Fears deflation will knock global recovery off course

With oil prices on a seemingly never-ending slide, China, Europe, and, Indeed, Ireland wait to see the ramifications, writes Kyran FitzGerald.

before Christmas, a friend of mine got a bit of a shock. Having filled his petrol tank, he examined his bill. It was lower than expected. He panicked, thinking that he had mistakenly put diesel in his car. Happily, he soon discovered that his fears were misplaced. The drop in oil prices has been both welcome, but also and for some, unsettling.

Last week, it emerged that across the eurozone, consumer prices had actually fallen in December by 0.2% compared with the previous December. This is the first time since 2009, in the immediate aftermath of the financial collapse, that a drop in prices across the zone has been recorded.

The continuing drop in the price of oil has been identified as the major reason for this latest recorded decline. In itself, of course, the fall in the price of energy and, indeed, that of other commodities is a good thing for a country like Ireland where consumers are financially hard-pressed.

The economies of western and central Europe, unlike, say, much of Australia, New Zealand, and western Canada, typically benefit from the shift in their terms of trade that occurs when the prices of commodities weaken. This applies even to Ireland, despite the undoubted strength of our food production base.

However, concerns have been raised that this sharp drop in the price of many key commodities is the harbinger of worse to come, that it is a sign global demand is repressed and that falling prices could become the order of the day.

The example of post-1989 Japan — caught in a seemingly never-ending deflationary spiral — has been cited along with that of Western economies during the Great Depression of the 1930s.

Deflation is defined as a “sustained decline in the aggregate price level”. The fear of falling prices, it is said, causes consumers to delay purchases in anticipation of further drops.

That, undoubtedly, was the case back in the 1930s.

At the time, moreover, consumers simply lacked the ability to purchase the goods and services available.

The English economist John Maynard Keynes pointed to the key role governments could play in helping to eliminate the gap through deficit budgeting during that stage in the economic cycle.

However, in today’s world, the prices of many manufacturing goods have been falling for quite some time due to a combination of globalisation and technological innovation.

Any speeding up in this process is likely to be largely a problem for China and other countries in eastern Asia, given their dominance of international manufacturing.

The real problem is that, as a result of the rise to prominence in global manufacturing of these economies where people have a much higher propensity to save rather than consume, demand worldwide for goods and services has been held back.

We all should hope that the Chinese leadership, in particular, succeeds in its stated goal of boosting consumption across the economy, thereby mopping up surplus goods while increasing the size of the traveling army of hopefully high-spending tourists.

One of the key developments of recent years has been the decoupling in price trends as between services and manufacturing goods. Inflation in services, particularly in areas such as health and education, has been a marked trend in this country, though this is attributable in part to moves by the State to reduce subsidies (to private healthcare, in particular).

An ageing population means that demand for services is likely to grow realtive to that for goods, though demand for medical goods will continue to soar. A real concern is that any firming up, or deepening in deflation, could impact on labour markets, putting downward pressure on incomes, at least in stagnating economies.

The American economist Irving Fisher, back in 1933, warned that debt deflation, a drop in the price level that raises the real value of nominal debt, can exacerbate the costs of a period of deflation. By pressing down on real incomes, it reduces the ability of the heavily borrowed to service their debts, increasing the prospect of debt defaults, both corporate and personal.

The threat of debt deflation is something that no doubt concerns the president of the European Central Bank, Mario Draghi. However, it remains to be seen whether all his fellow ECB board members are on the same side when it comes to the quantitative-easing measures he is developing in order to counter the threat.

The markets in anticipation of such measures have pushed down the value of the euro against the dollar well below $1.20 to the euro. So, in a sense, the Draghi measures are already having an effect, provided that they do not turn out to be of a kind that disappoint.

In recessionary times, a depreciating currency can be a real tonic for the patient and, in this case, export- dependent Ireland stands to be a particular beneficiary.

Moreover, the impact of a depreciating currency should, in a matter of short months, begin to impact on price levels.

The price drop caused by the fall in commodities is like a form of ‘good cholesterol’, serving to boost real income levels.

If anything, the concern here is that oil prices might rebound in short order, as a result of a successful attempt by the market leader in oil production, Saudi Arabia, to squeeze competition out of the system.

KBC Bank economist Austin Hughes has been feeling the pulse of Irish consumers, by means of a monthly survey series, for quite some time now. His view is that the data on deflation, released last Wednesday, should not be dismissed out of hand, but neither should it serve as a cause of panic.

“Is the drop telling us about the weakness in the global economy? Is it a forerunner of a broader reduction in prices,” Hughes asks.

“The scale and speed of the drop in oil prices has caught people by surprise.”

As he points out, three months ago, the ECB was basing its assumptions on an oil price at $85 to $90 a barrel. It now looks like being $50.

But he also points to the mistaken impression on the part of many experts, particularly German ones, that somehow the boom would return almost of its own volition.

As a result of such views, leading to the conclusion that inflation was lurking waiting to pounce, efforts aimed at jump-charging the euro economy have been, at best, half-hearted and over reliant on a banking system no longer fit for purpose and on a borrower battered by a mixture of debt and pessimism.


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