As global leaders gather in Davos this week for the World Economic Forum they’ll find that the key topic on most economic policymakers’ minds is not specifically on the agenda: deflation.
Global inflation is 1.5 per cent and last week it emerged that eurozone inflation has fallen to 0.7 per cent.
European Central Bank president Mario Draghi said it was vital to avoid a scenario where inflation gets stuck below 1 per cent. Managing director of the IMF, Christine Lagarde, said: “With inflation running below many central banks’ targets, we see rising risks of deflation, which could prove disastrous for the recovery.”
Central banks seem to be fighting a losing battle against falling inflation. Weak demand and rising supply has meant that while global share prices have gone up 25 per cent in the past 12 months, commodity prices have declined 8 per cent, underpinning the decline in inflation.
The only thing that is stopping the world falling into outright deflation, apart from central bank money printing and near-zero interest rates, is that fact that oil has bucked the trend of falling commodity prices. Oil has held at around $US100 a barrel for three years as weak demand has been offset by turmoil in the Middle East and Africa.
But that could change this year. Last week, Deutsche Bank’s global head of commodities, Michael Lewis, put out a report predicting a slump in the oil price this year because of a big new supply glut.
He wrote that US share will add 1 million barrels a day to global supply for the third year in a row, Libya will increase shipments from a near-collapse in 2013 and “Iran will come out of hibernation”. “This will push OPEC spare capacity to levels last seen in the depths of the financial crisis. We estimate that crude oil is now the mostly richly priced commodity in the world,” he concluded.
There is a limit to what Saudi Arabia can do to limit supply. Lewis estimates that it would have to cut output by a quarter to stop the bottom falling out of the market, but Ambrose Evans-Pritchard of The Telegraph says this would push its budget into deep deficit and endanger the welfare subsidies required to keep a lid on tensions in its Eastern Province and the aggrieved Shia minority.
Europe is clearly at the greatest risk of falling into a Japan-style quagmire of long-term deflation and depression, caused by a combination of fiscal austerity and zombie banks.
Last week a report by researchers in Berlin and New York estimated that European banks have a capital shortfall of up to $US1 trillion, with French and German banks in the worst shape. Global bank regulators have let them off the hook to some extent by not increasing the leverage ratio as much as expected, but they still have a long way to go to get their balances sheets back to non-zombie status.
In that context a big drop in the oil price – a reverse oil shock – would not necessarily be a good thing, as you might think.
In theory deflation causes demand to shrink and the value of debt to rise, although in practice during the 19th century prices halved and output increased seven fold. The difference this time is the existence of so much debt and the fact that so many banks are still under-capitalised.
And in addition to Europe, China’s economy has serious problems with debt and falling money supply. Ambrose Evans-Pritchard wrote the other day that “China looks eerily like the US in 2007 when broad money buckled.”
If Chinese demand collapses at the same time as an oil supply glut emerges and United States imports continue to fall, we could find out what deflation in the modern world means in practice, instead of just in theory.