Deflation's hidden threat
It is contradictory to speak of “negative inflation,” but when did that ever stop economists? The phrase oxymoronically but aptly describes the problem confronting an increasing number of countries worldwide. The most obvious reason is the oil price, which has more than halved in US dollar terms over the last two quarters. Therefore, even when inflation is “turning negative” on a global scale, we would still not be in a state of deflation.
In fact, rather than being the textbook term for negative inflation, deflation might be better defined by price expectations. As long as the population thinks prices will rise, they will continue to act “normally.” However, once they start to expect prices to fall, we begin to enter a deflationary regime. Households will delay purchases of consumer goods, especially large discretionary items such as cars, because they expect these items to be cheaper. Companies might be inclined to push wages down and delay investments if they expect prices and profit margins to come under pressure. In turn, workers threatened with lower wages will consume less, putting even further strain on prices.
Moreover, in a deflationary environment, the value of debt expressed in purchasing power tends to increase at the same pace as the decrease in prices. Debtors become more and more at risk of default, adding downside pressure on the economy. This kind of “bad” deflationary environment is usually synonymous with low growth, contraction, or even depression. Recent examples are Japan over the last 25 years, and the peripheral European countries over the last five.
Since the Great Depression of the 1930s, central banks have considered deflation as the evil to fight at all costs. Former US Federal Reserve Chair Ben Bernanke made this very clear in his famous “helicopter” speech of 2002, in which he said, “Sustained deflation can be highly destructive to a modern economy and should be strongly resisted.”
Bernanke certainly walked the talk, and his successor, Janet Yellen, finished what he had started. Since 2008, the Fed has increased its balance sheet almost fivefold. Most major central banks have also torn a page out of the Bernanke playbook. The Bank of Japan has doubled its balance sheet since 2012, while the European Central Bank, a relative latecomer to the quantitative easing party, will start its own program next month, with a resolve to turn around falling price expectations.
However, apart from the threat of deflation itself, the current environment bears another – in my view even more vicious – risk, one best illustrated recently by Switzerland. At the end of 2011, aware that a too-strong appreciation of the Swiss franc would lead the country to a state of bad deflation, the Swiss National Bank introduced a floor of 1.20 Swiss franc per euro. Until last month, it fiercely defended this floor, increasing its balance sheet to a whopping 80% of Swiss GDP.
With the lifting of the exchange-rate floor, bad deflation has become an increasingly likely outcome for Switzerland. Many Swiss exporters are currently contemplating reducing wages. Hence, despite having done almost all conceivable “whatever it takes” measures to avoid the fate of deflation, the Swiss National Bank has de facto refuted Bernanke’s argument that in a world of fiat money, a central bank can always generate inflation by simply printing more money.
This means central banks are not necessarily the omnipotent institutions many believe them to be. This is dangerous, because in a fiat money world, the only true value money has is the confidence we have in the monetary authorities’ ability to keep its value intact. If this confidence gets dented because central banks prove unable to fight deflation, it could plant the seeds of mistrust that, at a later stage, the authorities might be unable to fight inflation. Therefore, in my view, the biggest long-term risk from the current deflationary environment is hidden in this assumed paradox.