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Mark Lamb | Wednesday, 25 November 2009

The rise of deflation

Weekly international investment round up to November 24, 2009

Japan slipped back into deflationary mode this week for the first time in three years shattering the fragile confidence which had briefly returned following the election of a new government and its recent exit from recession. The report issued by Japan’s Central Bank showed consumer prices excluding fresh food dropped for a seventh consecutive month in September and based upon the basket of goods used to measure price movements it was the largest decline for over half-a-century.
The ghost of deflation hangs heavy over Japan and the report has again forced the country to remember its ‘lost decade’ of the 1990s and the devastation brought on it by this scourge. Could deflation become an issue elsewhere?
Almost to the day a year ago I highlighted this looming threat in my article entitled ‘Good vs. bad deflation’ and suggested that while lower costs may certainly appear to be a good thing ‘reductions’ are very different from ‘real deflation’ which is the dark side of falling prices. According to investorwords.com the definition of ‘deflation’ is ‘a decline in general price levels, often caused by a reduction in the supply of money or credit.’ Furthermore, it goes on to state that it can be brought about by direct contractions in spending and that a side effect of deflation could see an increasing level of unemployment in an economy since the process often leads to a lower demand for goods and services.
A good explanation of deflation is offered by the information resource ‘Inflation Data’ when it imagines an island that has only 10 equally desirable goods with only ten €1 euro coins in circulation, from this it can be assumed that each item will end up costing €1 each.
If the quantity of money increases to €20 on this island, without increasing the quantity of goods, their price will eventually increase to €2, this is inflation. If however, the quantity or availability of money decreases to €5 their price will eventually fall to 50 cents, this is deflation. On this particular island the money supply can be reduced for example if someone hoards half of it and refuses to spend it on anything no matter what, thus creating a reduction in spending.
Price levels are therefore not only based upon the supply and demand for any given item but also the value of the money used to pay for them – money too has its own supply and demand.

‘Good deflation’ therefore happens when the actual quantity of goods increases (stimulating employment) thus placing pressure on prices to naturally fall while it could be said that ‘bad deflation’ is caused by the decreasing availability of money and a loss of liquidity.
The unprecedented governmental cash injections or ‘quantitative easing’ methods deployed over the last twelve months has certainly helped stimulate the supply of money but while there may now be more cash available to borrow consumers appetites remain subdued. So, while the horse may have been led to water until it decides to drink again from the money fountain the threat of deflation will not disappear.

Mark Lamb is Head of the Life Dept. at Citadel Insurance plc which is authorised to carry on general and long term business of insurance under the Insurance Business Act, 1998 and is regulated by the MFSA. Contact by email: mlamb@citadelplc.com Tel; 25579000. Website: www.citadelplc.com
This article does not intend to give investment advice and its contents should not be construed as such. Information in this article has been obtained from various public sources and is given by way of information only. Readers are always encouraged to seek financial advice before making any investment decision.

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25 November 2009
ISSUE NO. 609

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