The credit crunch that began in 2007 looks very much like previous deflationary crises. In one respect, though, the slump is more worrying. The debt mountain that it generated is much bigger than anything that ever went before it. The accompanying chart (Chart 1, below) shows total indebtedness in America compared to the size of the economy. Reducing this Everest of debt is likely to be a slow and painful process, potentially taking many years.
The case of Japan shows just how long deflationary problems can last for. During the 1980s, the Japanese created a momentous bubble in land, stocks and other assets, while companies over-invested in their facilities. Much of the speculative excess was financed by debt. When the bubble burst, companies began to pay back debt, while the banks sat on trillions of yen-worth of losses on dodgy loans. A lasting recovery has eluded Japan to this day and deflation remains a feature of its economic landscape, as the chart (Chart 2, below) shows.
Chart 1: US household debt
Learning from the past (and present)
Central bankers around the world are rightly terrified of deflation. They are well read on the history of the Great Depression and on the recent experiences of Japan. In both cases, they are convinced that the authorities could and should have done more to solve the crisis. This time round, they are determined to avoid the mistakes of the past.
In the 1930s, many central banks insisted on keeping their currencies linked to gold. As a result, they had to set high interest rates even as economic growth was collapsing. The money supply in America shrivelled drastically during the period as many banks failed and others found themselves unwilling or unable to lend. Meanwhile, governments fell into the trap of trying to balance their budgets by slashing spending.
The Japanese have been more proactive in fighting deflation over recent years. As well as lowering interest rates to zero, the central bank has pursued 'quantitative easing' – expanding the money supply by buying up government bonds. And the Japanese government has tried to make up for companies and consumers not spending by splurging vast sums on often unnecessary public works, such as empty highways and bridges to nowhere.
Chart 2: Japan's decade of deflation
Slaying the monster today
Central banks and governments around the world have reacted much more quickly and aggressively to the crisis today than either the Americans did in the 1930s or the Japanese did in the 1990s.
Whereas Japan took more than a decade after the bursting of the bubble there to reduce interest rates to rock-bottom levels, the rest of the world lost little time doing so last year.
With interest rates already on the floor from New York to New South Wales, central banks have also proved very willing to embrace unconventional methods. The UK's exercise in creating money to buy bonds dwarfs Japan's earlier efforts to do the same.
Although the central banks are enthusiastically printing money, it is not yet clear that the policy is working. True, the international money-markets are no longer paralysed as they were last year. And the gush of liquidity has sent stock, bond and commodity markets soaring, making investors feel better – or at least, less bad.
So far, however, the tidal wave of new money has yet to do what was really meant to. Bank lending to real businesses is going down sharply, rather than up. So, businesses and households are either unwilling or unable to get new loans. Instead, the emphasis remains on paying back debt. And if enough people do this at the same time, as in Japan, then the economy shrinks and deflation takes hold.
Chart 3: Japan: bonds trounce stocks in deflation
Inflation could follow deflation
Despite all the signs of deflation, many experts and the public seem more worried about inflation taking hold. As far as they are concerned, all the money being created out of thin air can only lead to a rapid escalation of prices at some point down the line. As a result, there is a growing belief that interest rates will have to go up sooner rather than later and governments should start balancing their books now, by cutting spending and putting up taxes.
To the Japanese, this would all sound painfully familiar. On several occasions during Japan's ongoing deflation, the authorities started to fret about inflation and balanced budgets at the first sign of economic improvement. The policies resulting from these fears have succeeded every time in beheading any economic green shoots and ensuring that deflation remains entrenched.
Still, this is not to underplay the risk of inflation entirely. If central banks around the world decided to print and distribute unlimited amounts of money, they certainly could do so. But while unleashing hyperinflation would benefit today's debtors and manufacturers of wheelbarrows, it could also create economic and social meltdown. Quite simply, replacing deflation with uncontrollable inflation would simply be a case of 'out of the frying pan and into the fire'. We'll look more closely at the threat of inflation in a forthcoming feature.
