DEPRESSIONS...

A repeat of the Great Depression is unlikely
By Wolfgang Munchau

How big is the risk of global deflation? Five years ago, central banks led by the US Federal Reserve fretted and cut short-term interest rates aggressively. This time the Fed is largely alone in seeking insurance against the possibility of a deflationary depression. Both the European Central Bank and the Bank of England may ease further. But neither is inclined to follow the Fed into “whatever it takes” territory.
Deflation is the ultimate economic calamity – because of the human and financial misery it brings and the constraints it puts on policy. We fear deflation because of its self-reinforcing effects. If people expect prices to fall tomorrow, they hold back on consumption today. If investors expect falling returns, they hoard cash. This is also known as the liquidity trap.
In his debt-deflation theory, the US economist Irving Fisher explained a truly toxic mechanism that has some potential implications for our own post-subprime world. If a debt crisis coincides with severe deflation, the value of outstanding debt rises even as debt gets repaid. While all this is happening, central banks are constrained in their ability to stimulate the economy by the zero nominal interest rate bind.
But it is important to remember that these destructive mechanisms do not kick in the minute the officially recorded rate of inflation falls a fraction below zero. The deflation we fear is a large slump in the price level and a permanent shift in price expectations. During the Great Depression, the US wholesale price index fell by 33 per cent. Such a price fall is not likely in our globalised economy.
So even if a repeat of the Great Depression is unlikely, how about a Small Depression, similar to Japan’s in the 1990s? Popular folklore has it that the bursting of an asset price bubble and a restrictive monetary policy caused that country’s 1990s stagnation. While Japan undoubtedly suffered a fall in consumer prices in the second half of the 1990s, its deflation was relatively mild, with annual prices falling by less than1 per cent. More important, these price falls did not produce nearly as many of those toxic self-reinforcing effects that were in evidence during the early 1930s.
A far more plausible explanation of Japan’s lost decade is that by Professors Fumio Hayashi and Edward Prescott* who explain it in terms of weak factor productivity growth. When productivity falls, so does an economy’s long-run real interest rate. And when that happens, the effect of monetary policy stimulus is accordingly reduced. An examination of credit conditions and flow of funds data led them to conclude that a credit crunch might have contributed to Japan’s economic misery only briefly from late 1997 to early 1998, but cannot explain a whole decade of low growth.
Is there a risk that the US will suffer a Japanese-style lost decade? Of course, but for different reasons. US growth will slow as the savings rate needs to rise. For a country with an unsustainable current account deficit, this is necessary and inevitable adjustment, not a catastrophic event against which one should seek insurance. In terms of its structural characteristics, the US economy is not comparable to Japan in the 1990s and even less comparable to the US in the 1930s. US productivity growth is much higher than Japan’s and much of Europe’s.
That said, there is one scenario that could produce a 1930s-style deflationary depression in the US: a large-scale financial meltdown. By that I mean a situation in which the financial sector would cease to fulfil one of its basic functions: to provide liquidity to the real economy. But surely, lower central bank interest rates today could neither prevent such a scenario from happening, nor provide any comfort to an economy when it has no physical access to credit.
In the eurozone, deflation is not likely either. There is no comparable indebtedness problem, except perhaps in Spain; no property crash, except in Spain and Ireland; and a relatively robust financial sector. Of course, the eurozone is not decoupled from the global economy.
The UK is perhaps more vulnerable, because of the relatively large size of the financial sector in the economy, an over-reliance on a property market that is about to deflate, and chronically low productivity growth in non-financial sectors. There is now clearly the possibility of a severe and prolonged recession, followed by a long period of low growth.
So the risk of a global deflationary depression is small. But might it still not be worth insuring against? The trouble is that such “insurance” does not come in the form of a “price” but in the form of additional risk – of future inflation and financial instability. Last week, 10-year US Treasuries bonds yielded a mere 3.7 per cent, a rate below the actual rate of US consumer price inflation. In the event that the US recession turns out to be unexpectedly shallow and short (not very probable in my view, but vastly more probable than a deflationary depression), yields may well shoot up to 6 or 7 per cent. So the “price” for avoiding deflation may be a bond market meltdown, your quintessential financial crisis.
The rise in interest rates implicit in such a scenario would then give us a valid reason to fret about the future.