Subprime's bad? Deflation will be worse
A deflationary spiral could ultimately propel economies into recession
"This guy's saying inflation isn't such a bad thing. Of all things, inflation! How can inflation be good?" she was saying.
I could barely open my eyes after a Sunday afternoon siesta.
"How did you get in?"
"That's not important. Answer my question first."
"Okay, okay, don't start pushing me around. See, there is a lot of uncertainty across the world today. Companies are slashing jobs, leaving workers in the lurch all of a sudden. People in the US and parts of Western Europe have some form of social security in the form of unemployment allowances, though it cannot quite compensate for a full salary. But workers elsewhere don't even have this support. Naturally, in times of uncertainty such as this, people in much of the world tend to be cautious with their money."
"But what has that got to do with inflation?"
"A good lot, you'll see. Those who lose their jobs will obviously be hurt directly, but others would also be more careful while spending money for fear their job may be on the line, too. And when many people cut spending like that, it slows down consumption. Lower consumption means lesser business for companies and professionals, which in turn means lower profits. And when that happens, businesses are forced to cut prices to maintain revenue growth. This may lead to a spurt in demand initially. But as more people lose their jobs and more uncertainty comes in, spending falls further and companies are forced to cut prices of their products and services even more. This phenomenon of prices coming down is referred to as deflation."
"Deflation?" she repeated.
"Yes, deflation. When consumers know that prices are falling and are likely to continue to fall, they have an incentive to delay their purchases. You know, why buy something now when you know it will cost much less sometime later? This is known as a deflationary spiral, where prices continue to fall, leading to progressively lesser revenues and profits for companies," I said.
"And how does that explain the situation in the US where everybody has borrowed big time?"
"Good question. The unemployment rate in the US in October was around 6.5%, up from 4.8% a year ago. This increased unemployment is adding to the deflationary spiral there. More than unemployment, it is the fear of unemployment at work. But there's another factor at work here. See, most of the consumption in the US was financed through loans. People first bought a house on loan. And since everybody was buying houses, the price of property went up. Now, if you bought a house for $200,000 and over a period the price went up to $250,000, you could even borrow against the increased value of $50,000, also known as home equity. This home equity loan was used to buy stuff. As the price of the houses kept rising, more home equity loans were taken and more stuff was bought. So, people kept financing their consumption through more and more home equity loans. Now that home prices have crashed, there is no more home equity loans are available. Also the financial system is in a mess and banks are not willing to give out such loans."
"So, Americans have run out of money they could splurge."
"By and large. Today, the debt-to-disposable income ratio is at 140%, up from 100% in 2000. Also, they now realise that all those loans have to be repaid. So where is the money to buy things? Companies have had to cut prices to make their products more attractive. But that hasn't helped because many are just not in a position to borrow, while those who have money are waiting for prices to fall further. The resultant deflationary spiral means companies make lesser revenues and profits as people buy lesser goods and services. Adding to the problems is the erosion in the stock market wealth of Americans, which has fallen by a little over 40% since the start of this year. When the stock market is doing well, the positive wealth effect is at work — investors feel richer and that leads to them spend more. When the stock market falls, the effect is the exact opposite. This has led to a recession in the US, Western Europe and Japan."
"Now, how do you define recession?"
"An economy is said to be in a recession if its gross domestic product (GDP) contracts for two or more consecutive quarters. GDP is the value of goods and services produced in the economy during a particular period."
"Is there any other reason for companies cutting prices?"
"Yes. The dollar has appreciated against most other currencies. US financial institutions had invested in stock markets all across the world. As the stock markets fell, these institutions exited these markets. And when they exited these markets they got paid in the local currencies, which had to be converted into US dollars before being repatriated back to the US. Due to this, demand for dollars went up and it appreciated against almost every major currency. This made imported goods cheaper for Americans, but forced American companies to offer lower prices, adding to the deflationary spiral."
"So, a little bit of inflation is good, isn't it? At least people won't defer consumption if they know the prices will rise in the days to come," she said.
"Yes. But the American situation is a little different. Going by economist Nouriel Roubini, who correctly predicted the current financial crisis, the US consumer is "shopped-out, having spent for the last few years well above its means."
"Can't the government do anything to revive consumption?"
"Oh, it needs to remember the famous British economist John Maynard Keynes."
"Keynes? How does he fit in here?"
"Years back, Keynes had suggested that in a recession, "The government should pay people to dig holes in the ground and then fill them up." Some said, "That's stupid, why not pay people to build roads and schools?" Keynes said "Fine, pay them to build schools. The point is it doesn't matter what they do as long as the government is creating jobs." His idea was that the government should intervene when a recession looms and give the economy a fiscal stimulus. You know, print or borrow money, which can be spent on things like creating infrastructure, social reforms etc. Money spent is likely to create jobs which end up as increased income in the hands of some and these people are likely to go out there and spend it. In fact, most American economists are now talking about Barack Obama legislating a fiscal stimulus package as and when he takes over as the US President."
"Will this fiscal stimulus work?"
"We can only wait and watch. But first tell me, how did you get in?"
"Oh, simple, the door was open."
(The example is hypothetical)
k_vivek [@] dnaindia.net
.......but then today I heard the 7500 level is dropped further to 6800......
