Dangerous than Inflation

Unlike inflation, deflation is difficult to stem and it takes longer for economies to normalise.

The current global financial crisis (which was a result of four excesses- excess liquidity,
excess leverage, excess complexity and excess greed) is no more confined to financial
sector. It has shaken the main street as well. The financial leverage which was 108% of
the world GDP in 1980 surged to 400% by 2007. The notional value of financial
derivatives was about $600 trillion by the end of 2007 or about 11 times of world GDP.
The five largest US investment bankers alone were leveraged 21 times and if we
consider their off balance sheet liabilities of $17.8 trillion, they were leveraged 90 times.
This crisis started showing its sign in early 2007 but the magnitude of that blew
unprecedentedly and came to the fore only in September 2008 when a number of
banks and financial institutions either failed or went for bankruptcy. In that month, over
25 major banks and financial institutions failed. During the second half of the late 2008
there was panicky across the world due to rising inflation. In India inflation touched
12.5% in August while the prices of gold and crude made new highs of $1,037 and
$148.8 respectively. The governments and central banks across the globe grappled
with inflationary situation in the period.

But things have turned upside down as the world fears that deflation not inflation is now
the greatest concern for the world economy. Deflation is a sustained fall in the general
price level and represents the opposite of inflation, in which case, the overall price level
declines over a period of time. This fear is genuine because deflation, or a widespread
drop in prices, is one of the most destructive forces that can hit an economy. In such a
scenario consumers hold off on purchases because they believe that prices will decline
even further. As the demand continues to falter, corporate profits begin to plunge.
Consequently companies respond by cutting production and laying off more people or
cutting down their wages which further affects demand. During the Great Depression in
the US output plunged by 40% whereas prices declined by 24%. In turbulent times like
this, we believe people will save more and avoid spending on buying expensive items
like automobiles or homes because they know those things will be cheaper in the
future. Despite fiscal and monetary measures taken, it’s difficult to say to what extent
they will be effective in bolstering the economic growth.

However, some experts believe that the current drop in prices may simply be a
temporary decline due to an adjustment between supply and demand and thus is not
deflation because that to happen, the price structure should collapse. In this report we
will discuss what the tools to fight deflation are and when the economy will be back on
the growth trajectory.

Deepak Tiwari
Research Analyst

deepakt@arthamoney.com

T: + 91 22 4063 3104

Feb 25, 2009 For Private Circulation only


Both “printing more money"
and "the Fed lowering
interest rates" are the same
thing. This is one of the
major tools to prevent
deflation.
Feb 25, 2009
Falling prices are damaging to the economy because they encourage consumers to
delay purchases and companies to cut costs - exactly the opposite of what is needed to
revive growth and get credit markets functioning normally again. The result of billion
dollar stimulus packages is yet to be seen. The central banks have cut rates across the
globe and have injected liquidity but banks are yet hesitant to lend to the borrowers and
cost of funds is still high. In future, the lending rates will come down. The stimulus
packages announced by govt. are especially in the form of tax cuts and infrastructure
spending. Both will put money in consumers’ pocket and should bolster demand. But
what if the deflation sustains?
Deflation can occur because of a combination of four factors:
Supply of money goes down.
Supply of goods and services go up.
Demand for money goes up.
Demand for goods and services go down.
Deflation generally occurs when the supply of goods rises faster than the supply of
money, and the pumping money into the system by printing more paper money is one
of the major tools to prevent deflation. But considering the fact that millions of people
are being laid off and unemployment is soaring, besides entrapped millions of people
who have burnt their hands in the US household bubble due to high leveraging, it’s
unlikely that the demand will pick up sometime soon. In China 670,000 factories have
been shut down and close to 20 million migrants lost their jobs. The urban
unemployment rate is 4.6% however unofficial figure is 9.4% excluding migrant
workers. The International Labour Organization ILO suspects unemployment in Asia
may surge by 23 million. Moreover unless the deleveraging happens and the bad
assets are cleaned up which may take at least 2-3 years, the US economy is far from
recovery. Deflation is also about consumers psychology. For example, if you are asked
to accept 2% salary cut when prices are falling by 2% or take 4% pay hike when prices
are rising by 4%, most of us will prefer second scenario.
Increasing money supply results in inflation.
The central bank can influence the money supply in many ways and thereby raise or
lower the inflation rate. The most common way is to change the inflation rate by
changing the interest rate. Changing interest rates causes the change in money supply.
The central bank lowers interest rate by buying government securities in lieu of money.
Thus the supply of such securities goes down (causing prices of securities go up and
interest rate to decline). Thus the central bank can increase the money supply by
lowering interest rates through buying securities and decrease the money supply by
raising the interest rates thru selling securities. However, this method of controlling
deflation is no longer an option as both in the US and Japan interest rates are almost
zero. Moreover, a country committed to a fixed exchange rate cannot freely print
money even if it is faced with deflation. But large economies with freely floating
exchange rates - like Japan or Euroland, or the US - are free to expand the money
supply as much as they like. So they should find deflation easy to prevent.
Billionaire investor George Soros believes that stimulus packages are not enough to
turn the situation around. He opines that even if the US govt. succeeds, the deflationary
pressures will be replaced by the specter of inflation and the authorities will have to
drain the excess money from the economy almost as quickly as they pumped it in. Of
the two operations the second one is going to be, politically, even more difficult than the
first, he reckons.
For Private Circulation only
 But is it too easy to print the money?

Let us quote Mr. Ben Bernanke “Like gold, US dollars have value only to the extent that
they are strictly limited in supply. But the US government has a technology, called a
printing press (or, today, its electronic equivalent), that allows it to produce as many US
dollars as it wishes at essentially no cost. By increasing the number of US dollars in
circulation, or even by credibly threatening to do so, the US government can also
reduce the value of a dollar in terms of goods and services, which is equivalent to
raising the prices in dollars of those goods and services. We conclude that, under a
paper-money system, a determined government can always generate higher spending
and hence positive inflation....”

The above statement reflects the US confidence in its currency. In uncertain times like
this investors don’t have any alternative for safer investments. Thus, it gives luxury to
the Fed to print more dollar as the demand for US securities increases. Though it will
have long term repercussions and affect the purchasing power of the US dollar, but the
US govt. is left with fewer options. It’s desperately trying to boost domestic demand and
have already announced trillion dollar bailout packages. To finance these packages, it
sells securities to investors like China.

Are such stimulus packages showing any result?

Now we will try to find the answer to the question “Are such stimulus packages showing
any result?” No doubt such packages will spur demand for housing, auto and consumer
durables but it will take long time. In some states like in California, housing sales have
really picked up in some of the hard hit inland areas. Inventory is moving from those
who can't afford it to those who can. This is a sign that the market is approaching a
bottom in some areas. Moreover, mortgage rates have come down and this should help
refinancing. But again this is too early to say that the economy has bottomed out.

As Nobel laureate Paul Krugman contends that the US bailout plans are intended to
mitigate the slump, not end it. A large part of the money is spent to buy bad loans.
American and European banks will need to recapitalise by $500 billion just to maintain
their capital adequacy ratio (CAR). But we still believe that such measures will prop up
the economies and only then can follow the rebuilding exercise. The stimulus packages
comprise of tax cuts, spending on infrastructure and monetary measures. Further,
spending on infrastructure has two problems. It takes too much time for money to go
into the hands of consumers and second is the planning and execution part. As we
witness with the US bailouts plagued with opacity. Tax rate cuts are considered the
fastest and most effective way to shore up the consumption. The recent indirect tax cut
by Indian government by 2% (both the excise duty and service taxes) is the right step in
the right direction.

When the pain will cease?

The central banks cut interest rate to pump into cheap money to consumers. But what
about the US and Japan that have already cut their rates almost to zero? During ‘Great
Depression’ and the ‘Lost Decade’ even zero rate regimes failed to end a prolonged era
of high unemployment. Mr. Paul Krugman observes in his blog that “the Great
Depression did eventually come to an end thanks to an enormous war. After the ‘lost
decade’ when Japan finally began to experience some solid growth, it was only because
of an export boom which was possible by vigorous growth in the rest of the world- not an
experience anyone can repeat when the whole world is in a slump.”

The answer to this question remains in the womb of time.

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Feb 25, 2009 For Private Circulation only