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Wednesday, June 9, 2021 Why Deflation is Bad Deflation is a situation where prices fall (negative inflation rate) Deflation in the UK in the 1920s. There are several reasons why deflation is considered to be harmful to the economy. Discourage buying. When general prices are falling, consumers tend to delay purchasing. For example, rather than buy a flatscreen today, they wait a year when they will be cheaper. The effect of falling prices is to depress consumer spending leading to lower economic growth. Increasing real value of debt . When people take on debt like mortgages, they expect the value of the debt to be steadily eroded by inflation. (A mortgage becomes easier to repay as your wage increases). When there is deflation, the real value of debts increases. You owe the same, but, your wage is falling. Therefore, you have to spend a higher % of your income on servicing the deb. The increasing real value of debt can cause a deflationary spiral. As prices fall and debt increases, it leads to lower confidence, lower spending (lower AD) and this leads to a further fall in prices and wages. Increasing Government Debt to GDP ratio. Deflation also increases the real value of government debt. It makes it much more difficult to reduce the debt to GDP ratio. Thus countries can start spending a higher % of income on debt repayment. Furthermore, as deflation tend to reduce economic growth, the cyclical deficit increases. The lack of growth of nominal GDP was a key factor behind the increase in debt to GDP in Greece, during the debt crisis of 2010s. In the UK in the 1920, deflation kept debt to GDP above 100% of GDP for two decades. Real Wage Unemployment . In deflation, wages may need to fall so firms can afford to keep employing workers. However, wages are often sticky downwards. (Unions resist nominal wage cuts). Therefore, falling prices are often not met by falling wages this leads to a rise in real wages. This creates real wage unemployment. It also makes a countries exports less competitive (particularly a problem in the Eurozone where countries can’t devalue the exchange rate) Demand for labour falls to D2 causing equilibrium wage to fall to W2. But, if wages are sticky downwards they remain at W1 causing unemployment of Q3-Q1. Monetary Policy Becomes ineffective . With deflation, zero interest rates may be too high. Even quantitative easing may be insufficient to get people spending. ( deflation and monetary policy ) The problem is that it is difficult to cut interest rates below zero and so the monetary authorities cannot adequately deal with the slow growth and deflation. Further Reading Inflation vs Deflation Deflationary spiral What is more likely inflation or deflation? Definition of deflation Posted by Tejvan Pettinger at 7:43 AM No comments: Email This BlogThis! Share to Twitter Share to Facebook Share to Pinterest Friday, March 20, 2020 How much can the government borrow? In 2020, the impact of the coronavirus and partial economic shutdown will cause a substantial and unprecedented increase in government borrowing. It will severely test the question of how much the government can borrow. There are a few quick points worth bearing in mind. Historical precedents . In WWII, the OBR said the UK ran a budget deficit of nearly 27% of GDP. By the early 1950s, UK national debt had risen to 240% of GDP. Yet this was not a significant problem. In the post-war period, the UK enjoyed a long period of economic expansion, where debt to GDP ratios fell. In March 2020, UK debt to GDP ratio was around 80% of GDP, so there is significant room for an increase in government debt. Source: Reinhart, Camen M. and Kenneth S. Rogoff, From Financial Crash to Debt Crisis,” NBER Working Paper 15795, March 2010. and OBR from 2010. Government’s have the ability to create money . Some economists (especially those believing in MMT ) argue the only constraint to government borrowing is inflation. In other words, higher government spending financed by printing money is only a problem when it causes inflation. In a severely depressed economy, with inflation falling (and possibly deflation) it maybe desirable for the government to create money and target a positive inflation rate. In 2009/10 recession, US and UK financed some borrowing through quantitative easing . In a recession , most economists accept that a rise in government borrowing is necessary to offset the fall in private sector investment and spending. Keynesian economics says expansionary fiscal policy can help an economy recover. But austerity (cutting spending) can make the recession worse, worsening tax revenues and be counter-productive in cutting borrowing. During a period of economic growth when the economy is close to full capacity, government borrowing can cause many problems such as crowding out of the private sector, pushing up interest rates, and possible inflationary pressures. The amount a government can borrow depends on many factors, such as Does it print its own currency? Do markets trust the government to maintain low inflation and not default? What are the interest rate on government bonds? What is the state of the economy? What is the purpose of government borrowing? To what extent is the government borrowing from domestic or foreign investors? Levels of government debt At times government debt has been very high: US 117% of GDP in 1945 (gross federal debt (1) UK 240% of GDP in the early 1950s Japan has national debt over 230% GDP How does the government finance its debt? Selling government bonds to the private sector - either domestic or foreign. The private sector buy bonds because the security and interest rate on them. The Central Bank can finance shortfall in revenue by increasing the money supply and buying bonds itself. This is sometimes known as quantitative easing. Factors which influence how much a government can borrow Domestic savings. If consumers have a high savings ratio, there will be a greater ability for the private sector to buy bonds. Japan has very high levels of public sector debt, but with high domestic savings, there has been a willingness by the private sector to buy the government debt. Similarly, during the Second World War, the government was able to tap into the high levels of domestic savings to finance UK debt. This shows that the rise in government borrowing in 2009/10 recession mirrored the rise in private sector savings. In a depression, we tend to see a rise in private sector saving (the paradox of thrift) because households fear being made unemployed and firms don’t want to invest. Therefore, in a recession, there is often surplus private sector savings. A surplus of unused savings means there is an advantage for the government to borrow, invest, create jobs and make use of these surplus savings. As Greg Mankiw said in March 2020. "There are times to worry about the growing government debt. This is not one of them." Relative interest rates. If government bonds pay a relatively high-interest rate compared to other investments, then ceteris paribus , it should be easier for the government to borrow. Sometimes, the government can borrow large amounts, even with low-interest rates because government bonds are seen as more attractive than other investments. (e.g. in a recession government bonds are often preferred to buying shares (which are more vulnerable in a recession). This is why US bond yields fell 2008-11, despite growth in US government borrowing. UK bond yields fell during a period of rising debt This shows that during a period of higher government borrowing 36% of GDP increasing to 80% of GDP - bond yields fell from 9% to 2% Lender of last resort . If a country has a Central Bank willing to buy bonds in case of liquidity shortages, investors are less likely to fear a liquidity shortage. If there is no lender of last resort (e.g. in the Euro during 2011/12) then markets have a greater fear of liquidity shortages and so are more reluctant to buy bonds....