Why deflation has overtaken all our other worries

Macro policy Economists have at last found something they can agree on: they are running out of tools to kickstart a global economy that has been struggling since 2008.

Plain-speaking US president Harry Truman once asked to have a one-armed economist brief him on a particular issue. Truman said he wanted a one-armed economist because he was tired of the two-armed variety that prefaced every answer with the caveat: "On the one hand . . ."

Last week's annual Davos talkathon proved to be one of those rare occasions when the high-profile practitioners of the dismal science presented a united front about the outlook for the global economy. The novelty of unanimity would doubtless have been more welcome if the content of their forecasts had not been so bleak.

Former US secretary of the Treasury Larry Summers, adviser to presidents Bill Clinton and Barack Obama and a Harvard University professor, set the tone. He warned that the US risked a deflationary spiral and a depression trap that would engulf the world if the Federal Reserve tightened monetary policy too soon. He said: "Deflation and secular stagnation are the threats of our time. The risks are enormously asymmetric".

Deflation is defined as a general fall in the prices of goods and services and is said to occur when the decline in prices reaches zero. Applying this metric, the eurozone with its 19 member states slipped into deflation in December. Most developed economies have seen price levels fall below 1 per cent in the past 12 months.

However, a fall of 50 per cent in the price of crude oil has had a deflationary impact across all of these economies. For oil-importing economies this constitutes a benign, not a negative development.

Perhaps the general climate of deflation-fear is best captured by the actions of the central banks of Canada, Norway, India, Denmark, Sweden and Switzerland. All have cut their interest rates since the beginning of December.

Secular stagnation is a theory that describes why monetary policy is unable to accomplish much more when interest rates hit the zero lower bound (0 per cent.) Although no firm date has been set for the US Federal Reserve to begin returning official interest rates to "normal", it has been suggested it could begin mid this year.

Nobel laureate Paul Krugman, writing in The New York Times, was every bit as doomish as Summers. He identified a "deflationary vortex" that was dragging down much of the world economy with falling prices causing an inescapable downward spiral in demand. The interaction of debt and deflation was a major contributing factor to the Great Depression of the 1930s.

William White, the former chief economist at the Bank for International Settlements (BIS) and now an adviser to German Chancellor Angela Merkel, said: "The global elastic has been stretched even further than it was in 2008 on the eve of the Great Recession". The excesses, he said, have reached almost every corner of the globe and combined public/private debt is 20 per cent higher of GDP today. "We are holding a tiger by the tail."


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Max Walsh


Max Walsh was for many years one of Australia’s top economic and political commentators, highly regarded as a journalist, author and broadcaster. Throughout his career, Max was involved in all dimensions of the media industry, which has encompassed positions with two of Australia’s largest publishing companies and television networks.

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