The articles linked below look at the dangers of deflation and policies of central banks to counter it.
Deflation in economics has three meanings. The first is falling prices: i.e. negative inflation. The second, more traditional meaning, is a fall in real aggregate demand, resulting in lower output, higher unemployment and lower inflation – and quite possibly an actual fall in the price level. These first two definitions describe what is generally seen as an undesirable situation. The third is a slowing down in the growth of real aggregate demand, perhaps as a result of a deliberate act of fiscal and/or monetary policy. This third meaning could describe a desirable situation, where unsustainable growth is reduced and inflation is reduced from an above-target level.
Here we focus on the first definition. The first two articles look at the dangers of a fall in the price level. The chart below shows falling inflation, although not actually deflation, in China, France, Germany and the UK (click here for a PowerPoint). Several European countries, however, are experiencing actual deflation. These include: Greece, Spain, Hungary, Poland and Sweden. Inflation in the eurozone for 2014 is expected to be a mere 0.5%.
The most obvious danger of deflation (or expected deflation) is that people will delay spending on durable goods, such as cars, furniture and equipment, hoping to buy the items cheaper later. 
The result could be a fall in aggregate demand and a fall in output and employment.
For retailers, this is all spelling Christmas doom. Already the runup to the most crucial time of the year for shops is being characterised by a game of chicken. Shoppers are wondering how long they can leave their festive buying in the hope of late bargains.
Interest rates may be low, but for people with debts, this is being offset by the fact that inflation is no longer reducing the real value of that debt. For people with credit card debt, personal loans and most mortgages, the interest rate they pay is significantly above the rate of inflation. In other words, the real interest rate on their debt is still significantly positive. This may well discourage people from borrowing and spending, further dampening aggregate demand. And, with a Bank Rate of just 0.5%, there is virtually no scope for lowering the official interest rate further.
At least in the UK, economic growth is now positive – for the time being at any rate. The danger is becoming more serious, however, in many eurozone countries, which are already back in recession or close to being so. The ECB, despite its tentative steps to ease credit conditions, it moving closer to the day when it announces full-blown quantitative easing and buys sovereign bonds of eurozone countries. The Bank of Japan has already announced that it is stepping up it QE programme – a vital ingredient in getting Abenomics back on track and pulling Japan out of its latest recession.
In the USA, by contrast, there is little danger of deflation, as the US economy continues to grow strongly. The downside of this, has been a large rise in consumer debt (but not mortgages) – the ingredients of a possible future bubble and even a new financial crisis.
Forget what central bankers say: deflation is the real monster The Observer, Katie Allen (23/11/14)
Why Deflation Is Such A Big Worry For Europe NPR, Jim Zarroli (31/10/14)
Exclusive: China ready to cut rates again on fears of deflation – sources Reuters, Kevin Yao (23/11/14)
Central Banks in New Push to Prime Pump Wall Street Journal Jon Hilsenrath, Brian Blackstone and Lingling Wei (21/11/14)
Are Central Banks Panicking? Seeking Alpha, Leo Kolivakis (21/11/14)
Questions
- What are (a) the desirable and (b) the undesirable consequences of deflation? Does the answer depend on how deflation is defined?
- What is meant by a ‘deflationary gap’? In what sense is ‘deflationary’ being used in this term?
- Why have oil prices been falling? How desirable are these falls for the global economy?
- Is there an optimal rate of inflation? If so, how would this rate be determined?
- The chart shows that inflation in Japan is likely to have risen in 2014. This in large part is the result to a rise in the sales tax earlier this year. If there is no further rise in the sales tax, which there will probably not be if Mr Abe’s party wins the recently called election, what is likely to be the effect of the 2014 tax rise on inflation in 2015?
- If the Bank Rate is below the rate of inflation, why are people facing a positive real rate of interest? Does this apply equally to borrowers and savers?
- In what sense is there a cultural revolution at the Bank of England?
Since coming to office two years ago, Shinzo Abe’s government has been determined to revive the Japanese economy. The policy has involved ‘three arrows‘: expansionary fiscal policy, expansionary monetary policy and supply-side reforms. But figures just out show that the Japanese economy is back in recession. The economy shrank by 0.4% in quarter 3, having shrunk by 1.9% in quarter 2.
This has come as a huge disappointment for Mr Abe, who has staked his political reputation on escaping from deflation and achieving sustained economic growth. In response, he has called a general election to put a revised economic plan to the electorate.
The main cause of the reversal into recession has been an increase in the sales tax on all goods, which has dampened spending. The tax rise, planned by the previous government, was to help reduce the deficit and start tackling the huge public-sector debt, which, at over 230% of GDP, is by far the highest in the developed world. Another rise in sales tax is due in October 2015 – from 8% to 10%. Mr Abe hopes to cancel the rise and it is this that he may put to the electorate.
So what is the outlook for Japan? Will quarter 4 show economic growth, or will pessimism have set in? Will the Bank of Japan introduce even more quantitative easing, or will it wait for the latest increase in QE to take effect (see the blog post, All eased out: at least for the USA and UK)?
The following articles look at the implications of the latest news, both for Japan and globally, and at the options for the government and central bank.
Articles
Japanese economy falls into surprise recession Independent, Maria Tadeo (17/11/14)
Japan’s economy makes surprise fall into recession BBC News (17/11/14)
Coming to a crunch: Time is running out for Abenomics The Economist (20/11/14)
Japan’s economy: Delay the second consumption tax hike The Economist (17/11/14)
Defying Expectations, Japan’s Economy Falls Into Recession New York Times, Jonathan Soble (16/11/14)
Japan shocks as economy slips into recession CNBC, Li Anne Wong (17/11/14)
Japan Unexpectedly Enters Recession as Abe Weighs Tax: Economy Bloomberg, Keiko Ujikane and Toru Fujioka (17/11/14)
The world should be wary: Japan’s economic woes are contagious The Guardian, Larry Elliott (17/11/14)
Why is Japan heading to the polls? BBC News (18/11/14)
Previous news items on this site
A new economic road for Japan? (January 2013)
A J-curve for Japan? (May 2013)
Japan’s three arrows (June 2013)
Abenomics – one year on (December 2013)
Japan’s recovery (January 2014)
Japan’s CPI: An Update (May 2014)
All eased out: at least for the USA and UK (November 2014)
Data
Quarterly Estimates of GDP Japanese Cabinet Office
Japan and the IMF IMF Country Reports
Economic Outlook Annex Tables OECD
Questions
- Give details of the Japanese government’s three arrows.
- Discuss the pros and cons of the rise in the sales tax. Is it possible for the rise in the sales tax to increase the size of the public-sector deficit?
- What have been the effects of Japanese government policies on (a) prices of goods and services; (b) living standards; (c) asset prices?
- Who have been the gainers and losers of the policies?
- How is the Japanese situation likely to effect the value of the yen? How is this, in turn, likely to affect its trading partners? Could this set off a chain reaction?
In his 1971 book, Income Distribution, Jan Pen, a Dutch economist, gave a graphic illustration of inequality in the UK. He described a parade of people marching by. They represent the whole population and the parade takes exactly one hour to pass by. The height of each person represents his or her income. People of average height are the people with average incomes – the observer is of average height. The parade starts with the people on the lowest incomes (the dwarfs), and finishes with those on the highest incomes (the giants).
Because income distribution is unequal, there are many tiny people. Indeed, for the first few minutes of the parade, the marchers are so small they can barely be seen. Even after half an hour, when people on median income pass by, they are barely waist high to the observer.
The height is growing with tantalising slowness, and forty-five minutes have gone by before we see people of our own size arriving. To be somewhat more exact: about twelve minutes before the end the average income recipients pass by.
In the final minutes, giants march past and then in the final seconds:
the scene is dominated by colossal figures: people like tower flats. Most of them prove to be businessmen, managers of large firms and holders of many directorships and also film stars and a few members of the Royal Family.
The rear of the parade is brought up by a few participants who are measured in miles. Indeed they are figures whose height we cannot even estimate: their heads disappear into the clouds and probably they themselves do not even know how tall they are.
Pen’s description could be applied to most countries – some with even more dwarfs and even fewer but taller giants. Generally, over the 43 years since the book was published, countries have become less equal: the giants have become taller and the dwarfs have become smaller.
The 2011 Economist article, linked below, uses changes in Gini coefficients to illustrate the rise in income inequality. A Gini coefficient shows the area between the Lorenz curve and the 45° line. The figure will be between 0 and 1 (or 0% and 100%). a figure of 0 shows total equality; a figure of 1 shows a situation of total inequality, where one person earns all the nation’s income. The higher the figure, the greater the inequality.
The chart opposite shows changes in the Gini coefficient in the UK (see Table 27 in the ONS link below for an Excel file of the chart). As this chart and the blog post Rich and poor in the UK show, inequality rose rapidly during the years of the 1979–91 Thatcher government, and especially in the years 1982–90. This was associated with cuts in the top rate of income tax and business deregulation. It fell in the recession of the early 1990s as the rich were affected more than the poor, but rose with the recovery of the mid- to late 1990s. It fell again in the early 2000s as tax credits helped the poor. It fell again following the financial crisis as, once more, the rich were affected proportionately more than the poor.
The most up-to-date international data for OECD countries can be found on the OECD’s StatExtracts site (see chart opposite: click here for a PowerPoint). The most unequal developed county is the USA, with a Gini coefficient of 0.389 in 2012 (see The end of the American dream?), and US inequality is rising. Today, the top 1% of the US population earns some 24% of national income. This compares with just 9% of national income in 1976.
Many developing countries are even less equal. Turkey has a Gini coefficient of 0.412 and Mexico of 0.482. The figure for South Africa is over 0.6.
When it comes to wealth, distribution is even less equal. The infographic, linked below, illustrates the position today in the USA. It divides the country into 100 equal-sized groups and shows that the top 1% of the population has over 40% of the nation’s wealth, whereas the bottom 80% has only 7%.
So is this inequality of income and wealth desirable? Differences in wages and salaries provide an incentive for people to work harder or more effectively and to gain better qualifications. The possibility of increased wealth provides an incentive for people to invest.
But are the extreme differences in wealth and income found in many countries today necessary to incentivise people to work, train and invest? Could sufficient incentives exist in more equal societies? Are inequalities in part, or even largely, the result of market imperfections and especially of economic power, where those with power and influence are able to use it to increase their own incomes and wealth?
Could it even be the case that excessive inequality actually reduces growth? Are the huge giants that exist today accumulating too much financial wealth and creating too little productive potential? Are they spending too little and thus dampening aggregate demand? These arguments are considered in some of the articles below. Perhaps, by paying a living wage to the ‘tiny’ people on low incomes, productivity could be improved and demand could be stimulated.
Infographic
Wealth Inequality in America YouTube, Politizane (20/11/12)
Articles
The rise and rise of the cognitive elite The Economist (20/1/11)
Inequality in America: Gini in the bottle The Economist (26/11/13)
Pen’s Parade: do you realize we’re mostly dwarves? LVTFan’s Blog (21/2/11)
Here Are The Most Unequal Countries In The World Business Insider, Andy Kiersz (8/11/14)
Inequality in the World Dollars & Sense, Arthur MacEwan (Nov/Dec 14)
Britain is scared to face the real issue – it’s all about inequality The Observer, Will Hutton (19/1/14)
The tame inequality debate FundWeb, Daniel Ben-Ami (Nov 14)
Is inequality the enemy of growth? BBC News, Robert Peston (6/10/14)
Data
GINI index World Bank data
List of countries by income equality Wikipedia
The Effects of Taxes and Benefits on Household Income, 2012/13 ONS (see table 27)
Income Distribution and Poverty: Gini (disposale income) OECD StatExtract
Questions
- Distinguish between income and wealth. Is each one a stock or a flow?
- Explain how (a) a Lorenz curve and (b) a Gini coefficient are derived.
- What other means are there of measuring inequality of income and wealth other than using Gini coefficients (and giants and dwarfs!)?
- Why has inequality been rising in many countries over the years?
- How do (a) periods of rapid economic growth and (b) recessions affect income distribution?
- Define ‘efficiency wages’. How might an increase in wages to people on low incomes result in increased productivity?
- What is the relationship between the degree of inequality and household debt? What implications might this have for long-term economic growth and future financial crises? Is inequality the ‘enemy of growth’?
The spectre of debt has awoken many of us in the night. Indebtedness is a key economic issue in the 2010s. Economists are devoting ever increasing amounts of research time trying to understand its impact on economic behaviour. This will not surprise you when you learn that the debt owed by the UK non-bank private sector to banks stood at £2.17 trillion at the end of September. This is the equivalent to 150% of annual GDP.
Chart 1 shows the stock of outstanding lending by Monetary Financial Institutions (banks and building societies) to the non-bank private sector bank since 1979. Back then the non-bank private sector had bank debt to the tune of around £70 billion or 10 per cent of GDP. Today’s figure is nearly 3000 per cent higher! Of this debt, around about 55 per cent is currently held by the household sector, 27 per cent by Other Financial Corporations (such as insurance companies and pension funds) and 18 per cent by private non-financial corporations. (Click here for a PowerPoint of the chart.)
Chart 2 shows the stocks of debt as percentages of annual GDP. We can infer from it that there are waves of growth in bank debt. Two notable periods are during the 1980s and again from the late 1990s up to the financial crisis of the late 2000s. During the early and mid 1990s the relative size of debt stocks tended to stabilise while in the early 2010s the actual stocks of debt, as well as relative to GDP, declined. A credit binge seems to be followed by a period of consolidation. (Click here for a PowerPoint of the chart.)
It is important that we understand the drivers of the growth of debt. The impact of debt on the balance sheets of the non-bank private sector and on banks themselves has implications for economic behaviour. In the early 2010s this has been to markedly slow the pace of growth through its impact on aggregate demand. Economic agents have, in general, looked to consolidate. There is no doubt that this partly reflects a precautionary motive. An important means by which debt and the balance sheets on which it is recorded affect behaviour is through a precautionary mechanism. This is difficult to accurately quantify because it represents a psychological influence on spending. Furthermore, it is affected by the prevailing circumstances of the time.
In looking to understand the factors that affect the growth of debt we may, as a result, learn more about the framework within which we may want banks and their customers to operate. Consequently, we may be in a better position to ensure sustainable longer-term growth and development. If there are cycles in credit it is important that we understand why they arise and whether, as some have suggested, they are an inherent part of the financialised economy in which we live. If they are, can we mitigate their potentially destabilising effects?
Articles
Retail shares facing nightmare before Christmas The Telegraph, John Ficenec (9/11/14)
Growing wealth inequality in the UK is a ticking timebomb The Guardian, Danny Dorling (15/10/14)
Richest 10% of Britons now control more than half the country’s wealth: Nation is only member of G7 where inequality between rich and poor has increased this century Mail Online, Mark Duell and Corey Charlton, (15/11/14)
Household debt is growing as families struggle Yorkshire Evening Post (31/10/14)
Consumer spending forecast to be the highest for four years The Telegraph, Ashley Armstrong (10/11/14)
Data
Statistical Interactive Database Bank of England
Quarterly National Accounts, Q2 2014 Dataset Office for National Statistics
Questions
- What is the non-bank private sector?
- What factors might affect the rate at which non-bank private sector debt stocks grow?
- How might we go about assessing whether the aggregate level of lending by financial institutions to the non-bank private sector is sustainable?
- How might we go about assessing whether the level of lending by individual financial institutions to the non-bank private sector is sustainable?
- What information is conveyed in the balance sheets of economic agents, such as households and private non-financial corporations
- What is meant by precautionary saving?
- Can precautionary saving occur when the economy is growing strongly?
- What are the mechanisms by which non-bank private sector debt could impact on economic behaviour?
In the Blog, A VW recession for the eurozone, as German growth revised down?, we discussed the pessimistic outlook for the eurozone, in part driven by the problems facing the engine of Europe: Germany. While the German government noted that the weak growth figures are due to external factors, it appears as though these external factors are now sending waves through the domestic economy.
Over the past 6 months, German confidence has fallen continuously and now stands at almost its lowest level in 2 years. Think tank data from a survey of 7000 firms in Germany fell from 104.7 to 103.2 for October – the weakest reading since December 2012. Confidence is always a key factor in the strength of an economy, as it affects consumers and businesses. 
Without consumer and business confidence, two key components of aggregate demand are weak and this downward pressure on total spending in the economy depresses economic growth. An economist from Ifo, the think-tank that produced this business climate index, said that firms felt ‘downbeat about both their current situation and the future.’
As confidence continues to decline in Germany, the economic situation is unlikely to improve. Unfortunately, it is something of a vicious circle in that without economic growth confidence won’t return and without confidence, economic growth won’t improve. The industrial sector is crucial to Germany and the data is concerning, according to Chief economist at Commerzbank, Joerg Kraemer:
The latest numbers from the industrial sector are very worrisome…The third quarter was probably worse than expected, the economy may have stagnated at best.
Numerous factors continue to depress the German economy and while negative growth is not expected, estimates for quarterly growth from July to September remain at around 0.3%. As Europe’s largest economy, such low growth rates will be of concern to the rest of the Eurozone and may also bring worry to other countries, such as the US and UK. With growing interdependence between nations, the success of countries such as Germany and Europe as a whole influences the economic situation abroad. Commentators will be looking for any signal that Germany is strengthening in the coming months and an improvement in business confidence will be essential for any prolonged recovery.
German business confidence falters again in October Wall Street Journal, Todd Buell (27/10/14)
German business morale weakens to lowest level in almost two years Reuters, Michelle Martin (27/10/14)
Zero growth best hope for Germany as confidence disappears The Telegraph, Szu Ping Chan (27/10/14)
German Ifo business confidence drops for sixth month Bloomberg, Stefan Riecher (27/10/14)
German business confidence plunges again as analysts urge fiscal stimulus International Business Times, Finnbarr Bermingham (27/10/14)
German business confidence falls again, Ifo says BBC News (27/10/14)
German business confidence tumbles The Guardian, Philip Inman (24/9/14)
The German way of stagnating BBC News, Robert Peston (11/11/14)
Questions
- Why is consumer and business confidence such an important element in explaining the state of an economy?
- Use an AD/AS diagram to illustrate the impact on national output of a decline business confidence. What are the other consequences for the macroeconomic objectives?
- What actions can a government take to boost confidence in an economy?
- If economic growth is weak and confidence is low, is there any point in cutting interest rates as a means of stimulating investment?
- If the eurozone did move back into recession, what could be the possible consequences for countries such as the UK and US?
- How useful are indices that measure business confidence?
The articles linked below look at the dangers of deflation and policies of central banks to counter it.
