Deflation is better than its reputation
With unchanged or rising nominal wages, deflation hikes the real purchasing power of income, which in principle should encourage households to consume
ECONOMIC theory tells us that deflation is bad. Rising real value of debt soaks money out of the system instead of boosting consumption or investment. That may be correct as a partial analysis, but a general analysis is more complex and does not warrant such hasty judgement.
With unchanged or rising nominal wages, deflation hikes the real purchasing power of income, which in principle should encourage households to consume. Figures from the US, Japan, and the eurozone do not give a uniform picture as these players' economic policies diverge instead of converge. US real wages have recently been in the doldrums with a marginal increase over 2014; figures for the last couple of months of 2014 were good, nourishing expectations of rising real wages in 2015. Real wages in the eurozone rose over 2014 auguring higher purchasing power. Real wages are falling in Japan with 2014 posting the 17th straight year-on-year drop.
Households have debt, much of it in the form of mortgages, which are inflated in real value when prices fall, but this "fact" does not automatically lead to reining in consumption as a "behavioural" change. Consumer behaviour is guided by the perception of future real burden of borrowings compared to the real value of the property as these two figures define property's future real wealth. The presumption is that higher real value stimulates consumption; lower real value depress consumption. Analysing the current picture, it is not at all clear why households should expect future real wealth to fall.
From an analytical point of view these two observations puncture the myth of a negative impact of deflation on purchasing power. For the American economy, and even more for the eurozone economy, it looks like purchasing power goes up - not down.
Most of the liquidity pumped into the system by the US Federal Reserve (quantitative easing, QE) and the European Central Bank, ECB (expanded asset purchase programme, EAPP) will, as things stand now, eschew the market for goods and services and find its way into the asset market.
At first glimpse this may not seem good, but on further reflection the conclusion may be different. It will keep the interest rate at a low level - the real interest rate can be close to zero or even negative - while asset prices continue to rise or at least not fall. That being the case, households' balance sheet improves. Consumption should go up.
Financial institutions enjoy the luxury of liquidity. They can go for balance sheet improvement or lending to the business sector. Deflation in itself does not play any significant role in their choice. Consumption and investment (the demand side of the economy) determine the outcome. If higher consumption kicks in now - which is possible, maybe even likely, but not certain for the US and the eurozone - enterprises may begin to borrow for investment, reversing financial institutions' possible initial preference for balance sheet improvement. The explanation is straightforward: They earn money by lending.
CURBING MONEY SUPPLY
Long term, one wonders how it will be possible for the Fed and the ECB to curb money supply. Japan has shown that it cannot happen with a high and semi-permanent government deficit, which is financed through bonds with low interest rates accumulated by financial institutions. A more restrictive monetary policy will push the interest rates up, inevitably. The government's net interest payments may become unsustainable.
US Congressional Budget Office expects the federal deficit to rise again in a couple of years for this reason. Financial institutions which improved their balance sheet will confront falling prices on bonds threatening a new round of anxiety over banks' capitalisation. The cry of insolvency will stage a comeback forcing them to stay away from government bonds, eroding ability to finance public deficits.
The three major central banks (Fed, ECB and Bank of Japan) know this, of course, so why do they persevere? Because to their mind deflation in the goods and services market justifies an expansive monetary policy. Liquidity, however, has little or no impact on prices, which are controlled by global wage costs. The world turned away from inflation in the 1980s not because of monetary policy (inflation targeting), but the integration of China in the global economy.
If in the coming years labour-intensive, low-cost manufacturing moves to countries (India, Vietnam, Indonesia and several others) with a rising labour force, prices in the goods and services market will not go up irrespective of what central banks are doing or not doing.
Common sense dictates that there is something wrong with a high level and even more an upward trend for assets simultaneously with low global growth. It raises the spectre of a bubble with potentially severe consequences for the global economy. We do not know which level of asset prices is sustainable so maybe a bubble followed by a steep fall can still be avoided by adroit policymaking. There is no precedent for where we are now. We can, however, spot two major - probably unwanted - side-effects.
Inequality already at a disturbingly high level rises further as people with assets are also people with relatively high incomes. Currency rates are starting to move as an omen of possible "economic warfare" shifting as much as possible of the burden of adjustment to other countries. Both constitute a deadly threat to economic globalisation.
