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Posted August 27th, 2010 by Jackie

Deflation or inflation – which will win?

Over the last 18 plus months the economies of the western world have been recovering, albeit slowly, from the depths reached in late 2008 and early 2009.

Most people must have thought this was inevitable, as surely the only way was up for the world’s economies, given the extent of the pull back we had seen in production and sales.

But it is important to remember that the governments of the western world had thrown everything at their economies – including the kitchen sink – in an effort to kick start them. Also, it has to be remembered many companies destocked at the start of the crisis and some of the growth.

Here in the UK, the level of government debt grew significantly and our budget deficit spiralled out of control as they battled to save a number of banks and pump money into the economy. But this can’t go on for ever and the new coalition government has made it clear that government costs have to be slashed and the books balanced as soon as possible.

Similar actions are being made elsewhere. The embattled southern states of the euro zone; Spain, Greece, Italy and Portugal, are implementing their own cuts in government spending and as such, we see businesses suffer and unemployment rising.

In the US, we saw the withdrawal of various incentives used to encourage people to consume when the “cash for clunkers” and the homebuyers tax credit were both withdrawn. The slump in house sales that followed the withdrawal of the homebuyers tax credit resulted in its reintroduction for a further 6 months – but the effect this time round is proving to be somewhat muted, with exiting house sales for July 2010 hitting a 15 year low.

And where has all this money that has been pumped into the banks ended up? Mainly in their balance sheets rather than being lent to their customers. There are a number of reasons for this.

The banks themselves have to rebuild their balance sheets to cover their losses, both actual and possible and they are also being forced to increase capital levels under new legislation. And the final reason is that their clients are borrowing less because their working capital requirements are reduced given the lower level of activity.

So, we are now beginning to see most western economies beginning to falter and this is worrying their respective governments as it raises the spectre of deflation.

Pimco, one of the worlds biggest fund managers, have carried out two detailed analyses in the last 12 months on the state of the US economy with the aim of working out how likely the US is to suffer from deflation.

First time round they calculated the chances at 10%. This time around they have calculated the chances at 25%. Quite an increase.

So why are the “powers that be” so scared of deflation?

There are a number of reasons, but the one that stands out in my mind is an almost self reinforcing economic cycle that ends up in a deflation spiral.

Consumers start saving because times are tough. This reduces consumption. Prices then come down as sellers try to stimulate demand. But consumers decide to hold off buying as they believe the goods will be cheaper next month. Sellers reduce prices further and consumers decide to delay buying yet again. So on it goes.

Okay, this is a very simplified economic model, but in many ways, it mirrors what has happened in Japan for the last two decades. It is also has a huge affect on employment which falls away as the sellers are unable to sell their goods and have to lay people off.

Japan has its lost generation of unemployed and a banking system that is still full of bad debts that should have been written off a long time ago.

So a lot to be frightened of if deflation comes to the economies of the western world, but how likely is this?

As per the Pimco’s analysis, I think the likelihood of deflation is higher than people think.

Consumers are scared. Clearly low interest rates are helping those with debts, but if economies aren’t growing and people’s jobs aren’t safe, all they will do is pay off those debts and start saving for a rainy day.

Governments have much less ammunition in their armoury than they did 12 months ago and will be unable to try and fund growth in the same aggressive way – and banks are rebuilding their broken balance sheets rather than lending.

So the alternatives seem fairly simple.

A one in four chance of deflation – or a three in four chance of growth – albeit somewhat muted for the next few years.

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