period of credit crunch, many smaller firms but with great growth potential have problems in their balance sheet. Larger firms which are cash-rich may take this opportunity to acquire good firms sold at attractive prices. Furthermore, there are likely be lesser competitors bidding for it

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