Deflation is bad for an economy, particularly for the heavily indebted – your mortgage remains the same even if your salary declines and Government debts increase in real terms as deflation increases the value of the currency they are denominated in. Over time this leads to debt repayments consuming a greater portion of income leaving less to spend so reducing aggregate demand and consumption.
In addition, deflationary expectation adds to economic drag by encouraging people to defer expenditure – spending less today in the hope that the same things can be bought for less tomorrow.
The good news for the heavily indebted in Switzerland is that interest rates are falling so while principle repayments might increase in real terms, declines in interest payments will reduce the sting, although this is no consolation for those with fixed rates.
The negative impact of deflationary expectation will be highly uneven and general Consumer Price Indices (CPI) misleading. Deflation calculations are based on the price movements of a basket of goods however many of the items in the basket are not deferrable purchases. For example it is unlikely that people will defer buying milk and eat dry cereal. On the other hand they might delay buying a new car. A decline in the price of milk is therefore less of a concern than a decline in the price of cars. In the same way supermarkets will fare better than car sellers, one reason why Mercedes Benz recently lowered Swiss prices by a whopping 20%.
What can be done to prevent deflation? Money creation by central banks is one cure however it doesn’t always work. To put downward pressure on the Swiss franc the Swiss National Bank (SNB) created lots of Swiss francs and stuffed them into the banks only to find that it just sat there with little effect. It then resorted to using newly minted francs to buy large quantities of Euros (and other foreign currencies) only to find itself with a gargantuan balance sheet and a currency cap that it couldn’t defend. Weakening a currency and staving off deflation are two sides of the same coin and require similar central bank medicine.
So the SNB has tried this medicine and it didn’t work. What else can be done? If Swiss businesses can find ways to produce more with the same people either through increased investment, increased efficiency or by shifting towards higher value-added products and services nominal GDP growth (measured in Swiss francs) could be maintained. Of course this is nice in theory but slow and difficult in practice. Switzerland however does have an enviable track record here. A nation with few natural resources (not even a sea port) has invested heavily in education and technology with startling results in sectors such as pharmaceuticals. If it can do more of the same it could weather the storm and emerge stronger than ever. Only time will tell.