Deflation is a matter of national choice
By Avinash Persaud
Published: May 29 2003 20:02 | Last Updated: May 29 2003 20:02
For all the recent anxiety over deflation, it is still unclear whether the global economy will indeed be caught in the vice of falling prices. But what is clear is that the ebb and flow of deflation risks will be the most important driver of world financial markets over the next 12 months or more.
These risks are not evenly distributed across countries and markets. Differentiating regions, countries and markets by their risks of deflation will be the key to investment success this year. Borders are back.
In boom times, especially during booms centred on technological progress, as in the late 1990s, geography does not matter. Once railways, electricity or information superhighways had been "invented", their potential was global. But in downturns policy matters - and policy is still confined largely by geography.
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President George W. Bush's dividend tax cut, for instance, will primarily affect high-dividend equities such as those in the utility and financial sectors - but only in the US. Similarly, the risks of deflation will hinge on the willingness and ability of domestic policymakers to avert it.
It is true investment overcapacity, high indebtedness and banking sector fragility are also seen as increasing vulnerability to deflation. But these are as much products of deflation as contributing factors. Just over a decade ago the world's largest and best-capitalised banks were Japanese. Now, Japan's entire banking system would be on the edge of insolvency without government support and optimistic valuations.
Deflation destroys collateral. Low measures of overcapacity, debt and financial fragility today do not guarantee that deflation will be avoided tomorrow.
Insufficient willingness on the part of policymakers to avoid deflation is often attributed to their stubbornness, blindness or plain silliness. The more foreign the policymakers, the more colourful the adjectives. But, as ever, stereotyping of foreigners misses the real point. Deflation - where a dollar or euro or pound buys more over time, not less - leads to a transfer of resources from debtors to creditors. The more powerful the debtors, the greater will be the political resolve to avoid deflation; the more powerful the creditors, the weaker the resolve.
US officials and commentators often exhort the Japanese to inflate their economy. This fails, not because the Japanese are deaf but because Japan is a nation of creditors. If you are a creditor, voting for inflation is on a par with a turkey voting for Christmas.
Arranging the world's biggest economies by their net creditor or debtor status suggests deflation is most likely in Japan, Switzerland, Italy and Germany and least likely in the US, Canada, Australia and the UK. On an international basis, the US's net liabilities to the rest of the world are about 25 per cent of its gross domestic product. Japan, by contrast, is running a net surplus of about 35 per cent of GDP.
Whether a country as a whole is a creditor or a debtor has much to do with the age and wealth of its population. Since age and wealth are slow-moving factors, this pattern is slow to change and easy to predict.
The Bank of England's monetary policy committee is facing its first real test. The UK is only marginally a net debtor internationally but household debt has risen strongly. In an attempt to forestall a collapse of the housing market it is likely to err on the side of the debtors. It is interesting to note that sterling is falling and UK inflation is rising.
Currency movements will compound country differences in deflation risks. In this age of unilateralism, one way of reducing deflationary risks locally is to allow the value of your currency to fall. But this merely exports deflation abroad. As US and UK policymakers resist deflationary pressures and their currencies slip, they will export deflation to Europe. The current state of US-European relations suggests that US officials will shed few tears.
What does this all mean for investors? Deflation reduces the value of real assets and raises the value of nominal assets. It is good for currency and bonds with good credit ratings and bad for property and equities in general, especially the equity of companies whose cash flows are small. This would imply that the dollar has further to fall against the euro and the yen, as investors opt for European and Japanese bonds in preference to US and UK bonds. Despite the less favourable valuation it also suggests that US and UK equities will outperform European and Japanese equities, especially in the industrial, cyclical and export sectors. Investors neglect these geographical realities at their peril.
The writer is professor of commerce at Gresham College and global head of research at State Street bank, Boston
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