Deflation: the taboo which needs to be examined

The funds management industry is famous for its navel-gazing. After a crisis, you can just imagine how much of it goes on. But, perhaps, that self-examination may provide more rewards if it starts to actually look at industry taboos rather than accepted practices.

Take deflation: the potential scourge of the economic world and something which is to be feared more than anything. Or is it?

For pension funds, there are several themes which should be occupying the minds of directors and trustees. These are things such as: whether asset allocation theories continue to apply; whether the crisis has meant markets have altered their fundamental relationships; and whether debt and equity should be put into the same different growth/defensive boxes they have been in for the past 30-40 years.

At a more detailed level, for investment professionals, the three big themes which fiduciary investors should be looking at currently are these:

1. The emerging world has been emerging for a long time and it’s about time Western investors, especially fiduciary investors, recognised it. For instance, the largest countries, as represented by the G5, accounted for about 50 per cent of the world’s GDP in 1950. Now it’s less than a third. In terms of the world’s growth, the G5 last year accounted for less than 20 per cent.

2. Broad market equities no longer provide a free lunch. The equity “premium”, first analysed in 1985 by academics Rajnish Mehra and Ed Prescott, seems to have disappeared during, and maybe post, global financial crisis. Or has it? Worth a look, at least.

3. Diversification, as first espoused by Markowitz through Modern Portfolio Theory in the 1950s, doesn’t mean much if you cannot get it. As we now know, in times of crisis, traditional and non-traditional asset classes all head to a correlation of one.

So, in the spirit of self examination, why not introduce another big provocative observation? Maybe, in the changing world we’re seeing, deflation is not necessarily a bad thing. Maybe, economics needs to be questioned along with investment finance?

Notwithstanding all this, when economists and fiduciaries look at the world’s economy, they have traditionally taken heart that the authorities have always tried to avoid deflation. Inflation’s not great, but a little bit is not that bad, so the consensus goes.

The UK-based asset allocation advisory firm of Smithers & Co begs to differ. And its principal, Andrew Smithers, mounts a good argument.

Smithers, a popular investment commentator in the UK, wrote a report published September 20 in the London financial trade paper Financial News, in which he suggested ways of rebalancing the global economy.

The interesting thing about this is that Smithers, who is generally regarded as a bear on equity markets, puts an economic case for what he sees as the current over-valuation of markets, rather than an investment or financial one. And in the same breath, he provides world governments with a blueprint for working their way through the current mire.

In his recent article he says: the developed world must have a much lower inflation rate than developing countries. At the same time, budget deficits in G5 countries must be brought down. An improvement in current account balances is essential and cannot occur without either protectionism or a fall in real exchange rates in the developed world.

He questions the assumption that developed countries should aim for an inflation rate of 2 per cent. Deflation has, historically, not been that bad for economies. Milton Friedman, the monetarist economist who dominated accepted theory during the 1970s and 80s, believed that deflation should run at the same rate as real growth, such that nominal GDP was unchanged.

“The fear of deflation is probably more dangerous today than deflation itself,” Smithers wrote. “(Deflation) in a mild form for developed economies would help the essential progress towards a more balanced world economy.”

*Greg Bright is the Beijing-based publisher of