[Is there a new editorial writer at the Economist? This seems to contradict everything they've said or implied for the last six months. Still, it's nice to see them come around. If you ignore the sneers and just look at the substance, this is pretty much what Doug and others were saying months ago.]
Deflation: The new danger
FOR several decades the bogeyman for most rich economies has been inflation. Policymakers began to fight it seriously 20 years ago, when Paul Volcker, chairman of America's Federal Reserve, dramatically tightened monetary policy.
Countries from Britain to Brazil then joined the fray. With great success: the average inflation rate in the G7 economies is now a mere 1%, the lowest for half a century. But even as the old enemy seems quiescent, a new and possibly more dangerous one may be rising up: deflation.
This is not a claim that The Economist makes lightly. We have long urged central banks on in their determination to resist inflation. And isn't the sign of a good central bank its willingness to turn a deaf ear to calls for monetary expansion, whatever the circumstances? Actually, no. The right target is broadly stable prices, which requires that a central bank should be ready to attack deflation as fiercely as it does inflation. Not only that, but a good central bank also keeps in mind that deflation can be more damaging than inflation, if it creates a downward spiral in which the expectation of falling prices reduces demand and pushes prices lower still, as happened in the Great Depression.
Seen it all before
In much of the world outside America, the risk of falling consumer prices (ie, deflation) is at its greatest since the 1930s (see article) . Japan is already in the grip of deflation. Prices are falling in China and some other parts of East Asia. Continental Europe's inflation rate, if correctly measured, is close to zero. Prices are coming down partly thanks to the beneficial effects of new technology and deregulation, and partly thanks to cheaper oil and other commodities. Such deflation is generally benign. But alongside it are signs of a more malign deflation, caused by excess capacity and weak demand. On current forecasts, the global "output gap" between actual and potential production will, by the end of 1999, be at its widest since the 1930s. If the economies of America or Europe were now to take a sudden lurch downwards, the world might easily experience outright depression, with prices and output falling together, just as they did 70 years ago.
Given such a risk, monetary policy in the rich world, taken as a whole, looks dangerously tight. Real interest rates are only slightly below their long-term average, which hardly seems appropriate when growth is so far below trend. Nominal GDP in the G7 economies is forecast to grow this year by only 21/2%, virtually the slowest since the war and well below what is required to sustain healthy growth with stable prices.
True, monetary policy has been eased since last summer, but the easing has often come in the wrong places. The biggest drop in real interest rates has been in America, where growth of almost 6% in the fourth quarter of 1998 hardly points to imminent deflation. In a less gloomy world the Fed might be raising rates to cool the economy. In contrast, monetary easing has been more cautious in Japan and Europe, where the danger of deflation is much more immediate.
Japan seems to be stuck in a classic liquidity trap: it needs lower real interest rates to boost demand, but because of deflation they are stuck painfully high. At the same time, government debt has exploded to a size that makes fiscal policy less potent. Yet there is still another instrument in the Bank of Japan's tool-kit: it can increase the quantity of money by buying government bonds—ie, by printing money. This solution is not without its drawbacks (see article), and banks weighed down by bad debts may still prove reluctant to lend more. But such a monetary boost would push down the yen, and so both lift exports and push prices up. Moreover, unless it is backed by monetary easing, Tokyo's latest policy twist (trying to talk down the yen) will simply not work.
The European Central Bank (ECB) also needs to relax more. In response to pressure to cut rates from European politicians, notably Oskar Lafontaine, Germany's finance minister, the ECB has argued that its rates are already at a historical low and that European unemployment is structural, making it in the long run impervious to monetary policy. But real rates are not in fact that low. And not all European unemployment is structural—some is caused by economies operating below full potential. Forecasts last year suggested that the euro-11 economies would, on average, enjoy growth of almost 3% this year. But now most economists reckon it will be no bigger than 2%, meaning that the euro area's output gap will widen. Given a risk that deflation is looming, that seems to make it safe and prudent to cut interest rates further. If Mr Lafontaine really wants this, however, he might be wise to shut up: his demands are encouraging the ECB to delay any cut, to avoid seeming to bow to political pressure.
Indeed, the Bank of Japan and the ECB are resisting an easing of monetary policy partly for similar reasons. They fear that their independence and credibility might be damaged. But to seek to keep inflation above zero is hardly to risk hyperinflation. And central banks' credibility would suffer far more if they allowed deflation to take root.
The world economy is precariously lop-sided. Even as America's economy continues to surge, much of the rest of the globe is drifting towards deflation. It is scary that America's boom, fuelled by an unsustainable stockmarket, is now the main prop for global demand. For how much longer? Global deflationary pressures are already choking American profits, making its share prices look ever more overvalued. This could yet topple the stockmarket. No wonder American policymakers are urging Japan and Europe to reflate.
Most economists believe that a repeat of the 1930s is unlikely, if only because people ought to have learned from their mistakes. Yet central banks failed to foresee either the 1930s depression or the great inflation of the 1970s. A big concern for the world economy may now be that central bankers, having successfully scotched that inflation, will prove too slow to come to grips with the prospect of deflation.