prospects for deflation: Andre Meier and Gavyn Davies

Gavyn Davies as blogger

Gavyn Davies, formerly chief economist for Goldman Sachs, then head of the BBC, is now among other things a blogger for The Financial Times.

My experience as a portfolio manager has been that Goldman’s economic commentary has always been truly excellent, and the high spot of the firm’s research offerings. As to Mr. Davies in particular, I read and admired his work for years.  (Equity strategy and individual stock research at Goldman is another story—lots of facts, no useful opinions would be my call.)

A recent post on his FT blog talks about deflation.

The  deflation problem, in a nutshell,  is this:  the main tool governments use to treat a sick economy is to lower interest rates to the point where the real (that is, after adjusting for changes in the price level) cost of funds is less than zero.  But an agency like the Fed can only lower rates to zero, where they are now.  It draws the line at actually paying us for the privilege of lending us money.

Because of this, a deflationary economy, i.e., one with a falling price level, is like having a patient with an antibiotic-resistant virus.  You can’t make real rates negative.  So tried and true treatment methods for curing a slumping economy are ineffective.  The monetary authority can either try unconventional methods, which have no track record, or stand on the sidelines with fingers crossed, hoping the patient recovers on his own.

It doesn’t help matters that the word deflation conjures up images of the worldwide depression of the 1930s or the decades-long stagnation of Japan.

Andre Meier on deflation threats

In his post, Mr. Davies cites work by Andre Meier of the IMF in cataloging and analyzing all the instances of recessions in the developed world over the past forty years that have been serious enough to pose a deflation threat.

Mr. Meier’s conclusion:  while inflation does rapidly approach the zero level in the twenty-five instances he looks at, it doesn’t seem to want to cross over into negative (deflationary) territory.  The higher the previous inflation, the faster the plunge downward, but in all cases save two the rate of descent slows and the inflation rate stabilizes as the zero line is reached.

In pre-1990 instances, which tend to originate at higher inflation levels, the march to zero is relatively steady.  Post 1990, the initial fall is sharp, but disinflation then tends to decelerate in later periods.  In the two exceptional cases from the past paragraph, which start from very low initial levels of inflation, Sweden in 1992-94 and Japan 2001-2003, the price level actually starts to rise as the recession deepens (presumably because of currency weakness and imported commodity strength, but odd nonetheless).

conclusions

Both economists interpret the data as indicating that there’s something very unusual about the occurrence of deflation, and that it seems to take negative economic shocks of much larger magnitude than the world has seen at any time in the post-WWII era–including now–for deflation to take hold.

The question is why this is the case.  Both Meier and Davies point to structural rigidities around zero.  As a practical matter, firms are reluctant to cut the wages of highly skilled employees, for fear they’ll leave when economic conditions improve.  They don’t want to cut the prices of their output, either.  Experience has taught them that it’s extremely difficult–in many cases, nearly impossible–to raise them back again.  In addition, in many cases legally binding agreements–government workers’ salaries, for example, or long-term materials supply contracts–mean price cuts aren’t possible.

On a macroeconomic level, it may be that inflationary expectations–there’ll be low inflation but at least some–have been very deeply established in our collective economic psyches.  World governments response to recent crises, much as we may want to criticize the details, may have been enough to preserve or reinforce these attitudes.

In any event, the experience of the last forty years says deflation is not likely to happen.

my thoughts

No deflation doesn’t mean everything is ok.  But if we take the idea that general price levels are not going to decline as a working hypothesis, we can draw conclusions that may have useful investment implications.  For example, if salary levels aren’t going to decline, then firms will only be able to lower labor costs by laying workers off, or by pruning high-cost but unproductive workers and replacing them with lower-cost, more productive ones.  Companies could also prioritize between high value-added tasks and low value-added ones–and focus all/most compensation increases to workers in the former areas.

One might also try to distinguish countries where limited economic gains may be a chronic problem and those (like the BRICs) where it will not.

In discussing its most recent earnings performance, Procter and Gamble seems to be saying that these sorts of patterns are already becoming evident in their customers’ behavior.  For example, PG is finding that consumers of mainline/premium brands are beginning to trade up.  Value-brand users are continuing to trade down.

My experience is that in uncertain economic times, investors tend to become mesmerized by worry over the worst possible outcome and do little else except wring their hands.  True, we need to be concerned about even low probability events that have significant negative consequences.  But typically this doesn’t take much time.  I think there’s potentially a lot of money to be made by looking for hot spots of growth even in a world that may not be expanding that quickly.  And there’s certainly money to be made by working out the economic implications of having something better than the worst-case scenario unfold.

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