On Exporting Deflation

Returning to our characters of a few weeks ago, we remember that Bob and his country had increased the supply of waffles thus making the export of Bob’s organic grass-fed butter cheaper. This happens because other countries like Nigel’s can now get more waffles on the pastry currency market and can buy more of Bob’s butter. There is a slight (or not so slight in our example of doubling the waffle supply just so Bob could sell more butter) inflationary pressure in The Land of Guns and Large Border Fences. Another effect of this decision is a slight deflationary pressure in Nigel’s Land of People With Below Average Dental Hygiene (LOPWBADH).. The reason this is so is because of the connectedness of the two countries via the pastry exchange market. The Nigel’s clotted cream now costs more to export it to Bob’s country. On the surface this looks inflationary because the prices went up. But when thinking about inflation or deflation, it’s important to consider both prices and demand. Because Nigel will now sell less clotted cream, he may have to lay off Colin, his dairy manager. Colin may then have to get a lower paying job which means he has fewer crumpets to spend. This lack of demand on a broader scale leads to deflationary pressures.

This lack in aggregate demand is a side of the inflation-deflation discuss that you’ll rarely see in financial press because it’s the part of the equation central banks have almost no control over. We’re currently seeing this in Euroland where the economies of the monetary union have been under significant downward pressure for months as unemployment remains stubbornly high in many countries. When you don’t have a job, you don’t buy either clotted cream or expensive imported grass fed butter. The continued deflationary pressure can quickly spiral downwards. Once upon a time, deflation was a normal part of the economic cycle and when every major currency in the world was tied to a hard asset, typically gold, there was a general deflationary pressure because you can’t increase the money supply without increasing the production of the hard asset. These days, with no country tied to a hard asset, deflation is supposedly a thing of the past (though the time may be returning as the Chinese government has been buying gold in large quantities, another fact you won’t see mentioned in the financial press). And in fact, deflation is a terrifying prospect for governments and citizens that are heavily indebted. During deflation, the cost of debt rises as the currency appreciates.

Imagine a scenario where 50% of your income goes to servicing your credit card debt. What happens if you suddenly make less money or if the interest rates rise? Big trouble, that’s what happens. Now your debt to income ratio goes up and you either have to do without things or begin to think about defaulting on the debt. Our reliance on debt as a society both consumer and government means deflation is extraordinarily dangerous. For example, it takes half the tax revenue of the country of Japan to service their public debt. What happens if interest rates rise in Japan? Suddenly, they struggle to pay their obligations. That’s why they (and many other countries) can’t afford to let interest rates rise. Their answer is to adopt a policy of zero interest rates by manipulating the market with made up money.

Europe is currently on the precipice of deflation. To fight it, the European Central Bank has announced a $1.3 trillion (give or take a euro or two) stimulus program aimed at increasing the inflation rate and stabilizing the fall in prices. Leaving aside whether this will even work, what effect does this have on other countries? This intentional devaluing of the Euro will lead to stronger currencies in the trading partners of Europe. Those stronger currencies now have to contend with the deflationary aspects which is exactly what is hoped for by the Eurozone. This beggar thy neighbour approach eventually causes other countries to retaliate leading to a currency war which many people think we are currently in. This is the meaning of exporting deflation.

So how is the problem actually solved? A decreasing reliance on debt is the first start. In normal times (like the 1800s) deflation was part of the business cycle. As deflation would occur, people, businesses and countries would deleverage, reducing their debt. Eventually, the economies would cycle back to inflation. In today’s world, deflation can’t even be allowed to occur because of the debt levels of countries. The goal is permanent growth because without it, we can’t pay our debts. But permanent growth funded by increasing debts is a fantasy world that doesn’t have a happy ending. A country like Japan has no choice but to try and print money (the Bank of Japan currently buys almost all of the country’s public debt) to service their debt and increase inflation. This is a grand experiment of our central banks unseen before in history. In the short term, it means the Japanese yen will continue to lose value to the dollar and the European stock markets are likely to increase just like the US stock market went up over the past several years during our own quantitative easing. In the long term, it’s anyone’s guess. What happens if Japan defaults? What happens if the ECB’s trillion euro package doesn’t work? At some point, the levels of debt have to be reduced either by the difficult process of deleveraging or by default. Neither will be pleasing and the farther down the road we kick the can, the harder it will get. Eventually, the road will end on a cliff and we may all just tumble over it.