Monday, April 6, 2009

Switzerland Falls Into Deflation

As Ambrose Evans-Pritchard notes, Switzerland is the latest country to join the deflation club. Swiss CPI fell 0.4% in March on a year-on-year basis, and is projected to fall to -1% by July. The Swiss franc's status as a currency safe haven has exacerbated this downward pressure, as the franc has gained value, driving the value of imports down, and hence forcing domestic goods to become cheaper as well in order to compete. The Swiss National Bank (SNB) has promised to aggressively move to lower the exchange rate to counter this threat, raising the specter of competitive devaluations. Evans-Pritchard explains:
Yet even the SNB's hard men have thrown away the rule book, taking emergency action to force down the exchange rate of the Swiss franc.

Here lies the danger. If other countries try to export deflation by this means, we will face a second phase of the global crisis. Taiwan is already devaluing. Korea, Singapore, and Sweden all seem tempted to follow. Japan is chomping at the bit.

"We don't fully realise in the West what a catastrophic collapse Japan has suffered," says Albert Edwards, global strategist at Société Générale. "The West has dumped a large part of its economic downturn onto Japan by devaluing against the yen."
This is about to go into reverse as Tokyo hits the ping-pong ball back across the net. "As the unfolding collapse in the yen gathers pace, the West will see its green shoots incinerated to dust," he said.
By devaluing, a country makes imports more expensive, pushing up prices across the economy. There is a concomitant fall in prices abroad, as the country's exports become cheaper, pushing down prices with its trading partners. But this only works if it is pursued individually. If a host of countries try to gain a competitive advantage by devaluing, then there is a race to bottom that nobody wins. Relative prices between exports and imports remain the same, while the prices of real assets - commoditites, real estate, and stocks - jump. This is a path towards mutual ruin. Because wages are sticky, households will find it harder and harder to pay for the basics of housing and energy.

Will world leaders - particularly from trade surplus countries where there is an incentive to export troubles away - be able to organize the type of collective action necessary to avert such disaster? Not likely.

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