Entrenched Deflation Threatens Economic Recovery

By: Andrew_McKillop

TWO VIEWS ONLY
There are basically only two possible views. One is that entrenched deflation happens when there is persistent falling demand for credit and declining rates of money ciculation in the economy, driving down prices for goods, services and credit. This is confronted and made worse by increasing physical supply (and supply capacity) of goods and services. Due to generalized over-borrowing in the recent "economic cycle", QE Everywhere cannot fill the gap caused by secular deleveraging. All developed economies are "pushing on a string" and the temporary wealth effect of housing price and stock market gains has gone or will evaporate. They will all repeat the Japanese experience in their own way.

A supposedly alternate but in fact related view is that there is no fundamental conflict between inflation and deflation forecasts, there are only different time frames. Current and emerging deflationary forces in the economy are real and they will likely drive down prices, but the astronomic monetary expansion of recent years must sooner or later trickle down to the real economy and explode. To be sure this excludes the increasingly likely "option" of debt repudiation, fiat taxation of bank accounts (as in Cyprus), monetary re-basing or overnight "surprise change" of national moneys. All are deflationary.

UNCERTAIN SEQUENCING, NOT THE RESULT
Certainly until 2012, the monetary and fiscal stimulus which was operated in the wake of the 2008 crisis generated the expectation that serious inflation, if not hyperinflation must come. Actual and emerging deflation trends were for the least unexpected. Once the possibility is admitted, the length of any "deflationary phase" is also controversial or hard to predict. One major reason is that at least since the early 1980s, each serious economic or geopolitical crisis is followed by inflation. To find a multi-year period of  "chronic or entrenched deflation" we have to go back to the 1930s Great Depression, but with hinsdight it is also possible to consider the "high growth interval" or Trente Glorieuse of about 1948-75 as another long semi-deflationary period. This was shown by real prices tending to decline and inflation rates being very, very low while average earnings and revenues constantly increased.

In other words economic deflation can happen either under economic contraction, or expansion.

The US is in no way a special case. Periods of strong inflation historically occurred during wartime, but through 1948-75 this was the Cold War. Much more important economically, in the same way as for Japan and Europe during the same period, vast government overspending was combined with an ever-growing and strong private sector economy. This situation had already changed well before the end of the Cold War, with the collapse of the USSR in 1989.

Also, it is very easy to contrast the type of state "Keynesian type" stimulus applied to the economy through 1948-75, with the QE Everywhere situation of today, which in fact dates back more than 20 years, where State spending is completely unable to offset private-sector weakness. On balance this drives down private-sector demand.

DEFLATION TRENDS ARE STRONG
Staying with the US, the data is very clear and supports the previous "classic paradigm" of inflation/wartime and deflation/peacetime. Since 1776, wartime years recorded average inflation rates above 5% per year. Peacetime years averages were as low as 1% per year, and before the late 1970s and early 1980s, actually showed recurring year-on-year contractions of general prices.

Often ignored or underestimated, the worldwide trend to deleveraging is highly deflationary. This can be called a "flight from credit and debt". The real extent of current and ongoing deleveraging is underestimated, due to the process including both State and private-sector deleveraging. The first is the realm of QE Everywhere, but the second is real economy deleveraging. This is chronic deflation.

Real economy deflation is powerfully intensified by still increasing industrial output capacity in many domains despite saturated or semi-saturated markets, for example cars and cellphones, air transport, marine transport, energy, minerals. Debt reduction and reduced forward borrowing by private financial establishements is also strong, and is highly deflationary. Key effects of this of course include the policy response of the "Japanese experiment", an official attempt to restore inflation by whatever means are needed. In Europe, the UK is in open recession, despite massive and continuing State deficits and borrowing. The Eurozone can for all intents and purposes be considered a large economic region of generalized deflation. China’s GDP growth has slowed considerably, like the GDP growth of Brazil and India. US growth outlooks are "desperately modest".

Despite the massive apparent creation of liquidity, by QE Everywhere, the net effect is very low. This is due to two factors, both of them deflationary. Firstly there is deleveraging which most importantly includes bank recapitalization. Secondly there is rapidly intensifying decline of "monetary velocity" or money circulation in most major economies. In the finance sector, the decline in securitization and the elimination or writedown of so-called "off balance sheet vehicles", such as SIVs, is now in full swing as the banks dump "dubious assets" to raise capital ratios.

Increased savings are in progress in many major economies, despite derisorily low interest payable on deposits. This is at one and the same time a result of deleveraging, and of economic psychology, shown by increasing amounts of ATM cash withdrawals and liquid cash held by individuals "just in case", for contingencies and not spent. This is exactly the reverse-paradigm of the 1980s and 1990s process of increasing consumer indebtedness and constantly falling savings rates, providing both a stimulus to the economy, and to inflation. To be sure, US (and European) private consumption was the largest single driver of Asian and other export-led-growth economies until very recently.

THE DEMOGRAPHIC CRUNCH
Other deflation factors also operate at the private consumer level, such as equity stocks volatility since 2000 and especially since 2008, which undermine confidence in private equity portfolio holding, as a substitute for savings. At the same time, the previous very inflated real estate sector enabled home equity to finance debt and consumption, but this has significantly weakened. In many developed countries, "home equity" was the financing pillar of both the college education of children, and the retirement of middle class workers.

However, at least as important and of longterm future importance, often confused with regards to its cause and effects by political deciders, and studiously ignored by mainstream media, the developed countries face falling birth rates, slowing rates of population growth, and outright decline of national population. All of these longterm processes can only slow economic growth and favour deflation.

Several countries "afflicted" by outright population decline, as wide ranging as Russia and Singapore treat population decline as a national crisis. Others, due to its longterm nature and difficulty to reverse, such as Japan and Germany, have at least provisionally accepted the new demographic order but the fact that the 1930s Great Depression was also accompanied by, or caused falling birth rates, makes the reality of contracting national populations, or "demographic decline", a sensitive subject. Sensitive it might be, but this does not prevent it being real.

In fact major demographic change is a longterm process relative to the economy: demographic change concerns multi-decade, even centennial variations in the net balance of births against deaths and the average age of citizens. Today's demographic decline in a large number of developed countries, and radical declines in population growth rates in China, the MENA region and South America has taken place over 25 years, in many cases. The process can in no way be attributed to the most recent major economic crisis (post-2008). Also, the potential for this process being rapidly or significantly reversed is very low. Even more important, population ageing or the increase of the average age of any national population group, is a worldwide trend including India and Africa south of the Sahara.

Fertility rates are well below the world average replacement level of around 2.33 children per female (which can attain more than 3.3 in some cases), in most OECD countries today. Combined with ageing populations, this has a significant longterm sustained negative impact both on economic growth and expected, or possible, rates of inflation. Older persons tend to consume less than younger. Apart from the period of about 1980-2008 during which retiring and inactive "Baby Boomers" in the developed countries could expect to receive large pension payments, always corrected for inflation (even if it is declining), this "unreality interval" is now over.

Worldwide, but most intensely in the OECD countries whose combined GDP relative to world total GDP is declining, but is still close to 50% of world total GDP, the phenomenon of declining ratios of economically active-to-retired and inactive populations is intensifying. As a result, the working-age population relative to "dependents" will continue declining.This has many economic impacts, nearly all of them opposing economic growth and favouring deflation. Some are relatively subtle, such as declining or restrained rates of productivity growth and declining utilization of private cars even when they are regularly purchased. More dramatic effects include falling investment in R&D and falling capital investment, due to "flattening" of forward demand trends for goods and services and increasing amounts of surplus output capacity, which further incites companies to deleverage.

DEFLATION SHOCK
Under conditions of economic shock, especially post-2008, the combined impact of all these trends can or may create Deflation Shock.

Certainly since 2008, it is possible to measure the vast and growing gap between actual rates of economic growth, often close to or even less than zero in most European economies, and potential long-term trend growth measured on a basis pre-2008, for example 1985-1995. Where the gauge is 2004-2007 rates of growth against present, the gap is even more extreme giving us some idea of the surplus of output capacities of goods and services, and likely future demand. This is deflationary.

Excess supply and supply-capacity can then be seen for what it is: a stark cause of current and coming deflation. Many other factors, some of them relatively subtle, can only intensify the trend. For example the extreme intensity of income polarization or "the rich get richer but the poor don't have babies" combined with stagnant or declining net incomes of middle class households, creates the well known paradigm of economists as far back as Engels and Keynes, that is income elasticity of spending declines with rising income. National surveys of spending trends back this observation, with these surveys showing widespread trends to both increased savings, and increased income inequality, favouring the already-rich whose spending remains flat, despite often rapidly increasing income.

It is easy to argue that the cause-and-effect of declining birth rates or outright contraction of national populations, and declining economic growth and deflation, is "similar to the Great Depression", but this argument is almost certainly not true. Conversely the trend to increasing protectionism, as growth declines, is almost certain and is easy to compare with what happened during the Great Depression. The 2013 edition of the US General Electric Corp's "Global Innovation Barometer" of course gave high praise to ongoing Chinese corporate innovation - but this survey also showed that 71% of corporate executives in 25 countries want their governments to apply protectionist measures.

Normally, protectionism should favour at least a short-term rise in inflation as lower-cost imported goods are squeezed out, but the GE survey also showed a significant worldwide return to country-to-country or bilateral offset and barter trade, replacing conventional trade. The effects of this can on balance be deflationary, as declining amounts of currency payments and exchange, per transaction, tend to drive down the real economic costs and prices of global trade activity. Certainly this year, 2013, the trend for WTO-style "free trade" to give way to "every-nation-for-itself" is very likely to intensify, preceded by competitive devaluations to spur national exports and to impede imports.

As we know, again from the Great Depression, when all nations competitively devalue they all lose because foreign trade is both disrupted and declines - economic growth is further depressed. Simply due to its global money role, most devaluations will be against the US dollar, with an immediate negative impact on dollar-prices for almost all traded commodities. In turn, declining commodity prices can be expected to act in reverse mode to how they acted when "the commodity boom" operated: during a period of rising commodity prices, inflation tends to rise. During periods of falling commodity prices, deflation is likely to occur. In both cases, self-reinforcing "positive feedback" mechanisms tend to make the process durable.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

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