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Markets & economy


It seems the world may divide into two distinct camps: the mature economies gripped by deflation and stagnation, and the emerging markets, which continue to grow strongly. Sandy McGregor discusses how deflation can become a serious obstacle to prosperity, and governments may lack the power to reverse deflationary forces.

If one were to ask financial policy makers in Europe or the United States what their greatest fear is, the probable answer would be deflation. Deflation can be described as 'a continuing and general decline in the prices of goods, services and assets'.

Deflation and growth are not necessarily incompatible

When the aggregate level of debt in society is low, deflation can have a positive effect on economic growth. Falling prices allow consumers to increase the quantity or quality of goods which make up their shopping baskets, thereby increasing general wellbeing.

In the laissez faire conditions prevailing prior to 1914, there were periods of severe deflation during which the world economy grew strongly. For example, the advent of railways and steamships gave Europe access to much cheaper food produced in the rich agricultural regions of the Americas. Lower food prices caused hardship among Europe's farmers, but boosted the living standards of industrial workers. To a large degree economic growth depends on making things cheaper. Deflation and growth are not necessarily incompatible.

However, in a highly indebted society deflation can severely impede prosperity. When borrowers find it necessary to reduce their levels of debt, either for reasons of prudence or because access to credit has been withdrawn, loan repayments become their priority, reducing the amount that can be spent elsewhere. Savings increase and spending declines. Economic growth slows. Inflationary pressures abate. We are currently witnessing this process as highly indebted consumers and governments in Europe try to get their balance sheets in order. The greater the debt burden, the greater the risk of a deflationary contraction.

The great deflation of 1925-1935 was a seminal event. Initially falling prices in the period 1925-1929 did not have adverse consequences for growth. However, after 1929 excessive international debt could not be serviced, which resulted in a severe contraction in world trade, a series of banking crises and the worst of depressions.


The crisis of the 1930s and the Second World War transformed the role governments play in the economy. Big government became the order of the day. Proponents of state intervention found justification in the ideas of economist John Maynard Keynes, who argued that fiscal policy should be conducted in a countercyclical way to stabilise economic growth. An unintended by-product of the rise of government's role in the economy was persistent inflation. Initially inflationary pressures were mild, but ultimately the Keynesian response to the oil shocks of the 1970s generated a massive rise in prices. Even after the situation was brought back under control by a combination of real interest rates, globalisation and deregulation, inflation persisted in most developed countries, albeit at low levels of about 1% to 3% per year. The entire theoretical paradigm and policy framework assumed a background of rising prices.

A different story in Japan

However, there was one country whose economy behaved totally differently from the predictions of mainstream Keynesian and monetarist theories. In Japan during the late 1980s, prices of property and shares rose to totally unsustainable levels. Business was heavily indebted. High interest rates pricked the asset bubble. The economy went into recession. The government tried to restore growth by spending money on infrastructure - the Keynesian solution. It did not work. They tried to generate inflation by printing money. This did not work either. Both the Keynesian and monetarist responses failed. The stimulus merely increased savings and had little impact on the real economy. Japan has been in a state of deflationary stagnation for 20 years.

America has persistently criticised Japan, saying that its measures have not been aggressive enough, despite the fact that Japanese government debt now exceeds 190% of GDP. However, the US and Europe's massive responses to the Lehman and Greek crises have precipitated government debt crises from which it will be very difficult to escape. The cure for problems caused by excessive debt cannot be even more debt. This is especially true of the euro area where governments do not individually have the flexibility to debase their currency. But even the US and UK may be on the same path as Japan. Fiscal deficits are so large that they cannot be increased. Private savings, both of individuals and companies, are rising as debt is repaid. Consumer spending is under pressure.

A significant feature of a deflationary economy often is a rise in exports. For example, the growth that Japan has experienced has been entirely due to growing exports: exports as a proportion of GDP rose from 5% in 1990 to 14% in 2009. Similarly, German exports have grown strongly over the past decade. With strong growth in emerging markets, one can expect European and US exports to grow while their domestic economies stagnate. The pronounced trade imbalances of recent years will be reduced - yet another manifestation of rising savings in the developed world.

Rising savings and stagnant domestic consumption is a formula for price stability or deflation. The best panacea for excessive debt is growth in the nominal value of GDP, which can be achieved through a mixture of real growth and inflation. However, there is significant risk that Europe and America will get neither, and they will be condemned to repeat the experience of Japan. The frightening lesson from Japan is that governments may lack the power to reverse deflationary forces.

How should one invest in a deflationary world?

A key point is that while half the world - America, Europe and Japan - may sink into deflationary stagnation, the other half, where the large majority of the world's population lives, will continue to grow strongly. The balance sheets of emerging markets are strong, with large foreign exchange reserves and relatively low levels of indebtedness. The danger in emerging markets is not deflation but inflation. In practice, the reserve status of the dollar allows the US to export its monetary policy to the rest of the world. Consequently, emerging market interest rates are generally too low. Strong growth and low interest rates is a combination which promotes inflation. The world may divide into two distinct camps, the mature economies gripped by deflation and stagnation, and the emerging markets which enjoy a combination of inflation and growth.

As an emerging market South Africa will benefit from this dynamic. Of course we have many problems which might prevent us from achieving the same growth rate as other more flexible and less regulated economies. However, growth in Africa will create opportunities for South African business, and we should also benefit from the demand for commodities, especially in Asia.

While we cannot definitely assert that there will be a deflationary crisis in developed markets, there is a significant possibility that this will happen. Governments would welcome moderate inflation and will do what they can to get it. However, their efforts to reverse the deflationary tide may fail, just as the Japanese government's efforts have failed. Investors must be cognisant of this and structure their portfolios accordingly.

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