Posted on 29-5-2003

Paying the price for deflation
by Avinash Persaud,
Wednesday May 28, 2003,
The Guardian newspaper

Introduction by Alan Marston

PlaNet TV did a programme late last year (Economies of Scales) about a dark form looming on the global economic horizon, deflation. That programme pointed out the main aspect of deflation, it benefits people who are owed money and penalises people who owe money.

All things economic, and no-one but a hermit is unaffected by `the economy', are dominated by the US based corporates, and overall they owe money. That is why the prudent person can expect the US government to pursue a pro-corporate policy, the manufacture and export of deflation to the rest of the world, via a deflation of the US dollar.

New Zealand is currently experiencing the deflationary pressure from the USA, but the full effects of that on the New Zealand economy have only just started. Beware, the banks will defend themselves and the devil take the hindmost, i.e. those who owe money, i.e. a large number of New Zealanders who have borrowed heavily on houses and land. The end of the housing price boom is nigh.

But then again, I could be wrong...


Main article

It remains unclear whether the global economy will be caught in the vice of falling prices. What is clear is that the ebb and flow of deflation risks will be the most important driver of world financial markets over the next 12 months or more. So it is important to note that these risks are not evenly distributed across countries and markets. Borders are back. Differentiating regions, countries and markets by their risks of deflation will be the key to investment success this year.

In boom times, especially during booms centred on technological progress as in the late 1990s, geography does not matter. Once railways, electricity or information superhighways had been "invented", their potential was global. But in downturns, policy matters - and policy is still confined largely by geography. US President George Bush's dividend tax cut, for instance, will primarily affect high dividend equities like those in the utility and financial sectors, but only in the US. Similarly, the risks of deflation will hinge on the willingness and ability of domestic policy-makers to avert it.

Insufficient willingness on the part of policy-makers to avoid deflation is often attributed to their stubbornness, blindness or plain silliness. But this misses the real point. Deflation - where a dollar or euro or pound buys more over time, not less - leads to a transfer of resources from debtors to creditors. The more powerful the debtors, the greater will be the political resolve to avoid deflation; the more powerful the creditors, the weaker the resolve.

US officials and commentators frequently shout at the Japanese to inflate their economy. This fails, not because the Japanese are deaf, but because Japan is a creditor nation. If you are a creditor, voting for inflation is like turkeys voting for Christmas.

Arranging major economies by their creditor or debtor status suggests that deflation is most likely in Japan, Switzerland, Italy and Germany and least likely in the United States, Canada, Australia,  and the UK (and New Zealand - Ed.). On an international basis, the US is running a net debt position of around 25% of GDP versus the rest of the world. Japan is running a net surplus of around 35% of GDP. Whether a country is a creditor or debtor has much to do with the age and wealth of its population. Since age and wealth are slow-moving factors, this pattern will be slow to change.

The Bank of England's monetary policy committee is facing its first real test. The UK is only marginally a net debtor internationally, but household debt has risen strongly. In an attempt to forestall a collapse of the housing market it is likely to err on the side of the debtors.

Currency movements will compound country differences in deflation risks. In this age of unilateralism, one way of reducing deflationary risks locally, is to allow the value of your currency to fall. But this merely exports deflation abroad. As US and UK policy-makers resist deflationary pressures and their currencies slip, they will export deflation to Europe. The current state of US-European relations suggest that US officials will shed few tears over this implication.

What does this all mean for investors? Deflation reduces the value of real assets and raises the value of nominal assets. It is good for currency and bonds with good credit and bad for property and equities in general, especially the equity of those companies with little cash flows. This would imply that the dollar has further to fall versus the euro and the yen and that European and Japanese bonds offer better value than US and UK bonds. Despite the less favourable valuation it suggests that US and UK equities will outperform European and Japanese equities especially in the industrial, cyclical and export sectors.

· This is an edited version of an article sent to investors. The author is Gresham Professor of Commerce and global head of research at State Street. He would like to thank Michael O'Sullivan, Michael Metcalfe, Harvinder Kalirai and Marija Savina for helpful ideas and comments.