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Weekly Case Study - US$ and Deflation

This week sees a meeting of the G8 countries in Evian, France to voice confidence in a global economic recovery - the G8 refers to the eight most industrialised countries in the world and they are: USA, UK, Japan, Canada, Italy, France, Germany, and Russia.

However, the G8 summit did not plan any declaration about the United States dollar's fall, a key factor troubling its major trading partners as allowing the dollar to sink on foreign exchanges merely exports deflation to other countries. Furthermore, the flip side of a falling US$ is a rising yen and a higher euro, making it more difficult for Japan and the eurozone to sell their goods overseas as it becomes more expensive for other countries to buy their currency. Therefore, the weak US$ will not rescue the global economy.

The Problem is Deflation

The control of inflation has been the major focus of economic policy during the last 15 years but pressure was mounting on central banks to show that they can cope with the problem. So why are we expericencing this problem? It is all down to simple economics - supply and demand:

• The Globalisation of supply
• Two decades of anti-inflationary policies
• The end of the Cold War
• Freer Trade
• The break up of state monopolies
• The weakening of Trade Unions

This is not a problem when inflation is up above the 10% mark, as in the 1970's and 1980's, but there are major concerns when the figure is around the 1-2&percent; figure as it is now. According to Larry Elliott of the Guardian, the reason we have arrived at this position is that the Central Banks have misread the signals. As far back as 1996, the Bank for International Settlements (BIS) was warning that inflation was no longer the problem and that greater focus should be on the delfationary environment. In Japan the authorities knew there was a problem but ignored it until it was too late. They are now stuck in a liquidity trap. Other industrialised countries are also moving this way with interest rates nearing record lows and economic activity not being stimulated.

The Liquidity Trap

So what is the liquidity trap? This is a situation where monetary policy becomes ineffective. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. But John Maynard Keynes argued that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers.

The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates donot alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.

Figure 1 - The Keynesian Liquidity Trap

Questions

1. What is the key issue for America's trading partners?

2. How has it affected their own economies?

3. What has caused the deflationary problem in the global economy?

4. When would deflation not be a problem?

5. Why has Japan been in a liquidity trap?

6. What should have Japan done before gettting into a liquidity trap environment?

7. Explain what is meant by the liquidity trap?

8. What is the long-term outlook for interest rates in this environment and why?

9. In order to compensate the eurzone countries for a higher exchange rate against the US$ what could the European Central Bank do?

10. Some would say a period of falling prices mean that money is appreciating in value rather than been progressively eaten into by inflation. Why, therefore, does deflation spell disaster for the global economy?

Analysis

Outline the costs and benefits of deflation in the global economy.