Getting along with deflation
It was not long ago that people complained about excessively high prices, and the primary job of the central bank was to rein in inflation. Today, it is the opposite. The deflationary specter is lurking over Korea.
Deflation - sustained and broad decline in prices of products and services - in textbook theory has a devastating and demoralizing effect on an economy. People defer spending with expectations of prices going down. Companies reduce output and investment because products do not sell. Hiring and income are pared. The economy slips into a lengthy collective pall. Prices fall further on depressed demand, and the vicious cycle goes on and on. Japan has been under this pernicious spell for two decades.
But one must wonder: won’t we all benefit if we buy and get services at cheaper rates? We’ve become accustomed to falling prices. Once-luxury items like flat-screen TVs and smartphones are becoming cheaper. But that does not keep us from buying. We rush with eagerness when new products hit the shelves. When prices fall, the real value of our income rises. We can afford to buy more products with the same money. If we increase spending with more presumed affordability, companies can also profit.
It is the case with falling oil prices. News headlines raise hype about the curse of oil prices. But local drivers are saving greatly with gasoline prices brought down to 1,200 won ($1) per liter from 2,000 won. The royals in Saudi Arabia and other oil-producing Middle Eastern countries may have become poorer, but we have become richer. Consumption in locally-refined petroleum products has gone up, and cars with better mileage sell well. Overseas construction and shipbuilders are heavily hit, but overall, cheaper oil imports have done more good than harm in the local economy.
There was an interesting publication by the Bank for International Settlements titled “The costs of deflation: a historical perspective” last year in which analysts tested the historic link between output growth and deflation in a sample covering 140 years in up to 38 economies. The authors concluded there was a weak association between goods and service price deflation and growth, with the Great Depression being an exception. In most cases, the economy ran well regardless of declining prices.
Deflated asset prices, however, can cause bigger negative ripples in the economy. Lengthy decline in equity and property prices erode wealth and collateral values - especially harsh on debt as its real value is relatively inflated. Japan was the typical case. When the value of debt-financed real estate was undercut by a quarter, consumption came to a standstill, pushing down prices and causing the economy to recede.
Today’s Korea has not reached a state where the value of assets is in danger of deflation. Prices are subdued because of the fall in oil-related prices and the spillover to industrial products. Strictly speaking, we are experiencing disinflation, with inflation slowing but without negative effect. When international oil prices fall by 10 percent, consumption rises by 0.68 percent and gross domestic product by 0.27 percent, according to an empirical study by Hyundai Research Institute.
Prices are notoriously high in Korea due to an outdated distribution system and customary price fixing by predominant players. This needs to be rectified. But we must not let our guard down. If home value depreciates, the bubble of household debt reaching 1,200 trillion won could burst and send the country right into a Japan-like deflationary spiral.
The government has strengthened mortgage-backed loans and has been encouraging planned loan repayment. The safe mechanism to contain household debt should give the central bank more maneuvering room in rate policy.
The Bank of Korea must not hesitate to cut the base rate upon signs of deflation. Panic from deep-seated belief that deflation spells out danger for the economy is unnecessary. It can interfere with good judgment. If housing and income values aren’t pared, deflated prices are actually a boon. We should use the momentum to restructure the economy and expand domestic demand.
JoongAng Ilbo, Feb. 4, Page 28
*The author is the business news editor of the JoongAng Ilbo.
by Kim Kwang-ki