Tuesday, November 12, 2013

The Threat of Deflation

INFLATION, it is generally accepted, constitutes a threat to the capitalist system. Apart from its obvious impact on real wages, which can be socially destabilising, it also reduces the real value of wealth held in the form of money and financial assets, and hence is, very directly, economically destabilising as well. What is equally true, however, is that deflation, which is the very opposite of inflation and refers to a fall in the money prices of commodities, also constitutes a serious a threat to the system. And the advanced capitalist world is currently concerned about this threat.

Not that deflation has actually set in there; but inflation has fallen so low, especially in Europe, much of which is currently undergoing a severe demand squeeze because of “austerity” measures, that the threat of deflation is beginning to loom large over the horizon. In fact the headline in the Europe edition of The Wall Street Journal on November 1-3, 2013, was: “Low Inflation Threatens Europe”!

Deflation, constitutes a threat to the system for a number of reasons. First, it increases the real value of the debt of firms (and of government) which is typically contracted in money terms. It therefore upsets the balance sheets of firms, whose assets, consisting of an unchanged real stock of land, buildings and factories, now fall short of their debt in real terms. Since firms try to overcome this situation by cutting back on expenditures, especially investment expenditure, the demand for investment goods falls, which leads to a curtailment in output and employment in the sector producing investment goods. This in turn leads to a contraction in demand for consumer goods and hence in the output and employment in the sector producing consumer goods. An overall demand contraction, and hence recession, thus occurs in the economy.

An example will make this point clear. Suppose there is a 10 percent fall in commodity prices. Then the money value of the assets of firms falls by 10 percent while the money value of their debt remains unchanged. To improve this deterioration in their balance sheets which is potentially dangerous for them since it can cause bankruptcy, they ensure that at the margin at least the ratio of the increase in their debt to the increase in their assets, falls. If they were originally planning to make (in real terms) Rs 100 worth of investment, by borrowing Rs 50 and using internal funds worth Rs 50, now they revise their plans: they borrow, say, Rs 30, to go with Rs 50 of internal funds, and invest only Rs 80 instead of the original Rs 100. Since 30 divided by 80 is less than 50 divided by 100, they have at the margin reduced their debt-asset ratio, as a means of overcoming the worsened balance sheet. But the cutback in investment effected in this way by each firm pushes the whole economy towards recession.


Second, in the above example it was assumed that in real terms the availability of internal funds remained unchanged. This does not happen. When prices fall by 10 percent, if money wages remain unchanged then profits fall by more than 10 percent. In other words, they fall in real terms, which means that the availability of internal funds in real terms goes down. This acts as an additional factor reducing the level of real investment.

Third, the fall in internal funds in real terms is further compounded by yet another factor. In the above example, when prices fell by 10 percent, let us say that, with money wages remaining unchanged, profits fell by 15 percent. But out of these profits, interest has to be paid on past debt which in money terms remains unchanged; hence profits net of interest payments would fall even faster, say by 20 percent, which means that the fall in internal funds in real terms would be even greater.

This also explains why, even if money wages fall together with prices, ie, even if the real wages remain unchanged, and so do real profits, there is still a fall in the amount of real internal funds available. This is because out of an unchanged level of real profits, more has to be given out as real interest payment. The decline in investment can thus be quite significant in the case of a price deflation.

Fourth, consumer demand can fall for an additional independent reason during a deflation, quite apart, that is, from the induced effect of a fall in investment demand, such as what we have been considering till now. This consists in the fact that when prices are falling, consumers expect them to fall further and postpone their purchases to a later date to take advantage of the anticipated fall, which reduces their current demand.

Fifth, when investment and consumer demand fall for all these reasons, the capacity of the government to reverse this fall through policy measures also receives a setback. The typical policy instrument used in such situations is monetary policy, which operates through lowering the interest rate. The idea is that a lower nominal interest rate will result in a lower real interest rate, ie, a lower real cost of borrowing which will induce larger investment. But there is always a floor to the nominal interest rate, and in any case it can never fall below zero. Now even if the nominal interest rate is pushed down to zero, if deflation is occurring at 5 percent, ie, if prices are falling at 5 percent, then the real interest rate (which is the nominal interest rate minus the rate of inflation) is 5 percent, at which there may not be enough incentive to undertake investment. What is more, if the price fall accelerates, from 5 percent to 7 percent to 10 percent, let us say, then the real interest rate rises from 5 percent to 7 percent to 10 percent, which leads to a progressive contraction of investment, output and employment. The government can do nothing about this, because it can intervene only at the level of the nominal interest rate which in this example has already been pushed down to zero.

Sixth, the progressive contraction in investment, output and employment, which arises from the fact of accelerating deflation, itself contributes to accelerating deflation. Deflation in short sets up a spiral that becomes extremely difficult to negate, even as it keeps pushing the economy further and further in a downward direction.

Seventh, fiscal policy, which is the other main policy instrument apart from monetary policy, also becomes incapable of pulling the economy out of such a spiral. Since, as already mentioned, deflation increases the real magnitude of government debt, it also raises the ratio of government debt to the Gross Domestic Product of the economy. Since a rise in this ratio in the current era of neo-liberalism puts pressure on the government to lower its real expenditure, the tendency in the face of a deflation is to pursue “austerity” rather than an expansionary fiscal policy, which has precisely the opposite effect of compounding the deflation and pushing the economy in a further downward direction.


For all these reasons it is generally accepted that a terrible fate awaits an economy which gets pushed into a deflation. Japan is one such economy that has been in the throes of a deflation for over two decades now, with highly deleterious consequences. When the crisis of 2008 struck the advanced capitalist countries, the worst fear that many economists had was that these countries might slip into a deflation. But this has somehow been avoided till now. The US Federal Reserve Board’s policy of “quantitative easing”, under which it purchases government securities from the “public” and puts money into their hands instead, is a means of lowering the nominal long-term interest rate to pre-empt a deflation. Many other capitalist countries, like Britain, are pursuing a similar policy of getting their Central banks to intervene directly to lower the long-term interest rate. Such measures have worked till now. But now there is a fear that the imposition of “austerity” may well be pushing advanced country economies towards a deflation.

The consumer price index of the Eurozone increased by 0.7 percent in October over its level one year ago. This was not only the lowest annual increase in four years, but also represented a sharp drop from the level of 1.1 percent in September. And what is more it is dangerously close to zero inflation.

The European Central Bank may well decide to cut the interest rate to prevent a deflation from engulfing Europe. Because both inflation and deflation have serious adverse consequences for a capitalist economy, governments tend to aim at some sort of a middle ground: a sort of low inflation rate. According to current wisdom in the advanced capitalist world this rate is about 2 percent. The present inflation rate is way below this, and the ECB may well intervene to jack it up by lowering the long term interest rate.

But such lowering may not be enough. If the drastic “austerity” measures imposed on Greece, Spain, Ireland and even France and Britain continue to remain in place, then the curtailment in demand that they effect may not be offset by the dubious stimulus of a slightly lowered long-term interest rate, in which case the deflation may gather momentum. An obvious way of tackling the deflation is to abandon “austerity” and stimulate demand directly through fiscal policy. Even if this not done by the countries most affected by “austerity”, if demand is stimulated through fiscal means by Germany which has an enormous current account surplus, then that too will boost overall European and world demand, and prevent the onset of  deflation. But Germany which has been preaching “austerity” to others and which has been in the forefront of imposing “austerity” measures on southern European countries, may find it hard to go against its own preaching.

At the heart of the issue however is the ideology of finance capital. Germany has been preaching “austerity” because it is the champion of the ideology of finance capital in the European context. What we are witnessing now in short is finance capital being hoist with its own petard. Having imposed “austerity” upon the capitalist world in the midst of a crisis which demanded the very opposite policy response, it now finds the disastrous consequences of its own preferred course staring it in the face. But it cannot retract without putting the entire neo-liberal project into jeopardy. It can only keep its fingers crossed, and hope that the feeble response of an interest rate cut can prevent a slide into the abyss of deflation.

Prabhat Patnaik People's Democracy 20 November 2013

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