Stephen King: Tackling debt may help avoid a deflationary hangover

It's been an extraordinary week. The economic news has got worse. Worries about jobs in the United States, the eurozone's Growth and Stability Pact being labelled as "stupid" by Romano Prodi and Gordon Brown watching his budget deficit expand before his very eyes. Company results have been mixed. Ford appears to be suffering the pains of ever more aggressive discounts whereas Microsoft is flush with success. Yet despite the bad economic news and the mixed company results, the bulls are back with a vengeance. Pamplona might be exhilarating for those that like that kind of thing, but it's nothing compared with the recent gains seen in equity markets.

So are the bad old days now behind us? Unfortunately, probably not. The bears may have gone off for their winter hibernation but they can sleep comfortably, confident in the knowledge that all is still not well in the global economy. As DeAnne Julius, a former member of the Bank of England's Monetary Policy Committee, reminded us last week, deflation is still a risk. And, if it is, policy makers – unlike the bears – are likely to be having a few sleepless nights.

I've been looking quite closely at the deflation issue over the last few weeks. It seems to me that there's quite a lot of confusion about what deflation is and what kind of threat it provides to economic stability. So it might be worth kicking off with a definition or two. If inflation is defined as a persistent series of increases in the overall price level, it follows that deflation can be defined as a persistent series of decreases in the overall price level. By "overall", I'm thinking of the prices of everything – goods, services, wages and anything else you care to think of that has a price attached to it.

Thus, whereas inflation is a story about the falling value of money, deflation is a story about the rising value of money. One feature that both processes have in common is a potential threat to the allocation of resources. In either an inflation or deflation world, we find it difficult to tell whether a change in a particular price is a relative price change or whether it reflects a change in the overall price level. If these kinds of errors are made, the "invisible hand" that should deliver an efficient market begins to wither away and we end up with a misallocation of resources.

Deflation, however, has other characteristics that distinguish it from inflation. The most important of these is the impact of deflation on the ability of a central bank to set interest rates at the appropriate level.

Any decision to borrow depends on both the level of interest rates and the expected future rate of inflation. Consider two scenarios. In the first, the economy is weak but inflation is at 4 per cent. Under these circumstances, a central bank that wants to get things going can lower interest rates to, say, 1 per cent. In real terms, adjusting for inflation, this gives an interest rate of minus 3 per cent. Given this, a lot of people might be tempted to borrow. In the second scenario, inflation starts off at zero. The central bank cuts nominal interest rates to zero, hoping to stimulate an economic recovery. But real rates cannot fall below zero. As a result, the required pick-up in borrowing does not take place and the economy starts to weaken even further. As it does so, the price level starts to fall, implying that real interest rates start to rise. Things get even worse and the central bank finds that monetary policy has stopped working.

There are two ways in which deflation is likely to be particularly worrying and they are quite different in nature. Falling prices may be required to correct a problem with a country's competitiveness – if, for example, there is no way of adjusting the exchange rate – but falling prices may also be the result of problems with debt. Consider each of these in turn.

Germany may face the first of these two problems. Although the evidence is rather mixed, it seems likely that Germany's price level is too high relative to its competitors elsewhere in the eurozone. For the others, of course, this is great because it implies that they make competitive gains at Germany's expense. For Germany, however, life in the euro has become a constant struggle to preserve jobs and profits: companies would rather locate elsewhere where workforces are cheaper and where the risk of a sudden punitive increase in taxes is less.

The simple answer to Germany's problems is to have a dose of deflation: if the price level can fall quickly enough, competitiveness can be restored and the good times can come back again.

Knowing, however, that this is required is a bit like knowing that cutting your leg off will help you lose weight. It might work, but it's a treatment that you're likely to resist. No self-respecting union representative is going to negotiate a deal that requires a cut in wages. And no company is going to be happy about having to cut prices when maximum profit is the aim. So the patient's body keeps twitching around, making it more likely that the deflationary surgeon ends up removing a lot more than just a leg. Resistance to the treatment also implies that ultimate recovery is delayed, leaving banks fretting about possible bad debts, thereby undermining the financial system at the same time. Of course, there are some economies that have been through this process and have survived. Hong Kong is the great example. Germany, however, is no Hong Kong. Hong Kong has a much more flexible price level – there is less institutional resistance to the necessary change in prices. More importantly, Hong Kong has a much more open economy. Small changes in the price level can have quite big effects on trade: Germany, on the other hand, is likely to need big changes in its price level to stimulate an export-led renaissance.

The second concern is the relationship between deflation and debt. This is especially relevant today. Japanese indebtedness played a key role in its lost decade of deflation. Debt levels are now very high in other parts of the world, notably the US (see charts) and the UK and, within the corporate sector, many parts of the eurozone. Debtors do badly under deflation: in real terms, debt levels rise and, because real interest rates can't turn negative, there is no way in which a central bank can provide the required interest rate relief.

Indeed, it's reasonable to argue that it is precisely under conditions of high indebtedness that deflation is at its nastiest. Typically, debtors have a higher marginal propensity to spend than creditors so if deflation makes debtors worse off, there's a good chance that the overall economy will start to spiral downwards.

Deflation isn't just a story about a few falls in prices here and there. Lots of companies seem to be experiencing deflation today but much of this is just a change in relative prices: manufacturing companies may be losing out but rising consumer incomes and lower supply costs don't appear to be doing too much damage to retailers. But, for Germany, the lack of competitiveness in a rigid exchange rate system raises one deflation risk and, for the rest of us, the high levels of debt built up in recent years raise another. The rise in equity prices over the last few days is welcome but it does little to address these deep-seated structural risks. Ultimately, policymakers will have to think more about how to restructure and forgive debts if a deflationary hangover is to be avoided.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com