Devaluations risk leading to a Cycle of Deflation

Deflation.jpgIn February, the blog worried that we were at the start of a cycle of deflation, as depicted in the above chart from Comstock Partners.
The warning signs were that major excess capacity was developing in many industries, and some major countries were devaluing. Since then, the US and China have both undertaken competitive devaluations versus the euro, following the lead of the UK and other countries.
Now Nobel Prize-winning economist Paul Krugman raises the same issues in the New York Times. He believes that “in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation“. And he worries that this is happening as US unemployment is getting worse.
Equally, China has not yet come close to replacing its 23 million job losses in Q4 last year. And the risk is that both China and the US will want to devalue against each other. As Krugman suggests, this could easily lead to “month after month of headlines juxtaposing soaring U.S. trade deficits and Chinese trade surpluses with the suffering of unemployed American workers“.
Without capacity reductions, industries such as chemicals will not be able to restore their pricing power. The risk is that we will then see increased calls for protectionism in many countries. The cycle of deflation will then become unstoppable.

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