In defence of deflation

Hardly had deflation showed its nose in Mauritius for the briefest period of time when some economists raised the alarm. The year-on-year inflation rate for February 2016, as measured by the change in the consumer price index (CPI) between February 2015 and February 2016, worked out to minus 0.5 per cent. This was attributed to a drop in food, energy, transport and communication prices. But is there a real menace that “the country would enter a period of deflation”? And does deflation pose a threat to the economy? We must not confuse deflation (continuous decrease in prices) with disinflation (slower increase in prices). Overall prices can fall for some months, yet the yearly rate of growth of the CPI may be positive. When the inflation rate declines, this does not mean that prices are lower: they are still higher but to a lesser extent. There is a need to dispel the myth that deflation or disinflation sets in motion lower inflation expectations and is the cause of falling aggregate demand. It is argued that when individuals expect prices to collapse, they postpone buying products, they are less willing to spend and to borrow, and that in turn slows down economic growth. In fact, people must purchase present goods to maintain their well-being. The prospect of falling prices is accompanied by that of greater prosperity which provides an inducement to higher consumption in the present. Before World War II, the term “deflation” meant a decrease in the stock of money. By the 1950s, however, under the sway of the Keynesian Revolution, the definition of deflation as a general fall in prices became embedded in economic thinking. It remains that there are four factors of deflation, two on the demand side of money and two on the supply side of money. One component of the demand for money is the quantity of goods and services that are supplied in exchange for money. When we sell goods, we exercise a demand to acquire and hold money. An increase in the production and supply of goods, if it outstrips an expansion of money supply, operates to make prices of those products fall and the purchasing power of money rise. This is what we call prosperity. We have seen it in the electronics and appliances industries, where technical progress has powered innovations at ever-decreasing costs in a competitive environment, leading to lower prices and, nonetheless, to big profits. The benefits have spread amongst Mauritian consumers. A second cause of deflation is hoarding which occurs when a person intentionally reduces his current spending and adds the unspent income to his cash balance, i.e. the amount of money that he keeps on hand. Maybe Mauritians now desire building cash, but then this increased demand to hold money stems from a pessimistic view of the future rather than from the prospect that prices will drop as a result of economic growth. A decline in the supply of money produces deflation in two ways. Firstly, this may occur either through bank runs (depositors withdraw their cash savings and redeem their demand deposits en masse) or by means of a deliberate policy of the central bank to shrink bank credit. Secondly, the central bank can engineer a contraction of the monetary base by selling securities on a large scale or by raising considerably the reserve requirement. The fact is that Mauritius is not experiencing monetary deflation. It managed to avoid a credit crunch following the closure of the Bramer Bank, and domestic credit expanded by 8.1 per cent from January 2015 to January 2016. The monetary base grew at the same rate during that period while broad money liabilities witnessed a double-digit growth rate of 10.5 per cent. Deflation is not falling prices. Monetary contraction alone should be called deflation. It can exist even if prices climb. Prices will not come down if production diminishes to the same extent as the quantity of money. They will go up if the former decreases more than the latter. It is said that falling prices wipe out profits and make debt repayment more difficult. Local manufacturers fear that input prices will not adjust fast enough to a drop in output prices. However, if costs tumble by the same magnitude as sale prices, profits will be unaffected. But even if prices rise, profits will not necessarily be higher, and nor will the debt burden be alleviated. It is monetary contraction, not lower prices, that can cause a reduction in profits and increase the burden of repaying debt as there is less money to be earned and to be used for repayment. Falling prices in response to deflation are good for the economy. First, they imply a rise in the purchasing power of money, which reflects increasing real wages. Second, they improve the welfare of consumers. Third, they create incentives to save and to invest for the future. Fourth, they compel businesses to become more efficient. Fifth, they liquidate non-productive activities and purge malinvestments from the market by an adjustment process that reallocates resources to real wealth generators. And sixth, they allow the restoration of production and employment, bringing economic recovery. For that to happen, the inflation-adjusted interest rate needs to rise. Currently, interest rates in Mauritius are distorted, do not cover any default risk and no longer fulfil the critical function of allocating resources according to society’s time preference of consumption. High real interest rates not only wash out unsound loans but also support the readjustment of relative prices required to realign the production structure with economic reality. Sadly enough, deflation phobia serves to justify a further reduction of the interest rate by the Bank of Mauritius.