The preposterous deflation scare Part IV – Who should be scared of deflation?

There is no sound empirical evidence and no convincing theoretical justification for why deflation is such a danger to the economy. Although deflation can be the result of an economic crisis, it can also be caused by cost reductions due to falling raw material prices or technological progress. Historically, not only crises, but also periods of lasting economic success — e.g., the rise of Great Britain in the 19th Century — have both been linked to deflation.

Deflation is always the outcome of a (positive or negative) economic development and can in very unrealistic circumstances become the cause of a negative development such as a deflation spiral. There is also very little evidence that low or moderate inflation exerts a particular influence on economic growth. Could it be that it does not matter whether there is inflation or deflation — as long as inflation does not spiral out of control?

It does, however, matter for long-term investors, creditors and debtors, whose debts and liabilities are measured in nominal values. Inflation or deflation brings about a redistribution of the real value of assets between these groups. Read more ›

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The preposterous deflation scare Part III – The empirical data: When has deflation really been dangerous?

There have been different stages of varying levels of inflation in world economic history, but also long periods of price stability. The present period, which is characterised by relatively moderate and constant inflation rates of about 2% p.a., is relatively unusual from a historical perspective. Historically, there is only one other comparable period — that of the “price revolution” in the 16th Century, a time when changes in the money circulation and gold imports from the Spanish colonies permanently eroded the gold-based value of money throughout Europe.

As far as history can be reconstructed (there is very little meaningful data for many ancient cultures and the Middle Ages up until circa 1270), three phases of “genuine monetary stability” can be identified. In these phases, the value of money remained constant for an extended period of time and phases of inflation and deflation alternated.

  • The pre-Christian Roman Republic and the first decades of the Empire.
  • The age of Venetian gold ducats in the 14th and the 15th Centuries.
  • Great Britain in the 18th and 19th Centuries.

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The preposterous deflation scare Part II – Why are low inflation rates supposedly so dangerous?

The concept that very low rates of inflation are dangerous is closely related to the belief that there is some sort of an “optimum rate of inflation” for the economy, at which economic growth can progress at its smoothest. This concept emerged in the 1950s and 1960s based on the Keynesian approach to macro-economics, the prevailing model of the times.

On the one hand, policy-makers wanted to avoid strong cyclical fluctuations, which had been typical of the 19th Century. They generally favoured anti-cyclical fiscal policies which largely served to stabilise employment, even if they had an inflationary impact. In addition, both the USA and Great Britain discovered the benefits of “soft” inflation (also called “financial repression” today). An inflation rate that was only slightly below or even above government bond interest rates could relatively easily be used to devalue the public debt resulting from World War II. The main prerequisite was the policy had to be implemented very carefully, so that the effects were hardly noticeable, in order to avoid an escalating inflation spiral, as experienced in the German Reich between 1914 and 1923.

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The preposterous deflation scare Part I: How stable is price stability?

For months now, we have been showered in a flood of press reports and comments by economists, warning us about the catastrophic effects of potential deflation. However, they never justify their statements to any great extent. As a rule, the authors make vague references to the world economic crisis in the 30s and Japan’s lost years in the 90s. There are only very few economists,  who find the warnings too superficial and do not support them.

But what is deflation and why is it supposedly so dangerous? Read more ›

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Real commodity price trends – part 3: Aluminium

The real price of aluminium is moving in a long-term downward trend. This will not change because of large over-capacities for production in China. The recent pickup in prices only seems to be a “dead cat bounce”.

 

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Alu1

Source of data: U.S. GEOLOGICAL SURVEY

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Real commodity price trends – part 2: Crude oil

Despite all efforts to reduce the dependency on fossil fuels, crude oil is still the most used commodity with a daily consumption of approximately 90 million barrels per day. The EIA expects demand to grow to 97 million barrels per day in 2020 and 115 million barrels per day in 2040, notwithstanding rising oil prices., because there is no good alternative for transportation fuels. Non-OECD Asia is expected to be the largest source of growth in consumption.

Crude1 Read more ›

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Real commodity price trends – part 1: Gold

Contrary to popular belief, gold was not a good store of value in the last century. Adjusted for inflation, the gold price behaved very cyclical. Since the 1920ies  it showed a reverse pattern of economic sentiment. During periods of improving economic conditions, it fell and reached its lows when most people thought that prospects will remain bright (such as the internet bubble). In periods of increasing economic tensions it rose and reached the peak when the €-crisis seemed to get out of control.

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Gold_1

 

Data sources: IMF (www.imf.org/external/np/res/commod/index.aspx);.Kitco (www.kitco.com), World Gold Council (www.gold.org);, U.S. Geological Survey; Data Series 140: Historical Statistics for Mineral and Material Commodities in the United States (minerals.usgs.gov/minerals/pubs/historical-statistics/).  The inflation adjustment was based on the official consumer price index published by the U.S. Department Of Labor; Bureau of Labor Statistics (www.bls.gov/).

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Economic forecasting – voodoo or science? Part 4: The bottom line

Economic forecasts are not complete nonsense or impossible per se. Indeed, it is the way they are usually drawn up these days that can give rise to substantial problems.

  • The quality of the underlying data is often poor. Or it is manipulated or used selectively to support a previously fixed statement.
  • Forecasters try to sound like experts by formulating their predictions more precisely than is actually possible. Indeed, in order to maintain their image as experts who hold superior knowledge, they avoid mentioning possible margins of error, although this additional information would be very helpful for their target audience.
  • Economic forecasts are often made for a period of 1-2 years. However, during this period of time, the complexity of the economic system can often lead to surprises and therefore considerable deviations from forecasts.
  • A decisive factor for the success of some predictions is their ability to trigger a feedback loop with the economy.

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Economic forecasting – voodoo or science? Part 3: Predictions as a social phenomenon

a) “Paint a picture to suit yourself …”

Not only poor data quality influences the quality of a forecast, but also the deliberate selectivity and manipulation of the data used to draw up a forecast. Although economists and analysts work with very similar models, it is not uncommon for them to generate very different results. This is because some intentionally select data to produce results that suit the interests of their clients or their own ideological point-of-view.

In recent years, the American statistician Nate Silver has acquired renown for producing successful election forecasts. In his book “The signal and the noise”, he brilliantly describes the general problems of the methods used to draw up predictions. Based on the research of the political scientist Philip E. Tetlock, he differentiates between two main types of prognosticator – the ‘fox’ and the ‘hedgehog‘. Their personalities were originally described by the Greek poet Archilochos: “The fox knows many things, but the hedgehog knows one big thing“.

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Economic forecasting – voodoo or science? Part 2: The odd methods for producing economic forecasts

a) “Garbage in, garbage out”

If predictions are drawn up on the basis of data analyses, the quality of the underlying data is crucial. The most sophisticated forecast model is absolutely no good if the quality of the information entered into it is poor. Statisticians describe this phenomenon as “garbage in, garbage out”.

The quality of data used for economic forecasts is a major problem, in particular regarding predictions about macro-economic performance – i.e. about the domestic product, unemployment, export statistics and inflation. For some of these measures, reliable data is sometimes only available months after it has been collected. Initial predictions often subsequently have to be dramatically revised several times, particularly when the economic trend reverses. At the beginning of 2008, the US economy was already in a considerable downturn, as shown subsequently by revised data. However, most economists were not aware of this at the time, as they were basing their forecasts on incorrect information. As a result, they were making forecasts that were far too optimistic.

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