If Ben Bernanke had hair, he'd be tearing it out over deflation. As an expert on the history of the 1930s, the Federal Reserve chairman is convinced that persistently falling prices present a major threat to the US economy and beyond – and that radical measures are required to counteract this. Both the Fed and other central banks are therefore set to print further money in 2011 in a bid to ward off deflation.
The consensus view is that 'quantitative easing' will succeed in defeating deflation. In fact, many are convinced that the policy of creating new money out of thin air will not only prevent prices from falling but will also trigger the opposite problem of inflation. This is one reason for investors' ongoing scramble to buy into gold, other precious metals and commodities more generally, which benefit from inflation.
It's easy to see why investors might be fearful that these largely untested techniques will end up stoking inflation. Aside from careless talk about hyperinflationary episodes in 1920s Germany and more recently in Zimbabwe, the latest data in the UK, as well as in emerging economies such as China, point towards upwards price pressure rather than the reverse.
Despite this, though, it is important not to underestimate the strength of the deflationary forces at work. The crisis eliminated huge amounts of credit in the economy, which exerts pressure downwards on prices. And British, European and American households are clearly far more concerned with paying off their debts rather than borrowing anew. By contrast, high inflation in the 1970s was preceded by a big splurge of bank lending.
Even where there has been a lot of bank lending, deflation could still become an issue. The Chinese authorities prevented a deeper slowdown in that country in 2008-09 by encouraging lots of borrowing. But all this may well have intensified the over-investment in factories and infrastructure of recent years. When the next global slowdown arrives, China could well end up exporting falling prices to the rest of the world.
Still, many economists believe that the West will escape the slide into prolonged deflation that Japan suffered – and is still suffering – following the implosion of its debt-fuelled boom in the early 1990s. Above all, they correctly point out that central banks in the West have adopted quantitative easing much earlier and on a much bigger scale than did Japan. However, it is also the case that lending banks have still failed to repair their finances, preventing them from lending normally, just as in the land of the rising sun.
Ultimately, of course, central banks can create as much new money as they want, mailing it directly to households in order to bypass the broken commercial banks, if need be. Surely this means that inflation is inevitable, if the authorities decide that's what is required? There is a widespread suspicion that high inflation is not simply a by-product of quantitative easing, but one of its objectives. A burst of inflation would help ease the debt burden of hocked-up households, business and governments.
That said, deliberately wiping out debt via inflation would be devastating to the owners of bonds and other lenders, including many pensioners across the developed world. And having fought so hard to win credibility for restraining inflation in the 1980s and 1990s, central banks may think twice before deliberately sparking rampant price increases. So, even if deliberate inflation is the end-game, central banks are likely to try everything else possible before resorting to it.
With deflationary forces in the US likely to persist, it is too early to give up on the likes of US Treasuries and other leading government bonds, which prosper when general prices are falling. At the same time, investors can hedge their bets by also owning gold, which could also benefit from the ongoing quantitative easing efforts of central banks.
Either deflation – which seems likeliest in the medium term – or inflation – which could eventually follow, could harm the stock market. The deflationary 1930s and the inflationary 1970s were both periods of poor returns on equities. The likelihood of one or both of the 'flations' is further reason for me to believe that the secular bear market in shares – which began in 2000 – has a long way to run yet, perhaps another decade.
