What risk of Deflation?

Neville Bennett

The price level in the UK was the same in 1815 and 1914. This did not mean that prices were stable throughout that 100 year period: they fluctuated in long waves, with periods of inflation followed by deflation. More recently, there was a decade of deflation at the time of the Great Depression, and in Japan prices fell by an average of 0.5% p.a. from 1999-2005.

Deflation may again affect the US and UK, and perhaps spread further through the world economy. Consumer prices slipped by 2.1% in the year to July in the US, and 0.7% in the EU. In the UK the CPI is expected to be 1.8%, despite the Bank of England and Government desperately trying to keep it at above 2% by cutting interest rates to their lowest level in 300 years and pouring ₤150 billion into financial markets, a sum more than 12% of GDP.

The UK’s CPI does not contain housing costs, the Retail Price Index is more inclusive and it indicates that the UK had a -1.6% fall in prices for the July year: its first fall since 1960. I believe deflation is already strong in the UK as goods have declines in price since about 1995, but services have lifted the CPI.

There is widespread fear that the massive pump-priming by Governments globally will be over-inflationary, but I question that because it will result in higher interest rates, higher government spending on debt service and lower spending on welfare, increased taxes and higher costs to business for credit. Japan has tried for 19 years to create inflation but has failed. Moreover, there is a huge ‘output gap” putting pressure on all producers.

I do not intend, however, to gaze into the crystal ball so much as to discuss deflation and explain some its properties.

What is it?

Deflation is simply a fall in prices, and is regarded negatively because it is associated with depressions and with very low interest rates. The UK has not had a full year of deflation since the 1930’s. Indeed, inflation has been the norm, averaging 7%, since 1945.

Conventionally, deflation has virtues: consumers enjoy falling prices creating increases in real wages (the Great Depression was good for people in work). Moreover, it causes low interest rates, yet it is good for savings as their real value increases annually.

Deflation is not so good, therefore, for people in debt. The value of real debt increases each year, which affects people on mortgages as their house or farm may also decrease in value each year. It also discourages spending because the prices will be cheaper next year. Wages fall creating a downward spiral. It damages banks because they end up with a lot of surrendered property. The BNZ was the biggest landowner in New Zealand in the early 1890’s.

Recent Research

A recent Bank of England study by Groth and Westaway [Groth} discusses deflation’s costs in detail. Price adjustments for firms are costly, both for reprinting price lists but more in setting optimal prices in an environment of changing prices. Zero inflation is preferable. Deflation has an effect on taxation. In most cases, tax systems are not inflation indexed, so taxes rise with inflation.

The argument that consumers will defer consumption in periods of deflation is challenged by Groth and Westaway. They argue that in most cases low interest rates weaken the case for postponement.

Wages

Groth also discusses the difficulty of business in reducing money wages when this is justified by economic conditions such as the distressed situation of a firm or when all prices are falling. Workers may have a “money illusion”: they might focus on nominal wages rather than real wages. It they have a money illusion; they will resist a wage cut because they think they can buy fewer goods.

Many workers may resist pay cuts, not because they have a money illusion, but because they want to be rewarded for increasing productivity. British workers have raised productivity by about 2% a year over the last 30 years, so even if prices fall, there would not generally be a necessity (in the short-term) to cut in nominal wages. But in some industries, especially those particularly hard-hit, there would be a stronger case for wage cuts. If these are resisted, it can increase unemployment.

What evidence is there for downward rigidity in wages? Certainly there are more raises than cuts. But I believe many employees are prepared to accept cuts when there is a strong case. Most economists believe there is strong resistance, but this is exaggerated by the actions of a few trade unions. Employers find ways of cutting labour costs, moreover, by slashing non-wage benefits and bonuses, avoid customary raises for merit or seniority, or employing new workers at lower wages than those paid to existing workers.

In the UK there are a growing number of wage freezes, while wage cuts are relatively few. But British Chambers of commerce data indicates that about 10% of companies plan nominal cuts in 2009. Workers may be more flexible than they have been in the previous inflationary periods because they perceive growing unemployment: a lower-paid job is better than the dole.

Debt Deflation

Deflation increases the debt burden and recessions are deeper for countries carrying the most debt. The key element is a transfer of wealth from debtors to creditors caused by an unexpected fall in inflation. Many mortgage holders expected benevolent inflation. About 40% of Britons entered fixed-rate contracts and are now suffering from a real rise in interest rates. This effect is magnified by falling employment and a fall in asset values. Defaults will rise and impact on financial institutions.

The authors say many writers have demonized deflation but it is important not to confuse the effects of the credit- crunch shock with the effects of deflation itself. Goth says British workers are flexible about wages. She believes that with a massive monetary policy response, the deflationary episode should be short-lived. My knowledge of the Japanese economy makes me skeptical of that conclusion.

Government Debt – Analysis of Developed & Emerging Countries

Government Debt

Neville Bennett

This “Greater Depression” is a profound turning point in history. Recently, I analyzed how it had tipped the balance in global GDP away from the West to the emerging world (NBR June19). That change arises partly from differential economic growth rates. Obviously more is involved, and my focus now is on public debt and demography.

In essence, ever since the Asian Crisis, emerging countries have cleaned up their balance sheets and now have significant savings. But the developed world is encumbered with an ageing population, and unsustainable commitments in health and pensions. These prevent the paying down of public debt, which has been overblown by the need to bailout banks and fund costly stimulus packages. Japan and the UK are illustrative cases, but there may be lessons for New Zealand in this issue, as credit ratings come under pressure.

Global Public Debt

Governments have possibly stabilized the financial sector but there must be doubt about the remedy: massive public debt. According to the IMF, by next year, the gross public debt of the 10 richest countries will have risen from 78% of GDP in 2007, to 106%. It is an increase of $9 trillion in three years. New Zealand has made a modest contribution to this. Its public debt in May 2007 was NZ$28.8 bn, rising by a quarter to NZ$36.6 bn in May 2009.

There is worse to come. Weak economic growth and revenue, plus increased expenditure point to large budget deficits. The IMF believes public debt will be 111% of this groups GDP in 2014, but in a worst case scenario it may reach 150%. (See chart.)

This is the highest peacetime borrowing on record. The world economy will struggle for a decade at least with the weight of this albatross around its neck. It is the result of the paradox that crash caused by too much debt has been remedied by government bailouts to keep economies completely falling off the cliff. Most economists agree with this pump-priming in principle, but they may thereafter disagree on some aspects (for example: too much to banks) and the timing the necessary return to sounder fiscal management.

To be sure, governments have been ably to service this debt quite cheaply. Their reserve banks have driven down rates in order to stimulate the economy, and markets rates have been low as investors have flocked to find safety in government-backed securities. Nevertheless, yields are rising in response to new issuances and the cost of debt servicing is increasing net debt appreciably.

Will governments try to pay off the debt at the cost of lower economic growth? Or will try to inflate the debt away? Inflation can reduce the real cost of debt, and is attractive to governments as it is more politically acceptable than tax increases. But the cost is much higher than many politicians think.

The cost of high inflation is horrendous. Investors will buy debt only if they can make a real return. This requires an interest rate well above the CPI. If inflation is running at 10% p.a., medium term interest rates have to be higher, say 12%-16%. In the process, unless a lot of debt is paid off, the remainder will grow in line with interest rates. It is like a dog chasing its tail. The debt reduces when the dog is exhausted and can chew its tail. Meanwhile, high interest rates have slayed the economy. Only hyper-inflation destroys debt but it also destroys the middle class.

Recent History

Public debt always rises after recessions because Keynes’s policy of pump-priming is universally accepted. Some countries default. But the richer countries rely on fast growth. More recently some very fiscally responsible states like Canada, Sweden, Ireland and New Zealand have restrained public debt.

Although New Zealand will triple its bond issuance from about NZ$5 bn p.a. in 2008-9, to NZ$ 15 bn. in 2013-15,

It will keep public debt at a reasonable proportion of GDP. It is forecasting gross public debt as a proportion of GDP at 41.1% this year, rising the 45% in 2012-13 and 49% in 2014-15.

This is clearly responsible, but it does rest on projections on increases in GDP which may be optimistic. I am apprehensive that interest rates may rise to attract foreign investors, and that will be a drag on economic growth. Moreover, if NZ yields are attractive, the NZ dollar is likely to soar above fair value, hurting exports and our important tourist and student markets.

Rebound?

A rebound is difficult. Exports may be sluggish, particularly as households are rebuilding their balance sheets, with a marked reluctance to buy big-ticket items. The richer countries may follow a version of Japan’s past, where it is very difficult to stimulate the domestic economy when asset prices are falling. The Japanese Government has pump-primed until it is gasping. The country is still in deflation, but its gross debt-ratio has tripled from 65% of GDP in 1990 to 170% now.

Other Fiscal costs

The problem of repaying the cost of the bailout is dwarfed by the cost of an ageing population. According to the IMF, the present cost of the bailouts is only one tenth of the financial cost of ageing. If this problem is not addressed, demographic pressures will send the debt of the big rich economies to around 200% of GDP by 2030.

The world has regarded emerging country debt as the most in risk of default. This is an anachronism. The emerging members of G20 had a debt-GDP ratio of 38% in 2007 and it is falling to perhaps 35% this year.

The rich countries need to be careful to avoid tightening policy too soon for fear of snuffing out economic growth. But they may need to take other action to free up fiscal elbow-room. Pensions are an obvious problem, and raising the retirement age seems imperative as many superannuation schemes are unfunded. S&P have made it clear that the UK either raises taxes or cuts pensions and health spending if it is to avoid a credit downgrade. This is problematic as funding civil service pensions alone can amount to 85% of GDP.

UK Economic Assessment Grim

Grim forecasts for British economy

By Jean Shaoul
28 May 2009

 Several reports published in the last few days testify to the increasingly serious impact the financial crisis is having on Britain’s financial institutions, the broader economy, public finances and the living conditions of working people. They portend the introduction of sweeping austerity measures, the likes of which have not been seen in the post war era and which the traditional organisations of working people will do nothing to oppose.

Last week, the IMF issued a stark assessment of the UK economy, explicitly criticising the budget and its optimistic assumptions announced by Chancellor of the Exchequer Alistair Darling just last month.

It forecast that the UK economy would shrink by 4.1 percent this year, the biggest peace time contraction since the Great Depression of the 1930s, and 0.4 percent in 2010. It warned that despite the government’s “bold and wide ranging” response to the banking crisis, the banks were still exposed to bad debt from the fallout of the financial crisis and insufficiently capitalised, making it difficult for them to lend on the scale required for economic recovery. Figures just out indicate that business investment has fallen by 8.4 percent in the first quarter of this year from that of a year ago.

Consumers, faced with high levels of household debt, falling house prices, a reduction in the value of their occupational and personal plans due to the fall on the world stock markets, rising unemployment and reduced access to cheap credit, are cutting back on spending.

The Council of Mortgage Lenders announced a 60 percent fall in home loan advances for April compared to last year. The Economist Intelligence Unit in its report noted that “This [the lack of household credit] in turn is aggravating a severe downturn in the housing market, which may not reach bottom until 2010 or 2011. Employment has also started to fall, and we expect the rate of unemployment to rise sharply to close at 11 percent by 2011”.

The IMF cautioned that the UK remained susceptible to shocks, in particular to the banks and financial institutions, and that the government should prepare contingency plans to bail out the banks again. It said that the authorities should “stand ready to provide further support where needed”. But that must lead to a further increase in government borrowing and contingent liabilities—the potential claims on public finances if the banks redeem the government’s guarantees. Standard and Poor’s, the credit ratings agency, believes that such claims will reach £100 to £145billion (between 7 and 10 percent of GDP).

The IMF noted that it was not just the public debt that was rising, but so were its contingent liabilities arising out of its guarantees to the financial institutions. In addition, there are the explicit and implicit support measures for the government’s public private partnerships and bailouts of failed privatisations, all of which are—Enron style—off the balance sheet.

The IMF warned that “the sharp increase in public sector borrowing and contingent government liabilities, together with continued financial sector fragility, are significant vulnerabilities. In these circumstances, a severe shock has the potential to disrupt domestic and external stability”.

It insisted that the key to shoring up the banks’ financial situation was to restore “fiscal sustainability”. Stripped of the bland language of such reports, the IMF was serving notice that the government’s projected debt level is unacceptable, and that the bank bailouts must be paid for through attacks on working people. The Brown government and its successors are being called upon to implement public expenditure cuts and reduce borrowing much faster than the chancellor had planned, i.e., in one five-year electoral term, not two or three.

Standard and Poor’s report expressed similar concerns last week, downgrading its outlook on British sovereign debt from “stable” to “negative”. It said that the UK’s triple-A rating was at risk unless government borrowing was cut sooner rather than later. It reaffirmed the UK’s actual credit rating, but said the outlook had deteriorated “at a faster rate than Standard and Poor’s had previously assumed”, because of the massive borrowing to deal with the banking crisis and the recession, which last month cut tax receipts by £2 billion while increasing benefit payouts by £1 billion, compared to a year ago.

The government may miss its own forecast of £175 billion in debt for 2009-10, itself a massive increase on last year’s £90 billion. Standard and Poor’s expects public debt to reach 100 percent of GDP by 2013. The UK’s gross debt, already 53 percent this year, is expected to breach the European Union’s Stability and Growth Pact limits of 60 percent by next year.

It is the first potential downgrade of UK public debt since the agency began rating government debt in 1978. A credit downgrade could make it more expensive for Britain to borrow. A higher cost of borrowing would increase government expenditure on debt servicing. Bringing down the total level of debt would mean drastic spending curbs and tax rises.

Standard and Poor’s warning is significant because it is not based upon new data but is consistent with all the public finance forecasts.

Much to the government’s annoyance, the Bank of England also confirmed these reports. The Bank has cut its growth forecast over the next two years and raised its estimate for inflation since February. It appears to be projecting a decline of about 3.9 percent this year and growth of about 1 percent in 2010. The Bank believes that inflation will fall to around 0.5 percent by the end of this year before picking up to around 1.2 percent in two years’ time—below the Bank’s target rate of 2 percent.

Mervyn King, the Governor of the Bank of England, said that the economy would take time to recover. “There are pretty solid reasons for supposing that there will be a recovery next year, but also pretty solid reasons for questioning if that will be sustained”, King said. “But in the light of the state of balance sheets particularly in the financial sector, the committee [the Monetary Policy Committee] judges that the risks are weighted towards a relatively slow and protracted recovery”.

Last month, the Bank agreed to expand its programme of “quantitative easing”—in effect printing money—by spending £50 billion of the remaining £75 billion authorised by the government to buy up the banks’ worthless toxic assets. This comes on top of £75 billion in March. The committee wanted the chancellor to increase the £150 billion limit “should economic conditions require it”. But the Bank said it was “too soon” to know whether the quantitative easing was working.

 

While the Labour government has bailed out banks and mortgage lenders on the point of collapse due to their own semi-criminal and reckless policies, it has done and will do nothing to assist the millions of working people struggling with mortgages, rising bills and debt. Instead, they face a catastrophic decline in their living standards.

Prime Minister Gordon Brown has made it clear that public sector workers will see their pay rise by no more than 2 percent even as prices rise. He has encouraged private employers to similarly limit their pay increases.

The Institute of Fiscal Studies concluded on the basis of last month’s budget that working people would have to face 10 years of austerity measures to bring public debt down to 40 percent of GDP.

A report from the financial services company PWC gives an indication of just what such austerity measures might entail if the government is to bring debt below 50 percent of GDP by 2018. It warns that additional tax hikes or public spending cuts building up to £115 and £133 billion a year by 2017-2018 will be needed, equivalent to £5,000 for every family in the country.

John Hawksworth, head of macroeconomics at PWC, says that the Treasury believes that public finances will come under control by 2017-18. But this is just when the impact of an aging population takes effect. He is calling for tax increases or spending cuts “sooner rather than later” in order to “avoid unduly large increases in the tax burden on future generations of workers to pay for the future pensions and healthcare costs of current generations of workers”.

The National Institute of Economic and Social Research estimated that the state pension age would have to be raised to 70 to cut the debt.

Nicholas Timmins, in a Financial Times article, looked at where the axe would have to fall in order to balance the books. Selling off the state’s assets would not provide the cash it yielded in the 1980s. “More controversially, it involves reducing the role of—and burden on—the state and increasing the role the individuals will play, where politicians believe that will be justified. For example, the introduction of university tuition fees, which look set to rise again after the election; the long term rise in the state pension age; or a reduction in the generosity of public sector pensions”.

But as Paul Johnson, a former director of public services at the Treasury, lamented, “Shrinking the state is terribly difficult. [Governments] don’t get far in reducing the size of the state without reducing the numbers working for it or reducing the amount they are paid”. This is a recipe for a slash and burn programme of job losses and real wage cuts.