But, of course, what they intend and aim for is one thing; what actually results may be quite another. The world's governments and central banks did not plan for, forecast or anticipate the depression of the 1930s, nor the inflationary explosion of the 1970s. Rather, their hopes, intentions and plans were overwhelmed by events. In today's conditions, by setting policy so as to achieve a regime in which prices hardly rise at all, they run a serious risk that they will end up, not with a return to high inflation, but rather with price deflation.
Precisely because this would be so unexpected and ill-prepared for, it could have extremely dangerous consequences. If minimal inflation is the hope for the future, then price deflation is the fear.
Fear of Falling
The very pain inflicted by the process of reducing inflation (disinflation) makes a tip-over into deflation more likely. If the economic system were completely adjusted to minimal inflation then the danger of falling prices might be remote. But it is not. Consumers have become heavily indebted, particularly in order to purchase property, on the assumption of continual inflation. Without it, they will find their debts more burdensome. Many companies are both heavily indebted and are substantial owners of real assets. Governments throughout the western world have massive liabilities predominantly in long-term, fixed-interest form. As inflation falls, the real value of their interest payments will be higher than they originally bargained for and their balance sheet position will deteriorate.7
The effect of all these factors is to constrain spending and to weaken confidence as inflation falls. In principle, there ought to be gainers to offset these losers, but two factors undermine the forces which might otherwise be brought to bear to offset the deflationary forces emanating from debtors. First, the very novelty of the economic environment I am describing unsettles confidence -- falling prices for real assets such as property, very low interest rates, decreases in the general level of prices. Secondly, the rising real value of financial assets owned by creditors is of no benefit if it means that the debtors cannot pay.
The effects would be still more alarming if it came to be believed that, as substantial owners of non-performing assets, the banks were in trouble. For then the integrity of people's savings, and indeed the very monetary system itself, would seem to be imperiled. Once this stage is reached, we are beyond the rational models of economists and into the realms of mass psychology. We are dealing with the economics of fear.
Indeed, it is possible to imagine a vicious circle developing between falling asset prices, falling prices in the shops, rising real debt levels and downward spiraling expectations, reminiscent of what happened in the 1930s. If consumers expect prices to fall then they defer purchases, which puts more downward pressure on prices. Falling prices raise the real value of debt and force debtors to cut back on their spending. Some debtors inevitably go under, thereby endangering financial institutions and the banking system, which depresses confidence still further.
The behavior of stockmarkets may play a key role in this process. They are vulnerable to massive changes in sentiment which undermine the existing basis of valuation, causing a collapse of asset values and a loss of confidence which can spread beyond the realms of finance into what economists call the real economy, that is to say, the world of production and jobs. Whether or not it is a stockmarket 'crash' which leads the move towards deflation, a crash could well occur as a result of a move originating elsewhere, or the two could develop symbiotically, as happened in Japan in 1994-5.
After the stockmarket crash of 1987 failed to bring serious adverse implications for world economic growth, never mind the financial collapse that some commentators feared, it has become fashionable to dismiss the relevance of stockmarket values to economic activity. This is foolhardy. In 1987 we were fortunate. Central banks took evasive action; Japan, which seemed the weakest link, avoided becoming seriously embroiled; because the markets had risen precipitously in the months beforehand, the elevated level of the market was not firmly believed in and the losses were easily absorbed; and the underlying growth momentum in the economy was sufficiently strong that the shock was absorbed.
These factors provide no grounds for complacency about the effects of any future sharp drop in stockmarkets. Indeed, the system has subsequently become more fragile. The growth of mutual funds is a particular worry. In 1980 there were only 458 equity, bond and income funds in the US with combined assets of just under $60 billion. But by 1994, the number was 4394, with assets of $1500 billion. And the number of individual mutual fund accounts rose from 7 million in 1980 to 89 million in 1994.8 If individual holders of mutual funds panicked in a crisis they could cause a financial market crash.
Meanwhile, the world of 'sophisticated' institutional investors could be imperiled by the enormous growth of the market in derivatives, that is to say, financial instruments such as futures, options and swaps which are derived from the familiar, plain vanilla, financial assets such as deposits, loans, shares and bonds. Although there is nothing inherently wrong with derivatives, and indeed their appropriate use can greatly enhance the financial efficiency of business, they offer increased scope for speculation and, if badly used and managed, they can carry enormous risks, as the world discovered when Barings bank collapsed in 1995 following speculation in the futures market by the trader Nick Lesson. Well-managed banks and savings institutions have these risks under control, but no one can be sure about the fringes of the financial system, nor about how the system as a whole would behave in a crisis.
Nightmares Made Real
For the last 50 years, price deflation has seemed beyond the realms of plausibility. Now it does not. It has not struck most economic thinkers as a serious prospect, partly because in the last 25 years inflation has been high, and partly because in the period before that, when inflation was low, in most countries price rises were continuous, with no break in deflation. Economists' thinking about the future implicitly envisages a return to the sort of inflation which ruled in the 25 years immediately after the Second World War. If then, why not now?
But the whole weight of history stands against this conclusion, as will be explained in Chapter 7. The price level rising year after year without fail is an aberration. It happened after the war for two interrelated reasons. First, demand was high and growth was strong, buoyed up on a self-reinforcing wave of optimism. And, by a combination of luck and judgment, for the first 25 years there was no major demand shock to shatter this combination.
Secondly, because of the various inhibitions against lower prices and the restraints on competitive markets which I stress later in this chapter, prices, let alone pay, showed no tendency to fall even when demand was on the weak side. In those conditions, it would have taken a mammoth demand shock to bring on price deflation.
But neither of these conditions obtains today. We begin with generally modest growth and relatively high unemployment (except in the US and parts of the Far East). And confidence is fragile. Meanwhile, as I argue in Chapter 2, just about all the structural and institutional inhibitions to falling prices are crumbling. The result is that in today's conditions, a significant downturn in demand would produce falling prices.