|SocialismToday Socialist Party magazine|
Symptom of crisis
When a deflationary trend developed in Japan in the mid-1990s, leaders in the USA and Europe regarded it as a Japanese peculiarity, a local side-effect of the bursting of the 1980s bubble. Now some commentators recognise that US capitalism, with a decisive influence on the world economy, could be in a similar position to Japan then – on the verge of a deflationary spiral. LYNN WALSH writes.
A SPECTRE IS haunting world capitalism, the spectre of deflation. For over sixty years deflation was just a distant nightmare for bourgeois leaders. It hardly gets a mention in standard economic textbooks. The deadly enemy was inflation, which surged internationally in the 1970s and has periodically engulfed crisis-torn countries. Fears are now rising, however, that deflation – a broad decline in prices – poses a growing danger to the world economy.
By increasing the burden of debt, deflation threatens to prolong and deepen the current stagnation or even provoke a worldwide slump. When a deflationary trend developed in Japan in the mid-1990s, leaders in the USA and Europe regarded it as a Japanese peculiarity, a local side effect of the bursting of the 1980s bubble and the consequential paralysis of the world’s second largest economy. The relentless development of a deflationary spiral of debt deflation, which the Japanese government has proved powerless to arrest, has forced capitalist strategists to take it more seriously. Recently, a deflationary trend has developed in Germany, while at least some economic commentators now recognise that US capitalism, which has a decisive influence on the direction of the world economy, could be in a similar position to Japan in the early 1990s – on the verge of a deflationary spiral.
In pronouncements as ambiguous as those of the Delphic oracle, Alan Greenspan, chairman of the US Federal Reserve, has minimised the threat of deflation. While admitting there is a danger of deflation, he optimistically claims that a US recovery is imminent and Fed policy will avert the danger of a continuous, across-the-board fall in prices. But this optimistic view has recently been challenged by two presidents of regional Fed Reserve Banks, William McDonough of New York and Anthony Santomero of Philadelphia, and also by Edward Gramlich, one of the Fed’s seven governors. (David Leonhardt, Fed unanimity cracks, International Herald Tribune, 19 May) The April 2003 figures showed the biggest fall in wholesale prices since 1947 and the sharpest fall in consumer prices in 18 months.
Trapped in past economic dogma, capitalist policy-makers have been slow to recognise the swing to deflation. But since the 1980s, in most countries there has been disinflation – a continuous decline in the rate of inflation. Inflation averaged 7.1% per annum in the advanced capitalist countries during 1970-89, but only 2.7% during 1990-2001. (This has not prevented countries going through deep crises, such as Argentina, experiencing runaway inflation.) In the last two years, Japan and China, as well as Singapore and Hong Kong, have experienced declines in both consumer and wholesale prices. Canada, Germany, the US, Italy and France, in 2001 and 2002, as well as Indonesia, Taiwan, and the Philippines, have seen wholesale prices decline. More recently, US consumer prices fell 0.3% in March while in Germany prices rose only 0.7% in May from a year earlier.
This is clearly not just a cyclical trend; rather the steady fall in prices of most manufactured goods and tradable services is a long-term, structural phenomenon. Optimists claim that lower prices merely reflect the globalisation of manufacturing and the productivity gains of the last two decades. The current disinflation, they argue, resembles the mild deflation that accompanied the worldwide capitalist expansion in the last quarter of the 19th century. Cheaper production methods are undoubtedly a factor. Nevertheless, the current deflation much more closely resembles that of the 1930s, though the current world economic conjuncture combines features of both periods (see box: A short history of inflation & deflation). Worldwide disinflation and the onset of deflation reflect chronic overcapacity in the major capitalist industries, the steady weakening of demand, and the collapse of stock-exchange and property bubbles in Japan, the US and elsewhere. In other words, price deflation and associated debt deflation are part of a syndrome produced by the global stagnation of capitalism. As the symptoms intensify, they systematically aggravate the underlying malaise, raising the spectre of prolonged stagnation, if not another great depression.
On 30 April, the IMF published a major study, ‘Deflation: Determinants, Risks and Policy Options’ (www.imf.org), a somewhat contradictory document. While showing that Germany is now sliding into deflation, it says the IMF task force "did not see any compelling evidence of generalise global deflation". (p6, p25) Yet the opposite conclusion could easily be drawn from the material they present. Sustained mild deflation, says the report, is far more serious than mild inflation. "Past episodes suggest that sustained deflation can be unanticipated, even as inflation and nominal interest rates fall close to zero". (p32) The first lesson of history, they say, is that "deflation and deflationary episodes can take root surprisingly quickly". (p15) The IMF calls on governments and central banks to be prepared to take pre-emptive action to prevent inflation. Yet the report shows that sustained action by the Japanese government on the lines recommended by the IMF (reduction of interest rates to zero and a massive expansion of the money supply) has up to now completely failed to halt Japan’s deflationary spiral. Will Germany and the US do any better?
The debt time-bomb
WHY IS DEFLATION a problem? Falling prices surely mean lower living costs – isn’t that a good thing? The problem is that the current deflation – produced by excess capacity and weak demand – is a symptom of capitalist malaise, the product of prolonged stagnation. For workers, any gain from cheaper goods and services will be cancelled out by wage cuts, unemployment, and other adverse effects of capitalist crisis.
When prices are falling, people put off buying things in the expectation that prices will fall even further, depressing demand. Facing shrinking markets, the capitalists also find their profits squeezed by falling prices. At the same time, while real wages are rising (pay packets can buy more as prices fall) the bosses inevitably attempt to reduce their wage costs by launching attacks on nominal wages or by sacking workers. Either way, cutting the wage bill undermines purchasing power and strengthens the forces of stagnation.
The most severe effect of deflation, however, is that it increases the burden of outstanding debts by pushing up real interest rates (the rate that takes account of price changes). While inflation lowers the real cost of payment of interest and principal over time, thus favouring borrowers against lenders, deflation favours lenders. Interest on most business, consumer and housing loans (with the exception of some British mortgages) are fixed at the original nominal rate. As prices fall, however, the real rate rises (see glossary). This increases the burden (the real value) of existing debt at a time when the shrinking sales revenue of businesses and falling incomes of workers make it increasingly difficult to repay debt.
As deflation sets in, of course, nominal interest rates also tend to fall (though this does not help existing debtors with fixed rate loans or ‘high risk’ borrowers who are charged premium rates). Nominal interest rates, however, cannot fall below zero – negative nominal interest rates would mean banks paying borrowers to take out loans and charging savers to deposit their savings in the bank! But while the nominal rate cannot fall below zero, prices can continue to fall, continually pushing up real interest rates and twisting the deflationary screw.
The growing weight of debt, when the economy is stagnant, gives rise to a liquidity or debt trap. With incomes and profits squeezed, businesses find it increasingly difficult to service their debts. More and more default, and if the banks take steps to recover some of what is owed to them, debtor firms are forced into liquidation. An accumulation of bad debts increasingly becomes a problem for the banks and finance houses, threatening the most vulnerable with collapse. This is currently happening in Japan, were the banks officially acknowledge bad debts of around $500bn, though unofficial estimates put the true figure at about $1,000bn. Only huge injections by the Japanese government have prevented a catastrophic chain reaction of banking failures; but the bad debt problem remains unresolved. Naturally, in this situation the banks become increasingly reluctant to lend money to potentially risky borrowers, especially at virtually zero interest rates, even though, in the case of Japan, the Central Bank has made massive additional funds available to the banks in an attempt to stimulate business activity. Although base nominal interest rates are extremely low in both Japan and the US, banks and finance houses are in many cases charging business much higher premium rates for what they consider ‘high risk’ investments.
Under conditions of stagnation or slump, price deflation has historically been linked to asset price deflation, a collapse of share and property prices. This was certainly true in the 1930s, and has applied to Japan since its bubble burst at the end of the 1980s. During a boom, especially one dominated by financial speculation, share and property prices are enormously inflated. Speculative activity is invariably financed by borrowing (relatively low interest rates compared to high levels of speculative profits). The scramble for shares and property pushes up their prices, and these inflated assets are in turn used as collateral to secure new loans to buy more assets – and so on, and so on. A crash is inevitable at a certain point, when much of the inflated value will be wiped out. This precipitates a chain reaction of bankruptcies, deepening the downward economic spiral.
Japanese capitalism is a currently classic example of this kind of debt deflation. In the 1980s, the Japanese government deliberately encouraged the growth of the bubble as a cheap method of financing the modernisation of the leading sectors of the Japanese economy on the basis of the latest technology. This was aimed at increasing Japanese capitalism’s share of world export markets, especially in the high-value, hi-tech sectors. This resulted, however, in enormous overcapacity, which together with international factors resulted in deflation during the mid-1980s. The Japanese bubble burst after the international financial crisis of 1987, and Japanese capitalism has never recovered. Property prices have fallen over 80% since their 1988 peak, while shares have fallen to a 20-year low.
The bad debts of the banks are steadily increasing, a time-bomb under Japanese and world capitalism. The early 1990s were marked by disinflation, the result of a combination of factors: excess capacity, the bank crisis, slackening consumer demand, and competitive price pressure from imports (especially from countries like China). After 1994 disinflation turned into deflation, which has continued until the present time, hovering around -1%. Growth has been stagnant, with the economy going through three recessions in 13 years. While there are undoubtedly differences between Japan, and the US and Germany, the latter two nevertheless face conditions very similar to those that existed in Japan in the early 1990s.
An economic quick-sand
IF DISINFLATION AND deflation are the symptoms, what are the underlying causes of the disease? In fact, features of the two different variants of the disease are combined in the current outbreak:
(1) Prices have been depressed by massive worldwide overcapacity resulting from a long period of relatively weak and declining growth in the world economy. Despite the technology boom and the emergence of the Asian tigers in the late 1980s-early 1990s, globalisation did not stimulate an overall acceleration of growth internationally. According to UN statistics, world GDP grew at an annual rate of 5.4% in the 1960s, 4.1% in the 1970s, 3% in the 1980s, and 2.3% in the 1990s. This was inevitably accompanied by weakening demand for goods (not that millions did not need goods, but their needs were not backed by money). At the time of the Asian crisis in 1997, the then chairman of General Electric (GE), Jack Welch, said: "There is excess global capacity in almost every industry". (New York Times, 16 November 1997) Neo-liberal policies boosted capitalist profits, but cuts in wage levels and social spending shifted the distribution of wealth sharply away from the working class - further undermining the market for capitalist goods. In 1998 The Economist warned of "a malign deflation caused by excess capacity and weak demand", commenting that the gap between sales and capacity was "at its widest since the 1930s". (30 November 1998) Since then, the oversupply of goods has further undermining the capitalists’ ‘pricing power’ (their ability to raise prices). This variant of deflation is comparable to the ‘demand shock’ deflation of the 1930s, though it has not yet become so acute, even in Japan. It is combined, however, with ‘supply shock’ deflation comparable with that of the last quarter of the 19th century.
(2) Prices have also been steadily depressed, especially in the late 1980s and the 1990s, by the application of new technology, which has cut costs by raising productivity and saving labour, materials and energy. New technology, especially in communications, under conditions of a deregulated global economy, allowed the multinational corporations and speculative investors to relocate manufacturing in low-cost countries, such as China. (China combines features of supply-led deflation, produced by the growth of new, foreign-financed industries, with demand-led deflation, resulting from the stagnation or collapse of state-owned enterprises and the growth of mass urban and rural unemployment.) This began in labour-intensive sectors such as garments, shoes, toys, etc, but has been spreading to microchips, televisions, motor vehicles, and computers. Despite existing overcapacity in major industries, corporations have continuously invested in new plant and equipment in a ruthlessly competitive drive to cuts costs and increase their market share at the expense of their rivals. Globalisation has intensified this predatory competition, continuously driving down prices and adding to world overcapacity. While the volume of world exports grew by 7.3% per annum during 1991-2000, the price of manufactured exports declined by -0.8% per annum. This variant of deflationary pressure, particularly strong in China, resembles the ‘supply shock’ deflation of the 1880s, but it has developed (unlike the later 19th century) under conditions of international stagnation, which has produced demand-led deflation.
"If caused by rapid productivity growth, as in the late 19th century", comments The Economist, "it [deflation] can go hand in hand with robust growth. But if prices are falling because of a slump in demand, deflation can be dangerous. Today the world exhibits both sorts of deflation, but the vast amount of excess capacity suggests that it is mainly of the bad sort". (Hear that hissing sound? The Economist, 17 May 2003) Big business was to some extent cushioned from the full effects of overcapacity and the loss of pricing power, first by the rapid growth of the Asian tigers and other ‘emerging markets’ up to 1997, and then by the speculative bubble of 1998-2000 in the US and elsewhere. For a time, these developments provided highly profitable markets for both investment and consumer goods in some sectors and certain regions of the world economy. Even after the speculative bubble burst, relatively high levels of consumer spending, linked to the housing bubble and financed by record levels of debt, have postponed a precipitate collapse of demand. Prolonged stagnation since 2000, however, with rapidly rising levels of unemployment in the advanced capitalist countries, has once again brought the problem of overcapacity and the decline of demand to the fore.
"The immediate danger isn’t deflation per se", writes the economic commentator, Paul Krugman, "it’s the risk that the world’s major economies will find themselves trapped in an economic quagmire. Deflation can be both a symptom of an economy sinking into the muck, and a reason why it can sink even deeper, but it’s usually a lagging indicator. The crucial question is whether we’ll stumble into the swamp in the first place – and the risks look uncomfortable high". (Fear of a quagmire? New York Times, 24 May)
A policy impasse
IN RECENT MONTHS, economic strategists within the US Federal Reserve and the IMF have been debating the issue of deflation, largely behind closed doors. The question they are grappling with, of course, is what policies they should adopt to avert the danger of a deflationary spiral in the US. The experience of Japan is hardly encouraging. A recent study of Japan by the Fed concludes that the Japanese authorities did too little, too late. But the Fed has little useful advice to offer now, and it is uncertain, to say the least, whether more aggressive policy measures could have averted the onset of deflation in the mid-1990s.
The stagnation of the last 13 years is the result of the collapse of Japan’s 1980s bubble economy. There was massive overcapacity and a decline of demand. The slump in share and property prices left a mountain of bad debts, paralysing the banking system. Workers and the middle class attempted to pay off debts, while reducing their expenditure. Massive government public spending projects (mostly on big construction projects) ameliorated the slump but failed to lift the economy out of stagnation. The Bank of Japan steadily reduced interest rates to virtually zero and made vast funds available to the banks – but there was no incentive for banks to make new loans, or for companies to make new investments. As the deflationary trend got under way after 1994, Japanese capitalism became caught in the liquidity trap. The deflationary spiral has deepened, and there is the possibility of an even sharper downturn. Given the decisive role played by Japanese capital in supporting the US dollar (by hoarding huge dollar reserves) and in financing the US’s debt to the rest of the world (by purchasing US bonds and investing in the US economy), that would have a devastating effect on the US and world economy.
The US economist, Paul Krugman, is a lonely voice calling on the Japanese government to turn to a policy of deliberately stimulating a prolonged period of mild inflation (between 2% and 4%) to stimulate spending and revive investment. The theory is that if money is losing its value through inflation, people will spend sooner rather than later. Most bourgeois strategists, however, are not persuaded that attempts to inject massive additional liquidity into the economy would actually have the desired effect. Capitalist leaders in Japan and elsewhere, moreover, fear that once inflation was triggered, it could quickly accelerate into runaway inflation – a return to stagflation!
In Europe, Germany is already following Japan’s lead. In contrast to the US Federal Reserve, however, the European Central bank (ECB) has been very cautious in cutting interest rates (cut to 2% in May) and has maintained a tight money supply. Wim Duisenberg, head of the ECB, appears to be more concerned about imaginary waves of inflation than the quick-sands of deflation into which they are actually stumbling. At the same time, the fiscal regime of the eurozone, under which budget deficits are supposed to be kept under 3% of GDP, imposes a restrictive policy on economies, like Germany, France, Netherlands, and Italy, which are currently approaching zero growth. This demonstrates the perverse effect of the one-size-fits-all euro straitjacket, which will deepen the contradictions within European capitalism. The eurozone slowdown, moreover, has been accentuated by the rise of the euro against the dollar (by around 30% since May 2002), which has hit eurozone exports. As in Japan in the late-1990s, further cuts in eurozone interest rates are likely to come too late to arrest Germany’s deflationary trend, which could become a downward spiral ensnaring other EU economies.
In the US, Greenspan coyly refers to "the probability of an unwelcome substantial fall in inflation" (Fed statement, 6 May), avoiding the dreadful D-word. But there is no doubt that the Fed leaders are seriously concerned about the danger of deflation. After seeing what happened in Japan, the Fed moved quickly in January 2001 after the bubble burst, and again after 9/11, to reduce interest rates and expand the money supply. After a dozen cuts, rates have been reduced to 1.25%, the lowest level for 40 years, and they may soon be cut to 1% – virtually zero. This action undoubtedly prevented a severe slump but, at the same time, has not brought the recovery that Greenspan promised. US banks are not so weighed down with bad debts as their Japanese counterparts, but many US corporations have huge debts while household debt has reached record heights. Moreover, although Bush’s tax cuts for the super-rich will produce a growing Federal deficit, extra Federal spending on arms and security is likely to be more than offset by cuts in spending by the states (mostly imposed by cuts in Federal grants). Unemployment is still rising, and a growth rate under 3% will not prevent unemployment and overcapacity from rising further. All these factors point towards the likely development of deflation. A decline of the dollar, which will make imports more expensive in dollar terms, may tend to counteract falling prices; but this effect is likely to be limited, as overseas producers of manufactured goods will (as they already are) try to reduce any rise in the dollar price (accepting lower profits) in order to maintain their share of the US market. Japan’s slide into deflation developed slowly over a period of ten years, and the US could well be following the same path. With interest rates at 1.25% and ample liquidity, monetary policy appears to be approaching the limits of its effectiveness. As Keynes said, cutting interest rates at a time of weak demand and over-capacity is like pushing a piece of string.
19 June 2003
A short history of inflation & deflation
THROUGHOUT THE period since the end of world war two, bourgeois leaders have been preoccupied, if not obsessed, by the danger of inflation. They remained haunted by the hyper-inflation that convulsed Weimar Germany in the 1920s, which they blamed (somewhat simplistically) for revolutionary upheavals and the rise of fascism. Despite the relatively low inflation of the post-war upswing period the ideologues of big business considered that the Keynesian framework (the ‘welfare state’ and state intervention to sustain demand and full employment) had a built-in ‘inflationary bias’. Historically high rates of GDP and productivity growth, however, allowed governments to expand the public sector without provoking serious inflation. In the advanced capitalist countries, inflation rose from around a negligible 2% per annum in the 1950s to around a tolerable 4% in the 1960s.
As the upswing exhausted itself, however, and profits and investment declined, inflation began to climb (to an average in 1969-73 of 6.4% in Europe and 4.9% in the US). Inflationary tendencies in US capitalism (exacerbated by spending on the Vietnam war) were transmitted to the world economy. After the oil price shock of 1973, which marked the end of the upswing, inflation surged (averaging over 10% in Europe during 1973-79 and exploding in some countries to well over 20% in some years). Rapidly rising prices eroded the real value of debts, favouring borrowers against lenders. High inflation accentuated economic instability and provoked massive wage struggles by organised workers. Big banks and wealthy investors in government bonds feared that governments would increasingly resort to the ‘monetisation’ of their national debt – that is, rather than relying on tax revenue and loans, they would simply print money to cover their budget deficits, opening the door once again to hyper-inflation. In the late 1970s, therefore, leaders of major capitalist powers took a strategic decision to squeeze inflation out of the world economy.
Led by the US and Britain, the ruling class turned to ‘monetarism’ (high interest rates and a restricted money supply) and the policies since known as neo-liberalism – an assault on workers’ organised strength, cuts in social spending, reduction of state investment in economic infrastructure, deregulation of finance and industry, privatisation of services, etc. Together with the development of new technology and globalisation, especially the location of manufacturing in low-cost countries, this produced a widespread trend of disinflation – that is, a broad slowing-down of the rate of price increases – in the 1980s and especially during the late 1990s. Even so, capitalist leaders still feared that inflation could easily rear its head again. In 1994, for instance, just as the US economy was beginning to climb out of the prolonged recession after 1990, Greenspan clamped on the brakes, by raising the interest rate. The recovery faltered, and Greenspan turned back to a policy of relaxing credit. More recently, the ECB has been very slow to follow the US Federal Reserve in lowering interest rates. Despite the stagnation in the core euro-zone economies and the appearance of deflationary trends in Germany, Duisenberg, the head of the ECB, appears to be more concerned about the ghost of inflation than the reality of deflation, like a general still fighting the last war. Less blinkered bourgeois strategists, however, clearly recognise the growing danger posed by a generalised and sustained fall in prices, and are beginning to re-examine the past experience of deflation.
The Great Depressions
HISTORICALLY, WORLD capitalism went through two major periods of deflation, during the last quarter of the 19th century and in the 1930s. Both periods were in turn know as ‘the great depression’, but their characteristics were quite different, and it was the later period which threatened the survival of the system. During the nineteenth century, as capitalism developed on a world scale, there was a long-term trend for prices to decline gradually. In the 1870s and early 1880s, however, there was a sustained episode of deflation. This cut the capitalists’ rate of profit, caused debt problems for farmers in particular, and gave rise to a series of financial crises. At the same time, falling prices increased the real wages of sections of workers, giving them the confidence to struggle for trade union rights. Overall, however, the leading capitalist economies continued to grow. In fact, it was a period of intensive and extensive capitalist growth internationally. The application of new technology to production and transportation raised productivity and produced a plentiful supply of goods, which resulted in lower prices. (Apart from the expansion of the productive forces, a restricted money supply may also have been a contributing factor, as there was in that period a shortage of gold, the basis of the major currencies under the Gold Standard.)
The deflation of the inter-war period had a devastating effect on world capitalism. Falling prices were not the result of expanded production under conditions of worldwide growth, but the product of a slump in demand and massive over-production. The deflationary shock was triggered by the deep slump of 1929-33 in US capitalism, which dragged the rest of the world down with it. The slump followed the speculative boom of 1925-29, particularly frenzied in the US but paralleled by cyclical booms in Britain and elsewhere. The financial bubble burst when the slump in production and profits made itself felt. The sharp decline of producer and consumer prices reflected the collapse of demand and massive over-production, but the deflation inevitably exacerbated the crisis. Deflation made debt more expensive, and together with the collapse of share and property prices, this precipitated a banking crisis and a breakdown of the world financial system. The international crisis was undoubtedly aggravated by a deliberate policy on the part of the US, Britain and other powers of maintaining the Gold Standard, which severely restricted international liquidity.
1929-30 was a classic slump in the US, with massive overproduction and mass unemployment. It was followed, however, by an avalanche of bank failures, debt deflation, and depression – the classic example of a deflationary spiral. During 1929-33 real GDP fell by 30%, industrial production by 46%; unemployment rose to 25% or about 13 million workers. Prices, which had been steady between 1921-29, fell by 24% during 1929-33. Over a quarter of US banks collapsed (about 6,000), wiping out the savings of about six million families. The problems were compounded by the Fed’s policy of tightening the money supply, which fell by 30% during 1924-33 (a mistake that it has not repeated in the last three years). Each turn of the deflationary spiral further depressed demand for goods, pushing back any recovery of profits and investment. The dominant position of US capitalism ensured the transmission of deflation to other economies, with Japan and Sweden experiencing particularly sharp falls in prices (-25% and -20% respectively).
Surveying contemporary analyses of the 1930s slump, J Bradford DeLong, professor of economics at UC Berkley, comments that explanations were ‘widely divergent’: "Nevertheless, almost every analyst of the great depression placed general deflation – and the chain of financial and real bankruptcies that it caused – at or near the heart of the worst macroeconomic disaster the world has ever seen". (Why We Should Fear Deflation, March 1999, www.j-bradford-delong.net) Though ‘at or near the heart’ of the crisis, deflation was the process through which deeper contradictions of capitalism worked themselves out. The slump arose from a classic crisis of over-accumulation of capital. During 1925-29 in the US there was a strong investment boom and the rapid emergence of new, advanced technology industries. But the intensified exploitation of the working class and their reduced share of the wealth undermined the workers’ ability to purchase goods and services – and therefore the capitalists’ ability to realise profits on their capital investments.
PRICES: Trends in the broad range of prices (aggregate prices) are measured by several indexes. Inflation/deflation is usually calculated by the trend in consumer prices, measured by the consumer or retail price index (CPI or RPI). The index measurers the average price of a typical ‘basket’ of consumer goods and services (and also mortgage payments, council tax etc) purchased by the average household. The ‘headline’ rate refers to the whole ranges of prices included in the basket, while the ‘core’ rate, often referred to by economic commentators, excludes the mortgage rate, fuel prices, seasonal fresh food, etc.
But deflation/inflation can also be expressed in terms of the GDP deflator which measures the rise/fall of prices of a much broader range of goods and services that make up the gross domestic product (GDP) or in terms of the product price index, which measures the rise/fall of factory gate prices of goods produced. The recent deflationary trend has developed first and most strongly in product prices (as compared to consumer prices), reflecting intensified international competition in core industries under conditions of overcapacity and falling demand.
INFLATION: A general increase in prices, usually measured by the index of consumer or retail prices (the CPI or RPI). The rate of inflation is also measured by the index of wholesale or product prices (charged by the producers) or by the index for GDP prices (the ‘GDP deflator’).
Inflation means that the purchasing power of a unit of currency (pound, dollar, euro, etc) has been reduced. Put simply, people have to pay more for the same goods or services. Inflation arises when (a) rising costs (of materials, energy, labour or credit) per unit of output push up prices or (b) when purchasing power or the money supply (through increased public spending, an expansion of credit, etc) rise ahead of output, or (c) by a combination of these so-called ‘cost push’ and ‘demand pull’ factors.
During periods of economic upswing (for example, 1950-73), the growing economy goes through a ‘boom and bust’ cycle. Peaks (the booms) were typically marked by short-term, cyclical inflation. Increasing interest rates, or increasing taxes, tipped the cycle over into short-term bust (but always against a background of growth). In periods of crisis, however, such as 1973-79, following the end of the post-war upswing, capitalism can be hit by chronic inflation, with rapidly accelerating price increases, tipping into ‘stagflation’, that is high rates of inflation accompanied by high unemployment and stagnant levels of growth.
Historically, the most notorious episode of hyper-inflation, was that which convulsed German capitalism in the aftermath of World War I. In a desperate attempt to stave off economic collapse and socialist revolution in 1921-23, the shaky government of Weimar Germany furiously printed banknotes to finance government expenditure (rather than increasing taxation or raising new loans) in order to devalue the unsustainable burden of national debt due to ‘reparations’ demanded by the victors. In June 1923 prices peaked at nearly 20,000 times their 1914 level – workers needed a barrow-load of notes to buy a sandwich. German hyperinflation and its consequences has haunted the bourgeoisie ever since.
DISINFLATION: A steady slowing down of the rate of inflation.
DEFLATION: A steady across-the-board fall in prices (especially of manufactured goods). Prices may fall (a) as a result of the expansion of production, productivity increases, and cheaper transport, as in the last quarter of the 19th century; or (b) as a result of a broad decline in demand for goods and services, resulting in overcapacity and intensified inter-capitalist competition, as in the 1930s or Japan in the last decade; or (c) a combination of these trends, as in the current world situation.
‘DEFLATION’: In the sense of a deliberate deflationary policy refers to government measures (such as some combination of higher interest rates, tax increases, tighter money supply, and public spending cuts) aimed at reducing purchasing power in an attempt to reduce prices. In other words, it is an anti-inflationary policy.
ASSET PRICE DEFLATION: Refers to a fall in shares and bonds. Strictly speaking, it is a separate phenomenon from price deflation, but in periods of economic depression such as the 1930s or in Japan since 1990, the collapse of share and property prices has interacted with price deflation to exacerbate the deflationary spiral. In particular, the collapse of share and property prices (as in Japan) drastically reduces the value of collateral used as security for loans; if the banks start selling off these collateral assets on a big scale to cut their losses, they inevitable drive down share and property prices even further. The downward spiral caused by a combination of price deflation and asset price deflation is often referred to as debt deflation.
INTEREST RATES: Loan contracts (for business loans, consumer finance, mortgages, etc) are made on the basis of a nominal rate of interest - the ‘face value’ of the debt. Internationally, most loans are made on the basis of a fixed nominal rate, though many British mortgages are exceptional in having variable nominal rates. The real interest rate takes into account changes in aggregate price levels (measured by the consumer price index). The nominal and real rates coincide only in the unlikely situation of ‘price stability’, that is zero inflation/deflation.
Inflation (prices rising, so each monetary unit will buy less and is therefore devalued) effectively reduces the real cost of repayments of principal and interest. For instance, fully repaying a one-year loan of £100 at 10% per annum nominal interest rate costs £110. But after a year, with inflation of say 10% per annum, the £110 would only purchase the same basket of goods that £100 had bought at the beginning of the loan period. To calculate the real interest rate, the rate of inflation is deducted from the nominal rate. With a nominal interest rate of 6% and inflation of 2%, the real interest rate would be 4%. With a nominal interest rate of 15% and 10% inflation, the real rate would be 5%. If inflation suddenly accelerates, there can be (usually very temporarily) a negative real interest rate: a nominal rate of 15% with 17% inflation, would mean a real interest rate –2%. Good for borrowers, bad news for lenders. Low or sometimes negative real interest rates developed during the ‘stagflation’ of the late 1970s, which is why in the early 1980s US capitalism led a world-wide turn (starting with high interest rates) towards anti-inflationary, ‘monetarist’ policies to defend the interests of the big banks and finance houses.
Deflation (prices falling, so each monetary unit buys more and is therefore appreciating in value) effectively increases the real cost of repayments of principal and interest. For instance, fully repaying a one-year loan of £100 at 4% per annum nominal interest rate would cost £104. But with deflation running at 2% per annum the £104 would purchase 6% more goods. To calculate the real interest rate, the rate of deflation is added to the nominal rate. A nominal interest rate of 4% with 1% deflation gives a real rate of 5%. A nominal rate of 1.25% with 2% deflation would mean a real rate of 3.25%. Nominal rates cannot fall below zero – that would mean banks paying borrowers to borrow. In a deflationary period, businesses and savers simply hoard their cash since its purchasing power increases as prices fall. This has been the situation in Japan over the last few years with the government desperately trying to persuade people to spend.
WAGES: Nominal wages (or incomes) are expressed in monetary units (pounds, dollars, euros, etc), while real wages take account of across-the-board price changes (inflation or deflation) as measured by the CPI or RPI. If prices fall, wages can buy more – in other words, deflation raises real wages. Under deflation, bosses complain about the problem (in economists’ jargon) of ‘sticky wages’ – that is, workers resist wage cuts, so nominal wages do not automatically adjust downwards as prices fall. With inflation, price rises erode the value of real wages without the bosses doing anything, while capitalists can sell their products at higher prices – which is why steady, mild inflation has often had a stimulating effect on growth during upswing periods.