09/03/2015 - 05:40

Does deflation deserve its bad rap?

09/03/2015 - 05:40


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Not every economist buys the theory that that deflation leads to deferment of consumption, and is inherently a ‘bad thing’.

BENEFITS: A glass of beer in a Tokyo bar can cost as little as 180 yen, or about $A1.90. Photo: iStockphoto

Deflation is simply defined as a general fall in the prices of goods and services, but from coverage in much of the business press one could easily believe that deflation is some sort of insidious disease.

But is deflation really that bad?

According to Platinum Asset Management fund manager Kerr Neilson, there have been historical precedents of long periods of stable prices with wave-like tendencies, which differ in amplitude and duration with no periodicity.

Mr Neilson backs his case by referring to David Hackett Fischer's book, The Great Wave: Price Revolutions and the Rhythm of History.

Fischer, who is Earl Warren professor of history at the Brandeis University, Massachusetts, points to four great waves of inflation since around the year 1200.

He calls them price revolutions that occurred in the Middle Ages, followed by similar events in the 16th, 18th, and 19th centuries.

The first three waves were followed by a protracted period of price stability.

These revolutions were associated with declining real incomes, social instability and insecurity.

By contrast, the periods of price stability were marked by progressive falls in interest rates and spawned the Renaissance, the Enlightenment and the great industrialisation surge of the Victorian era.

The most interesting and perhaps relevant period was the 19th century.

Here we saw real wages rising three-fold and interest rates more than halving from between 4 and 6 per cent to 2 and 3 per cent in the Netherlands, France, Britain and the US.

Rents expressed as a percentage of sale prices of land were relatively flat, while share prices compounded upwards by 4 to 5.5 per cent annually in markets such as the US, Great Britain and France.

To ardent monetarists, who argue that excessive expansion of the money supply is inherently inflationary, it may also come as a surprise that two of these waves of stable prices were accompanied by large injections of additional money in the form of precious metal discoveries.

Fischer notes the most intriguing point was that the supply of gold and silver grew dramatically, six-fold, in the US from 1830 to 1850, while world gold and silver output rose 10-fold over that century.

During the American Civil War, prices escalated and subsequently fell, thereby completing a century of flat prices.

The point is that the scare of flat or falling prices is normally misplaced, as it reflects improved purchasing power of consumers due to higher real incomes.

Therefore, Mr Neilson is not convinced by those who buy into the argument that deflation leads to deferment of consumption.

He questions the nexus between central banks and their governments, which seems to lead to overdependence on monetary policy.

In other words, there is an expectation for central banks to overreact to price stability in order to placate popular demands, so as to be seen to be doing something.

Mr Neilson's view is that the excess supply of most commodities, combined with begrudging lending policies by the banks and a general reluctance to borrow by firms and individuals, leads to weak prices and low inflation.

However, the hunger for yield has persuaded investors to take more risks.

By forcing down yields, central banks have encouraged a narrowing of the risk premium paid between good quality and lower quality borrowers.

With the policy of central banks buying part of the outstanding stock of their government bonds and thus increasing the level of liquidity within their system, via quantitative easing, for the most part this has been a redistributive exercise.

The transfer of wealth is from those holding paper assets to those with real assets such as shares and property.

With inflationary risks continuing to fade, the central banks of Canada, Norway, India, Denmark, Sweden and Switzerland have all cut their interest rates since the beginning of December.

The decision by the Reserve Bank of Australia to lower the cash rate by 25 basis points, to 2.25 per cent from February 4, will further draw investors to equities, away from term deposits that offer negligible returns.

Those with paper assets are experiencing a net loss in wealth with their purchasing power, as measured by a basket of currencies, having fallen.

Things have grown so dire for European depositors that some are now paying banks a fee to hold their cash at no interest, otherwise known as a Nil Interest Rate Policy.

Yet home buyers are celebrating because for the first time ever, a Danish mortgage bank, Nordea Kredit, has issued a home loan with a negative interest rate.

After fees, their borrowers are paying close to zero interest rates.

Mr Neilson says there is still a great deal of caution, which is contributing to slow growth, but he suggests there is less risk than is perceived.


Steve Blizard

Authorised representative

Roxburgh Securities



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