The Hindu : On the brink of global deflation

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Saturday, Sep 28, 2002

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On the brink of global deflation

By C. Rammanohar Reddy

The least that can be expected is that during the IMF-World Bank meetings in Washington this weekend, the Finance Ministers of the world will look closely at the looming danger of deflation.

ON THE eve of an immoral U.S. attack on Iraq, there should be some concern about where the world economy is heading. There are economists and policy-makers who even argue that a war may indeed be good for the U.S. economy and therefore for the world economy as well. But these are fringe elements whose advice, if acted upon, will end in disaster. But that apart, war or no war, economic conditions in few parts of the world are anything to feel optimistic about. It is strange then that a mood of indifference has settled in among the global economic decision-makers on the eve of the annual meetings of the International Monetary Fund and the World Bank.

Economic growth in the U.S. continues to sputter at an annual rate of under two per cent. Long after the twin effects of the bursting of the technology boom and the loss of confidence in the aftermath of the terrorist attacks of 2001 have worn off, the U.S. economy has not fully recovered. The recession of 2001 was not as deep as initially feared, but the recovery too has not been vibrant. The slack in the U.S. performance is not being made up by either the European Union or Japan, where growth is slower or in some countries on the verge of turning negative. In parts of the developing world there is a deep crisis, notably in South America where Argentina's GDP is now nearly a fifth smaller than two years ago and Brazil where international capital is bent on showing its disappointment with the electoral choices that the country's citizens want to make. Among the other larger developing economies, it is now accepted that India will see growth slipping perhaps below five per cent in the financial year 2002-03. A slowdown in agriculture is the ostensible reason; but the incipient industrial recovery had begun to stall even before the monsoon began to play truant. The only bright spot in the world economy seems to be in South East Asia and China where growth will be strong in 2002. Yet, since these economies have tied themselves so closely to the global market, the less than anticipated renewal in world trade that is now taking place means that the current economic momentum is unlikely to last too long.

In spite of all these developments and trends, the IMF is strangely not very worried about the short and medium-term prospects of the global economy. In its biannual World Economic Outlook, presented earlier this week, the IMF appears to compliment itself for the accuracy of its April forecast for global economic growth in 2002 — 2.8 per cent. Realising that the ongoing economic recovery is not as strong as earlier expected, the IMF has no doubt lowered by a small proportion its prediction for growth in 2003. But the accuracy or otherwise of the estimates of the rates of growth is not the real issue. The more important question is whether or not the IMF sees that there are deep-rooted problems in the world economy, which have not been settled by the pricking of the technology balloon in 2000.

Unfortunately, the IMF does not seem to acknowledge the seriousness of the situation. It does, of course, observe that the risks are greater on the "downside" — that is, it is more likely that global economic growth will be slower (rather than faster) than expected. A handful of such risks have been identified. The first is a volatility/possible increase in international petroleum prices following a "conflagration" in West Asia (i.e. a U.S. attack on Iraq). The WEO estimates that a $15 "sustained" rise in global oil prices will shave off one percentage point from world economic growth. (This, however, does seem like a very mild impact for a 65-70 per cent rise in oil prices.) The second risk comes from an excessive dependence on the U.S. to lead economic recovery. In addition, the U.S. runs the prospect of a sudden downward adjustment in the value of the dollar because of its continued large current account deficit in the balance of payments. The third risk comes from the volatility in the equity markets of the advanced economies. In an interesting analysis, the IMF points out that the decline in equity prices has been in many cases larger in the past six months (March-September 2002) than in the previous two years beginning from the end of the technology mania in March 2000. Such precipitous declines (accompanied in the U.S. by a loss of confidence in businesses because of the string of corporate scandals) means higher borrowing costs for companies and an evaporation of the wealth effect that has driven the U.S. consumer boom all these years. The fourth risk is that the crisis in developing/middle-income countries (Argentina, Brazil and Turkey) will deepen and spread to other "emerging markets".

In spite of highlighting the dangers posed by all these factors, the WEO is confident in the prowess of the growth in productivity, that is supposed to have been ushered in by the IT revolution, to accelerate recovery. For some time now the sceptics of a global economic recovery have been pointing to another possibility — the likelihood of "a double-dip recession" in the U.S. which means that the recovery after the 2000-01 downturn will be short-lived and will soon be followed by another downturn. While that is a possibility, the more likely and more dangerous outcome at this stage looks likely to be deflation.

Deflation is the opposite of inflation: prices keep falling, as a result the economy begins to slow down.

For consumers who are used to rising prices, deflation may seem like a good thing. But that is not so. When prices steadily fall consumers feel they can gain by postponing their purchases and waiting for even lower prices. This can be a disaster in an economy which is growing slowly. Consumers' decisions to put off purchases affects producers who cut back on production, incomes then decline, prices fall further and the economy slows down even more. Deflation is something that Japan has been experiencing in recent years. Other countries too are facing a similar situation.

For that part of the developing world which is dependent on export of agricultural and metal commodities (which make up some of the world's poorest countries), falling commodity prices have been a fact of life from the early 1990s and even earlier. Commodity prices have recovered a bit during 2002. But deflation is now threatening to become more widespread in the advanced countries. Consumer prices in the U.S. and even the European Union are on an average rising at just a little over one per cent a year. Prices of many products, especially of assets, have actually been declining. Asset prices are falling because the advanced economies have not yet worked themselves out of the huge investment excesses of the late 1990s.

The IMF had earlier analysed the causes and consequences of deflation. But in the interests of expressing of what it describes as "cautious optimism" about the world economy, the multilateral institution is for some reason downplaying the importance of acting on "urgent pessimism", which must follow the acknowledgement of the threat of widespread deflation. The least that can be expected is that during the IMF-World Bank meetings in Washington this weekend, the Finance Ministers of the world will look closely at the looming danger of deflation.

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