Are Global Economies Slipping Into Deflationary Death Spiral?

The Global Economy’s Big Fear Becomes Real: Deflation

The deterioration of the global economy in the wake of the ongoing U.S. housing bust and subsequent credit crunch is accelerating at a frightening pace. In the U.S., nothing captures the concussive force of the downturn better than the Consumer Price Index issued Wednesday, which showed prices falling by one per cent in October after being flat in September. Suddenly, the prospect of outright deflation in the U.S. economy — and all the risks that entails — is a clear and present danger. (See TIME.com Nov. 6, 2008). “With the unemployment lines growing ever-longer there is a genuine risk that the U.S. economy could fall into a corrosive deflationary phase,” says Sheryl King, Senior US economist at Merrill Lynch.

But deflation isn’t just a U.S. anxiety. Japan, which only emerged from deflation earlier this decade, is now back in recession, has negligible inflation, and could soon see prices falling again. So too in Europe, where the European Central bank was behind the curve in seeing the risks to growth that the credit crisis posed, and kept interest rates too high for too long. Though not in outright deflation yet, the pressures across Europe are all on the downside. Even in China, the world’s largest developing nation, officials now acknowledge that the risk of inflation — its main concern at the time of the Beijing Olympics in late August — is now gone. At a high powered international financial conference in Beijing over the weekend, a senior People’s Bank of China official acknowledged to TIME that, “if anything, we now need to fight against falling demand, and possibly even falling prices.”

See pictures of The Global Financial Crisis

At the core of the mounting global concerns about deflation is this: the global financial system is going through a vicious process of deleveraging: financial institutions are reducing debt and raising capital, either directly from governments or from private sector sources. By desperately trying to rebuild their battered balance sheets and regain some semblance of investor confidence, banks and investment banks are not doing much lending. Indeed, the definition of deleveraging means reducing debt relative to assets. Assets, for banks, are loans. And these days pretty much everyone is deleveraging.

That doesn’t bode well for global growth prospects. David Roche, President of Independent Strategy, an economic consultancy in London, notes that throughout most of this decade “the world economy has been used to using $4 to $5 of credit for every $1 of GDP growth.” Even if this “profligate use of capital is halved,” Roche argues, “it still means credit expansion of 10 to 15% is needed to achieve real growth of 2 to 3%.” The problem: credit, far from expanding, is still contracting globally — despite governments’ efforts to date to salvage the financial system.

The result — a deflationary bust — is evident everywhere. On Thursday morning crude oil prices — as good a barometer as any for global economic activity — plunged below $50 a barrel. In July crude peaked at $147.

As Merrill Lynch economist King argues, it’s likely the deflationary forces will intensify as the result of a vicious cycle. As economic conditions deteriorate, bank lending naturally declines because the number of credit-worthy borrowers — whether corporate or individual — shrinks. In other words, financial institutions that got into their current, egregious situation by making bad loans aren’t going to recover by making more bad loans. Thus, a declining economy leads to contractions in lending, which further dampens demand.

What’s astonishing about the current cycle is how quickly the global economy got into this situation. Government — from Ben Bernanke, the U.S. Federal Reserve chief, to the Chinese Communists in Beijing to pretty much everyone in between — all know more or less that the only policy response available to them is to flood their economies with money. China announced a big stimulus package nearly two weeks ago, and in Beijing last weekend, government policymakers acknowledged that more is probably coming. In the United States, another fiscal stimulus plan seems inevitable; the Federal Reserve, meanwhile, is likely headed to what in Japan in the 1990s became known as the “ZIRP:” zero interest rate policy. The Fed funds rate is already down to one per cent, and the economy is still sinking. Rates have nowhere to go but down — all the way to zero. And by the time President-elect Barack Obama takes office in January, it’s likely the US will be debating what sort of tax relief to individuals and businesses might be best — mimicking policy discussions that are already occurring along the same lines in Europe and Asia.

The ferocity of the downturn now under way, and the downward pressure it is putting on prices, cannot be underestimated, argues Shanghai-based independent economist Andy Xie. “The world doesn’t need to just throw the kitchen sink at this to avoid a disastrous deflation, it needs to throw the bathroom sink, and the garage sink, and any other sink it can find.” And it needs to hurry.

http://www.time.com/time/business/article/0,8599,1861105,00.html?xid=feed-yahoo-biztech

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