Monday, March 2, 2009

The Need To Allow Prices To Fall

The wonder of the modern economy is the operation of the market and the price mechanism. This means that prices must rise and fall.

But how is it that everybody seems to be happy with inflation of their assets and policymakers are now worried about deflation that they are willing to stop it?

Prices rise because of an increase in demand - which will then trigger an expansion in capacity and supply - meaning that there will be an increase in equipment and space and a hiring of people to man the shop.

Demand increases because there is optimism in the future - by everybody and they feel that they are cleverest people in the world.

Pessimism arises when some part of the economy hits the wall. If it is just an industrial sector, the rest of the economy can pull along - and some additional spending by the government may help to fill up the lost demand.

But if there is systemic problem, where the foundation of the economy is hit - namely, the banking system - then everybody is adversely affected. There is a collapse of the banks (which the government must step in to support) and a loss in momentum in spending by the private sector (which no amount of spending by the government can fill in).

Everybody becomes an economic refugee.

When people do not know what to do, there is nothing that the government can do except to provide new opportunities.

New opportunities come from deflation. The fall in asset prices give a chance to savers an opportunity to hunt for bargains in assets - and this brings about a change in ownership - which is positive because those who have failed should learn a lesson while those who have been calculative should now step in to rebuild the economy.

The new owners will take the old economy into a new direction.

If savers are not allowed to bargain hunt for assets at home (because of the stop in the deflation process) and if the authorities further make it worse for the savers by cutting interest rates, then the only option left for the savers is to hunt for avenues of investment outside the country - and this results in a decline in the currency - which worsens the cost of doing business and the cost of living.

By pursing near-zero interest rates, the authorities are not putting a premium on the future - which means that it is not encouraging investment for the future. They are encouraging consumption - which is what got the economy in trouble in the first place (when the real rate of interest turns negative: inflation higher than the interest rate).

Demand is both consumption and investment - and rebuilding the economy means new investments in new direction - not the support of the old investment projects which have proven not to be commercially viable.

While the old employees get retrenched, the new economy should be built on the fresh graduates with their new ideas while the old ones get retrained. This allows the economy to shed old skin and come out with a new shine.

The adjustment of the economy is important - if the economy is to find its new footing for the future. Otherwise, it will end up dependent on a series of stimulative packages - when what it really needs is a kick in the back.

The price adjustment is an important transformation of the economy. The prices are not allowed to fall, there may be no adjustment in the economy.

The recession in the 1980s killed off the old generation. This one should kill off the current generation - and provide a chance for the new generation to define their own future.

For example, the problems of the construction may not be solvable in a nice way - if we are see better standards in construction with greater reliance on technology rather than using the old manual ones. Developers may have invested in overpriced properties and those without holding power may have to go under so that new, better, bigger and cheaper houses can be build to attract new buyers.

If the car industry cannot innovate, then it should be left to die so that there is greater need to expand the public transport system which is better coordinated with urban and township planning as well as entertainment and cultural centres to attract people to come out at night.

At the moment, we are stuck in the same old thing - in order just to preserve the old wealth.

1 comment:

de minimis said...


This is a good reminder of the quality of the economic policy thinking (or the lack thereof). The current tycoons will desperately cling to their dying businesses. This is to be expected. They hope to hang on until the storm blows over.

As you correctly say, this process of clinging on to their dying empire prevents the regeneration of the economy.