DEFLATING EXPECTATIONS

In the view of the latest issue of The Economist, “inflation is bad, but deflation is worse.“ (See The greater of two evils,” May 9-15, 2009.) An editorial reasoned that “inflation is distant and containable, while inflation is at hand and pernicious.”

It concludes darkly that we might be in for a “malign” form of deflation similar to the 1930s “... because demand is weak and households and firms are burdened by debt. In deflation the nominal value of debts remains fixed even as nominal wages, prices and profits fall. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.”

“Deflation robs a central bank of its ability to stimulate spending using negative interest rates,” the editorial went on. Moreover, using interest rates to combat deflation can slow the reaction of central banks when inflation once again becomes the issue.

By deflation, The Economist correctly means “persistent price declines” rather than passing ones that reflect temporary imbalances in the market. It focuses on the growing gap between the potential for global economic production and actual output as the source of the problem.

That production gap surely stems from other causes that The Economist overlooks. It’s not just debt-burdened households in the US and Western Europe that are not consuming; it’s also cash-rich households in Asia. Deflation surely stems in part from chronic underconsumption and over-reliance on export-led growth elsewhere. At the heart of this syndrome lies mercantilist price-fixing in the form of undervalued currencies.

So, why not go to the source – one of them anyway? Work out a new Plaza Accord with China, Japan and the others with misaligned currencies. This will help them bring their currencies into line with market forces, reduce their overdependence on exports to unwilling or unable consumers abroad, and stimulate demand at home to sop up some of that unused production capacity. That at least would be a step away from a repetition of the 1930s deflation and toward effective international cooperation to put the world economy on a sustainable growth path.