6 February 2009

Is the worry about deflation just a lot of hot air?

The following is written by Neil Reynolds for 6 February 2009 edition of "globeandmail.com".

Perhaps Bank of Canada Governor Mark Carney was right when he said last week that Canada would not – repeat not – slip into deflation. In Gauging Risks for Deflation, the International Monetary Fund says Canada, far more than most countries, is well positioned to avoid deflation in the year ahead. The IMF ranks Canada's deflation risk as “minimal,” placing us 28th on a list of 36 countries that produce 80 per cent of global gross domestic product.

The IMF ranks the U.S. deflation risk, however, as “high,” listing the American economy as the world's No. 1 deflation risk (excluding only Japan, already deflationary). Assuming that this assessment is correct and assuming that the U.S. enters a period of “sustained deflation,” many questions arise. How long can Canada inflate when, right across the border, the U.S. deflates? How should Canada prepare? How – a much different question – should Canadians prepare? Canada's federal stimulus program will subsidize Canadians who spend (and who, presumably, will go further into debt to do it). In a deflationary environment, is this the right strategy?

IMF staff economists Jorg Decressin and Douglas Laxton say in their report that the global economy will “most likely” avoid deflation – provided there are no more traumatic economic shocks. But, they say, it could be a close call. Subtract the inflationary exaggeration inherent in all consumer price statistics (by roughly 1 per cent a year in the U.S., roughly 1.5 per cent in Europe and roughly 2 per cent in Japan) and a number of countries are precariously balanced at zero per cent inflation already. The economists exempt five European economies from a “high risk” designation by the narrowest of statistical margins: Norway, Sweden, Finland, Switzerland and Belgium.

The IMF report calls on central banks for quick, decisive action to avert deflation – though mostly, it appears, to stop people from anticipating it. People who expect deflation can themselves cause it – by saving money rather than spending it. This is why central bankers don't like to talk about it. But silence carries its own risks. Deloitte, the consulting firm, noted this week that Canadians are still piling debt on their credit cards. Canadians are now significantly more indebted than Americans. (We have a personal debt-to-disposable-income ratio of more than 132 per cent, Americans 123 per cent; we have a personal savings rate of 1 per cent, Americans 4 per cent.) We don't expect governments or central banks to advise people to embrace an ethic of thrift, but shouldn't someone? Just in case?

To its credit, the IMF report doesn't use deflation to scare the living bejeebers out of people long indoctrinated in the mythology of inflation. As for the monetary phenomenon itself, the report says, deflation isn't nearly as evil as its reputation: “Deflation was not a rare phenomenon before [the Second World War], and the growth record during periods of deflation was not always bad. [Economists] point to two episodes in the United States: 1921-29, when prices fell by 1 to 2 per cent a year amid strong economic growth; and 1873-96, which saw sustained price declines of 2 per cent a year amid solid economic growth.”

In the inflationary era that followed the Second World War, the real unit cost of goods and services in the U.S. fell by half, producing unprecedented prosperity – though wholesale prices increased more than tenfold. The deflationary Victorian era in 19th century Britain produced a comparable increase in prosperity – though wholesale prices fell by half. In the U.S., in the single deflationary generation cited by the IMF (1873