Outlook: World-wide deflation: is it fact or fiction?

The threat of global deflation - a la 1930s - has suddenly become the fashionable thing to worry and talk about at City lunch tables. Is this just a passing fad, a bit like the new economic paradigm of a few months back (whatever happened to that theory?) and more an alarmist symptom of the present wave of stock market turbulence than anything else, or should we be genuinely concerned?

For stock market bears, the theory has become a very handy way of re- justifying their stance. In recent times stock market corrections or bear markets have generally been caused, at least in the Western world, by deteriorating liquidity as central banks raise interest rates to combat inflation. Plainly there's a bit of that going on in Britain right now. After yesterday's clutch of economic indicators, it rather looks as if last week's quarter point on interest rates won't be the last. Even so, this hardly justifies the present bout of jitters. Inflation is still in abeyance in most of Europe and North America.

Instead, the turbulence in Western markets has been caused by the opposite thing - the fear of deflation. The contagion has spread, moreover, not from Wall Street into the rest of the world, as it usually does, but from the Far East, from the developing Pacific Rim economies into Japan and then into the US and Europe. One feature of this phenomenon has been a tendency for bond and equity markets to decouple, for bond prices to rise even as equities are falling, much as they have done in Japan since the stock market bubble burst at the end of the 1980s. This is highly unusual, for the two normally track each other, and a clear indication of deflationary forces at work, the argument runs.

Taking the real economy, the deflation theory works like this. The crisis in the Pacific Rim economies may not be of critical importance to the US and Europe, but it is to Japan, half of whose exports go to Asia. Here there's a double whammy for Japan's already weakened economy. Nobody will be buying on past levels and even if they were, Japan's competitiveness has been severely undermined by currency devaluation in the region. What's more, the consequence of excessive investment in the region is overcapacity and too many goods looking for a market.

Still reeling from the after effects of Japan's own speculative stock market and property bubble, Japanese banks now have a whole new raft of bad loans to come to terms with. No wonder Barton Biggs, Morgan Stanley's stock market guru, is advising clients to quit waiting for a recovery, cut their losses and bail out of Tokyo.

With no Asian market to turn to, Japanese companies and their counterparts in the region will fix their efforts on the one big growth market left, the US. In the words of Andrew Smithers, of the London based investment boutique Smithers & Co, "a weak yen would be part of the general devaluation of Asian currencies and would exacerbate the growing disparity in the US between the rise in costs of labour and services and the price of traded goods. This would pose a major threat to the profits and cash flow of US corporations." A fall in the yen thus becomes the trigger for a further fall on Wall Street. In a worst case scenario, there's a trade war, pressure for protectionism, and, hey ho, it's the 1930s all over again.

Compelling isn't it? But actually rather unlikely, at least in this form. Here's the other side of the coin. World capacity and output have not been growing at an unusually fast pace; investment spending is at around, or below, its long-run average relative to OECD and world GDP, although it is at a cyclical peak in the US. There are gluts and falling prices - but only in a handful of commodities, in particular in semiconductors, steel, possibly chemicals and cars. Because they are high-profile they exercise a tyranny over popular thinking.

Although some OECD countries have high unemployment, this is structural. Others - the US, UK, and the Netherlands - have unemployment rates at 20 or 25-year lows; wages are rising faster than inflation across most of the OECD. The Asian slowdown will affect the rest of the world; but world GDP growth is still expected to be 3-4 per cent, well above the post-war trend. Asian growth forecasts have been cut from 8 per cent plus to 6 per cent, or about 4 per cent excluding China - still not a slump.

Commodity prices, the bottom of the price chain, are not falling. Outside Japan, real interest rates are relatively high; if there were any evidence at all of a troubling economic slowdown, central banks could easily tackle it by cutting interest rates. This is not to argue for complacency. The repercussions of the Asian crisis are still far from clear, and it does seem highly likely there will be real economic damage both to Japan and the US. But that it will cause a slump, or even a recession in the US looks at this stage rather improbable. A reduction in US economic growth? Certainly. An end to Wall Street's bull market? Very probably. A big Wall Street correction? Possibly. But worldwide deflation? Mmmm.

Suggested Topics
Start your day with The Independent, sign up for daily news emails
tennisLive: Follow all the updates from Melbourne as Murray faces Czech Tomas Berdych in the semi-final
Arts and Entertainment
'The Archers' has an audience of about five million
radioA growing number of listeners are voicing their discontent; so loudly that even the BBC's director-general seems worried
Arts and Entertainment
Henry VIII played by Damien Lewis
tvReview: Scheming queens-in-waiting, tangled lines of succession and men of lowly birth rising to power – sound familiar?
Joel Grey, now 82, won several awards for his role in Cabaret
Harry Kane celebrates scoring the opening goal for Spurs
footballLive: All the latest transfer news as deadline day looms
Arts and Entertainment
Master of ceremony: Jeremy Paxman
tvReview: Victory for Jeremy Paxman in this absorbing, revealing tale
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Ashdown Group: Market Research Executive

£23000 - £26000 per annum + Benefits: Ashdown Group: Market Research Executive...

Recruitment Genius: Technical Report Writer

£25000 - £35000 per annum: Recruitment Genius: A Technical Report Writer is re...

MBDA UK Ltd: Indirect Procurement Category Manager

Competitive salary & benefits!: MBDA UK Ltd: MBDA UK LTD Indirect Procurement...

Recruitment Genius: Web Developer - PHP

£16500 - £16640 per annum: Recruitment Genius: This fast growing Finance compa...

Day In a Page

Isis hostage crisis: Militant group stands strong as its numerous enemies fail to find a common plan to defeat it

Isis stands strong as its numerous enemies fail to find a common plan to defeat it

The jihadis are being squeezed militarily and economically, but there is no sign of an implosion, says Patrick Cockburn
Virtual reality thrusts viewers into the frontline of global events - and puts film-goers at the heart of the action

Virtual reality: Seeing is believing

Virtual reality thrusts viewers into the frontline of global events - and puts film-goers at the heart of the action
Homeless Veterans appeal: MP says Coalition ‘not doing enough’

Homeless Veterans appeal

MP says Coalition ‘not doing enough’ to help
Larry David, Steve Coogan and other comedians share stories of depression in new documentary

Comedians share stories of depression

The director of the new documentary, Kevin Pollak, tells Jessica Barrett how he got them to talk
Has The Archers lost the plot with it's spicy storylines?

Has The Archers lost the plot?

A growing number of listeners are voicing their discontent over the rural soap's spicy storylines; so loudly that even the BBC's director-general seems worried, says Simon Kelner
English Heritage adds 14 post-war office buildings to its protected lists

14 office buildings added to protected lists

Christopher Beanland explores the underrated appeal of these palaces of pen-pushing
Human skull discovery in Israel proves humans lived side-by-side with Neanderthals

Human skull discovery in Israel proves humans lived side-by-side with Neanderthals

Scientists unearthed the cranial fragments from Manot Cave in West Galilee
World War Z author Max Brooks honours WW1's Harlem Hellfighters in new graphic novel

Max Brooks honours Harlem Hellfighters

The author talks about race, legacy and his Will Smith film option to Tim Walker
Why the league system no longer measures up

League system no longer measures up

Jon Coles, former head of standards at the Department of Education, used to be in charge of school performance rankings. He explains how he would reform the system
Valentine's Day cards: 5 best online card shops

Don't leave it to the petrol station: The best online card shops for Valentine's Day

Can't find a card you like on the high street? Try one of these sites for individual, personalised options, whatever your taste
Diego Costa: Devil in blue who upsets defences is a reminder of what Liverpool have lost

Devil in blue Costa is a reminder of what Liverpool have lost

The Reds are desperately missing Luis Suarez, says Ian Herbert
Ashley Giles: 'I'll watch England – but not as a fan'

Ashley Giles: 'I'll watch England – but not as a fan'

Former one-day coach says he will ‘observe’ their World Cup games – but ‘won’t be jumping up and down’
Greece elections: In times like these, the EU has far more dangerous adversaries than Syriza

Greece elections

In times like these, the EU has far more dangerous adversaries than Syriza, says Patrick Cockburn
Holocaust Memorial Day: Nazi victims remembered as spectre of prejudice reappears

Holocaust Memorial Day

Nazi victims remembered as spectre of prejudice reappears over Europe
Fortitude and the Arctic attraction: Our fascination with the last great wilderness

Magnetic north

The Arctic has always exerted a pull, from Greek myth to new thriller Fortitude. Gerard Gilbert considers what's behind our fascination with the last great wilderness