Deflation Hanging Over the Global Economy

“The Financial World According to Inya” Column,
by Inya Ivkovic, MA
Despite monster bailouts, credit is still shrinking. Corporate spending has declined considerably, as has consumer spending. As a result, deflation is rearing its ugly head, haunting not only Japan, its well-charted territory, but also the recession-exhausted European and North American economies.

In August, prices decreased the most and the fastest in Japan, the country that had been losing one battle after another to deflation for the better part of the past 20 years. It is quite possible that Japan will never win against it. And Europe isn’t faring any better either. For example, Germany, Europe’s largest economy, has now gone through four grueling deflationary months in a row.

After massive and expensive efforts to fight the global financial and credit crises, as well as the subsequent recession, it seems that deflation would be a counterintuitive consequence. In fact, many economists, myself included, are convinced that, once world governments start unwinding their balance sheets, inflation, and potentially even hyperinflation, could strike us hard and deep. But there are other reasonable arguments, supporting the case for deflation as the more likely outcome. The same thing happened during the Great Depression, once deflation became almost entrenched in the economy.

So, let’s explore the possibility of deflation. If it persists, as it did in Japan and it still does, we could be doomed to years of truly depressing economic performance, unemployment beyond recovery, and deeply pessimistic corporate and individual consumers, whose focus would shift from healthy spending to merely surviving.

While there are reasons to fear inflation in the medium to longer term, such as unwinding financial stimulus from government balance sheets and the subsequent rising interest rates, there are reasons to fear deflation in the short term. Namely, unemployment rates around the world have hit the 10% rate, give or take. Unemployment is a huge hurdle to recovery in the U.S., Germany, in France, Italy, and even China and India. Just to put things further into perspective, in the U.S., if we were to include the underemployed in the figure (which was how unemployment rates were calculated during the Great Depression), the actual unemployment rate would be much higher, close to 17%. And, while in Japan the unemployment rate is about six percent, it is only because Japan counts it differently. And, after so many years, Japan is still trying to inflate its economy and it is still largely unsuccessful.

The fear is that the “Japanese syndrome” could spread. It is true that the Federal Reserve and Europe’s central bank have the ability to move much faster and to act more aggressively compared to Japan. Still, even if Japan’s central bank had moved faster, there are still no guarantees that the country would dispel deflation and pump new life into the economy. Simply, deflation is a formidable opponent that wins wars by exhausting its enemies. In such wars, the weak ones suffer the most. And right now, most global economies are weak and vulnerable.

What are the lessons here? Future deficits and their covering are a concern and investor focus cannot come off this particular ball. But these may not be the priority at the moment. Actually, in the short term, the public should carefully watch how their respective governments plan to keep the economy primed by keeping interest rates at historical lows. That’s not the only way to inflate an economy, but it has worked in the past and it could work again, even as our world is changing.