Deflation risks in the US

The bearishness over the outlook for the US economy is increasing with concerns over deflation with falling wages and prices. The dollar is very weak hitting new recent lows against the yen and sterling. I remain of the view that this is overdone. A weaker dollar will boost exports if nothing else.

Falling prices is not quite the end of the world. The real killer is a fall in nominal GDP. This is the situation in Japan where there has been no growth in nominal GDP in the last twenty years. Debt repayment is impossible in this environment. The good news for the United States is that nominal GDP has grown by over 4% in the last four quarters and is now higher than its previous peak in September 2008. The bad news is that this is only the first step in the right direction. Japan’s nominal GDP did grow by just over 1% pa from 1990 to 1997, whereupon it then fell back again to 1992’s level in 2001. It grew again until 2007 and then fell back yet again to 1992’s level in 2009.

Was this inevitable? I think Japan fell into the trap of trying to grow the economy out of its debt trap but at the same time manage the exchange rate. Japan was always under pressure by the Americans to keep the yen high so as to not achieve an unfair trade advantage. Unfortunately for Japan it needed to inflate its way out of trouble, not so much to achieve ‘real’ growth but rather to achieve ‘nominal’ growth. This implies a much weaker yen, something that was ruled out by politics. Deflation has been the consequence.

The lesson for the United States is to let the dollar weaken, particularly against emerging market currencies. Now whether this will happen is debateable and for another post but economic logic says it has to happen.