Deflation can be good, but now it's bad

From The TimesMarch 24, 2009

Deflation can be good, but now it's bad

Ian King, Deputy Business Editor


Deflation does not have to be bad. There are, it is generally accepted by economists, two types of deflation — one good, one bad.

Good deflation is the type that Britain enjoyed during the Victorian era. Prices fell for most of the 19th century, thanks to a “virtuous circle” in which higher demand led to greater profits, which led to greater investment, better productivity — mainly due to the spread of railways — and, in turn, lower prices. There was huge industrial expansion, the advance of mass production, the rise of the City of London and the advent of the large corporation as we know it today.

In the period between 1870 and 1896, wholesale prices fell by 50 per cent, while Britain’s economy grew, on average, by a staggering 4 per cent each year.

Good deflation was also a key factor in the US during the Roaring Twenties when technological advances — in mass electrification and car manufacture — led to huge increases in productivity.

The common factor was that productivity improved so rapidly it led to excessive supply — and hence lower prices.

From the mid-1990s onwards, it seemed reasonable to suppose that the world was in for a rerun of those happy times, with the advance of the internet, increasingly powerful microchips and the development of mass communications. This belief was given greater impetus with the emergence of China as the workshop of the world, churning out ever-cheaper goods in ever-greater quantity.

Unfortunately, in this instance, the virtuous circle was broken because that vast output, quite literally, required fuelling. China’s insatiable demand for oil, petrochemicals and other commodities fed through to inflation elsewhere in the world — eventually hampering demand for its goods.

Instead, there is now a danger that we are in for a period of “bad” deflation. Bad deflation, like good deflation, occurs when supply exceeds demand. The difference is that, while good deflation is caused by booming supply, bad deflation is caused by weak demand. This was the case during the Great Depression of the 1930s in the US and, more recently, in Japan.

Bad deflation sucks the life out of economies. Rather than a virtuous circle, the effect has been likened to a “negative feedback loop”, in which one piece of bad news leads to another. An example of this would be how consumers react to a fall in the stock markets — by cutting back their spending. This forces companies to slash the price of goods and services, leading to lower profits, and then to lower employment and a further reduction in spending.

The reason that most observers fear we are in an era of bad deflation is because of the vast amounts of debt now in the economy. That is particularly true of the US and Britain.

Just as inflation is good for people with large debts, such as homeowners with big mortgages, deflation is even more painful because the size of the debt becomes relatively bigger. That is why governments everywhere are spending vast amounts on trying to provide economic stimulus. Demand needs to be reintroduced to the world economy — and fast.

http://business.timesonline.co.uk/tol/business/article5962898.ece