Wednesday, October 30, 2002


This week on Life Matters with Geraldine Doogue I discussed deflation, as I had on The Business Show on SBS TV on Sunday.

If you haven't thought much about deflation, that's okay. Many Australians hadn't thought much about inflation back at the start of the 1970's. They needed to be convinced that it could be a problem. That's the sort of situation we are in now with deflation. It is happening. Price indexes are falling in China, Japan, Singapore, Hong Kong and Taiwan. They are on the edge of falling in Europe, and may soon fall in the United States. But is it a problem?

Japan's problems are well known - but there's more than deflation involved. The argument is that falling prices encourage consumers to put off spending in the expectation that prices will fall further, which encourages producers to cut prices to try to sell goods. And so on. Also loans become harder, not easier, to repay over time, forcing investors to sell assets, which pushes down the value of houses etc. in another downward spiral.

Well, that's the argument. On Life Matters and on the Business Show I asked whether deflation was really that bad, just as skeptics asked the same about inflation in the early 1970's. The answer may be that it is a question of degree. Mild inflation (two or three per cent) probably doesn't encourage consumers to bring forward spending, just as mild deflation probably doesn't encourage them to postpone it. As the macroeconomist Barry Hughes asked me: If you save $200 on the price of a $20,000 car by delaying buying for a year, would you do it?

And the downward asset price spiral caused by the inability to pay off loans is probably unlikely to take hold while interest rates are falling.

Which brings us to the real fear about deflation - seen in Japan, that it'll be impossible to get out of by cutting interest rates. In Japan they are already at zero.

The US Fed has studied what happened in Japan and it finds that there's a fundamental asymmetry in the management of prices. Interest rates can always be pushed high enough to kill inflation, but they can't necessarily be pushed low enough to kill deflation. Therefore it says central banks should err on the side of caution when deflation is a possibility. It's better to have prices moving up too much than it is to have prices moving down too much. You can always correct inflation. You can't always correct deflation. It is a message Australia's Reserve Bank is probably taking on board.

So, does Australia need to worry? Our CPI looks healthy - it is moving up at the rate of 3.2 per cent a year, but within that, the price of goods is scarcely moving at all. The price index for private sector goods moved up only 0.1 per cent in the September quarter. And this after three years in which our dollar has devalued against the US by about 30 per cent. So deflation is clearly knocking on our door. But against that most of what we do in Australia is not particularly affected by the price of manufactured goods. Australia specialises in mining, agriculture and services. We may be one of the last countries in the world to succumb to worldwide deflation should it take hold. Although we would certainly be affected by any worldwide recession that resulted.