WHY WE SHOULD NOT FEAR THE SPECTRE OF DEFLATION / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

Why we should not fear the spectre of deflation

By Edward Gottesman

Published: February 14 2010 19:56

No one has a good word to say about deflation. The ghosts of the Great Depression are invoked even as signs of recovery appear in most economies hit by the financial crisis. Pundits warn that prices and wages may fall and set off “a pernicious round of deflation” if monetary and fiscal subsidies are withdrawn too soon.

Japan’s “lost decade” is cited as a cautionary example. Yet bad policies, internal rigidities and demographic trends were primarily to blame for the long-term structural damage after the bursting of the 1980s bubble. Deflation was a symptom, not the disease.

From 1865 to 1895, the US had persistent deflation. During that period, industry flourished. While the monetary value of assets declined, businesses produced real output from innovation, capital investment and human resources, without illusory gains from currency depreciation. In contrast, 40 years of inflation in the US and UK have led to damaging imbalances. Although central banks have finally tamed consumer price inflation, excess money growth has fuelled repeated asset bubbles.

Inflation’s perverse incentives encourage debt. Youth have become chronic borrowers, believing that government will repay part of their loans by slow, but inexorable, debasement of the currency. Despite more than 15 years of growing personal indebtedness, governments still encourage consumption and penalise savers by maintaining artificially low interest rates. That tempts households to borrow more and investors to incur risk.

Savings and investment are vital for a dynamic, balanced economy. They have three sources: households, businesses and government. When households have little incentive to save, investment must come from the other two. Governments can save only if taxes exceed expenditure. California’s experience suggests that voters in Anglo-Saxon countries will not support higher taxes. The burden of saving thus tends to fall on companies.

Since the second world war, businesses have increasingly used retained earnings, third-party insurance and pension funds to promise future benefits to employees. To fund these, large pools of financial assets have accumulated in collective savings institutions run by self-selected investment professionals with little experience of private business and non-traded assets. This paved the way for private equity managers, who plunged into debt up to the hilt and earned egregious personal rewards. Their model relies on short-term financial engineering and “exit strategies”, not sustainable profits.

Inflation-fuelled debt is encouraged by deductibility of interest in assessing corporate tax. High returns to leveraged capital helped create the over-sized finance sector that became a breeding ground for the financial crisis. Periodic deflation would reverse that asymmetric bias. It need not spiral downward. Recent experience shows that deflation can be controlled by monetary and fiscal policies. Stimuli should focus on income-producing investment, not consumption.

The trend to lower debt and higher savings can be supported by raising interest rates to “normal” levels and eliminating corporate tax deductions for interest. That might prolong the cyclical recession, but fiscal stimulus for productive investment could mitigate the impact. Governments should restore the 100 per cent first-year allowance for capital expenditure and introduce tax credits for new employment that generates positive cash flow per employee. Higher interest rates would deter financial speculation, asset bubbles and profligate consumption, as well as closing businesses with marginal profitability.

Deflation promotes saving. Creditors win; debtors lose. Once savings rates are restored, prudent consumption and income-producing investment will follow. Encouraging savings can also relieve big government deficits. Counter-cyclical spending by governments can be financed by domestic savings, guaranteeing long-term income to savers. As the business cycle, innovation and a better balance between the returns to labour and capital generate higher real incomes, tax revenues will automatically rise to pay down government debt.

Deflation can help kick the debt habit. Going “cold turkey” is painful, but saving and investing before spending can improve the western world’s financial health.

The writer is a US lawyer practising in London and author of Credit Crisis 101, which was published in World Economics in September 2008

Copyright The Financial Times Limited 2010.