Home » Business » Why Deflation Is Bad for Zim [column]

Inflation data released this week confirms the fears that Zimbabwe is experiencing deflation.

However, this would not be a cause for concern if the economy was growing. On the contrary, economic growth has stalled and the threat of a prolonged period of deflation poses significant challenges for policymakers. So, why is deflation so bad and why should we worry about it?

There are actually three different reasons to worry about deflation, two on the demand side and one on the supply side.

Firstly, when people expect falling prices, they become less willing to spend, and in particular less willing to borrow.

After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield and anyone considering borrowing, even for a productive investment, has to take account of the fact that the loan will have to be repaid in hard currency that is worth more than the money you borrowed.

If the economy is doing well, all this can be offset by just keeping interest rates low but if the economy isn’t doing well, even a zero rate may not be low enough to achieve full employment.

Unfortunately, we have little control over interest rates, which remain high and unsustainable. Interest rates need to fall significantly to stimulate growth in Zimbabwe. This is unlikely to happen, as country risk remains high, thus increasing the cost of funds for most banks.

Even if we could reduce interest rates, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed.

This is widely known as the deflationary trap or deflationary spiral.

A deflationary spiral is a situation where a decrease in prices leads to lower production, which in turn leads to lower wages and demand, which leads to further decreases in prices.

Since a reduction in general prices level is called deflation, a deflationary spiral is when reduction in prices leads to a vicious cycle, where a problem exacerbates its own cause. The Great Depression was regarded by some as a deflationary spiral.

Secondly, even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum game, since creditors experience a corresponding gain.

However, debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount. So deflation exerts a depressing effect on spending by raising debt burdens — which can lead to another kind of vicious cycle, in which depressed spending because of rising real debt leads to further deflation.

Finally, in a deflationary economy, wages as well as prices often have to fall — and it’s a fact of life that it’s very hard to cut nominal wages — there is downward nominal wage rigidity. What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines.

Looking at the inflation graph above (from the Reserve Bank), one could argue that Zimbabwe has experienced a steady decline in prices since February 2014. Consumer prices fell by 0,5% in February 2014 and have declined steadily ever since. Prices rose marginally from June 2014, but have declined since November 2014.

A short burst of deflation associated with an oil price fall is good, since it acts as a tax cut, boosting consumers’ real purchasing power. That’s a timely boost for the moribund economy.

Although Zimbabwe appears to have avoided outright recession in 2014, growth has become so anaemic that it makes little difference. Zimbabwe is likely to slip into a recession in 2015 if nothing is done to stimulate investment and economic growth.

Deflation is bad if it persists and people and businesses come to expect prices to fall. That can lead to lower spending since it makes sense to postpone purchases and pay lower prices at a later juncture. A prolonged period of deflation would be crippling for Zimbabwe because both public and private debt are extremely high. The real burden of debt, which is generally fixed in nominal terms, rises when prices fall.

The worry about Zimbabwe slipping into a prolonged period of deflation is that the monetary policy levers to stimulate growth no longer exist in a dollarised environment. Further, the g economic recovery in the United States is likely to put further pressure on interest rates.

Zimbabwe needs an expansionary monetary policy and quantitative easing to stimulate growth and development. A brief burst of good deflation driven by the oil price fall could become a sustained period of bad deflation based on underlying weakness in the economy and expectations that prices may continue to fall.

Zimbabwe is at risk of falling into a deflationary spiral or trap.

It’s interesting that in less than a decade we have swung from a hyperinflationary environment to deflationary a one. Let’s hope we don’t fall into a deflationary spiral.

Source : Zimbabwe Independent

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