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Deflation was benign during the late nineteenth century, but pernicious during the Great Depression. It has been extremely troublesome in Japan of late, but seemingly not seriously damaging in China. It has prevailed in Hong Kong for the past five years but, despite the pain it may have inflicted in certain quarters, notably in relation to the property market, real GDP has expanded considerably since 1998. Therefore, deflation need not necessarily spell disaster. However, it is likely, if it persists, to lead to sub-optimal macroeconomic outcomes, in particular because nominal interest rates cannot be negative. In Hong Kong, the Financial Secretary is for the first time forecasting no prospective resumption of positive inflation in the medium term; a non-negligible risk of continuing deflation can be inferred. Meanwhile, he projects the underlying potential growth rate of the economy as 3% per annum. In such circumstances, it may be desirable to switch to an active monetary policy, designed to achieve modest positive inflation, but this would only be advisable if confidence in the new monetary order could quickly be established among markets and the international financial community. The present institutional framework within which the Hong Kong Monetary Authority operates may not be adequate to secure such confidence, and any attempts to alter the framework might prompt unhelpful speculation. Thus, Hong Kong may have little choice for the time being but to stick with the prevailing institutional relationships and its pegged exchange rate under the currency board.

It is only in the last few years that most of us have had any experience of deflation in our own lifetimes. The predominant state of the world from the onset of the second world war up until almost the end of the twentieth century was inflation, and for much of that time the main preoccupation of central banks was to combat or contain inflation.

Looking further back, however, deflation was not unusual. The two most recent preceding episodes were in the later part of the nineteenth century and during the Great Depression of the 1930s.

As to the present, Hong Kong may soon be embarking on its sixth consecutive year of deflation. Despite deflation, and the pervasive air of despondency which has accompanied it for much of the time, the economy has still grown in real terms. But has deflation nevertheless been holding things back? Might economic performance have been better had the price level been rising rather than falling? Can Hong Kong afford to acquiesce to the possibility of continuing deflation? If not, should anything be done about it?

This paper explores these issues, against the background of earlier episodes of global deflation. Thus, Section II considers whether and why one ought to be concerned about deflation. Section III reviews experience of deflation in the late nineteenth century, during the Great Depression, and in China, Hong Kong and Japan today. Section IV examines the sources of deflation today in comparison to the earlier episodes. Section V discusses the challenges which deflation poses for monetary policy.

Section VI analyses the current dilemma facing Hong Kong, and Section VII discusses the institutional relationship between the Monetary Authority and the Financial Secretary. Section VIII presents some conclusions.

As a preliminary, it is necessary to establish what we mean by deflation. It may mean different things to different people. It is taken here to refer to the phenomenon of a persistent period of decline in the overall price level for final goods and services (as typically captured by the consumer price index) or for factors of production (as in the GDP deflator),² whether or not it is accompanied by declining asset prices.

There is general agreement amongst economists and politicians alike that a stable monetary environment is desirable as a necessary foundation for prosperity of the real economy, and that the primary role of central banks is to deliver a degree of stability to the purchasing power of the currency. But how should that desired stability be defined?

A consensus emerged during the later years of the twentieth century that the aim should be for a steady rate of positive inflation, with preferred rates generally falling in the range 1% to 3% per annum in terms of the CPI.³ Thus, it was implicitly accepted that inflation is preferred to deflation. Why so? Why not deflation? Or, for that matter, why so low a target for inflation?

Inflation
There are well-known drawbacks to inflation: the asymmetric distributional effect between debtors and creditors; the pain suffered by those on fixed nominal incomes; the real wastage in so-called shoe-leather costs as you shop around to beat price hikes and make more frequent visits to the bank or ATM because of a desire to minimise holdings of depreciating paper money; inequities delivered by progressive tax structures; and so on. These potential problems are greater the higher is the rate of inflation. However, so long as inflation is correctly predicted, some — but not all - of these costs can be anticipated and largely averted, as indeed they were in many instances in past decades, for example by various forms of indexation. It became possible to survive with inflation.

In understanding why it was nevertheless felt necessary to keep inflation low and stable, but positive, there are two key considerations.

There is also an argument that aggregate inflation is necessary in order to facilitate the adjustment of relative prices. This is based on the view that individual prices are sticky downwards. Despite contra-evidence both from trend price reductions that have characterised certain durable goods at times over the past decades and from the opportunistic price reductions which are everyday evident in the shops, downward stickiness may exist in instances where price reductions would require lower input wage rates. To this extent the argument may carry some weight.

Deflation
As regards the problems posed by deflation, many of the concerns, as in the case of inflation, dissipate if the process is anticipated. It would in principle be possible to devise ways to help us live with deflation. Even nominal wage levels are no longer sacrosanct: Hong Kong's recent experience demonstrates how far previously entrenched attitudes may alter once a fundamental change in the environment is established. Provided that deflation is not so great as to confront the zero lower bound on interest rates, financial contracts such as mortgages and life assurance products could be redesigned to accommodate expected modest deflation in the same way as they have over the years been adapted for inflation.

However, the enduring obstacle is the fact that the nominal interest rate cannot in practice be negative. Despite some rare instances of deposit charges being levied on certain classes of bank customer in order to discourage speculative behaviour, there is no record anywhere of generalised negative interest rates being applied. Anyway, any such move would succeed only in precipitating a massive switch into physical currency, which would scarcely serve the other usual goal of the authorities - banking stability. Although it has been suggested that, in principle, negative interest could in turn be levied on currency holdings, there does not appear to be any practicable way of effecting this.⁴

The zero interest rate bound
The problem posed by the zero lower bound on interest rates is the overwhelming reason in favour of aiming for modest positive inflation. Two factors relating to this bound deserve particular attention.

• First, real interest rates, as they affect spending decisions, depend more on inflation expectations than on past price behaviour. A lapse into deflation that is widely expected to be temporary should have few adverse consequences. The greater problem arises only if economic agents expect deflation to persist.
• Secondly, the impact of interest rates on economic activity depends to a significant degree on the gap between the real rate (based on inflation expectations) and the natural or neutral rate, which approximates to the potential growth rate of the economy. For economies at a stage of economic development associated with fairly rapid productivity growth (of which China is an obvious example), this neutral rate is relatively high, so that mild deflation and a non-zero nominal rate may still be capable of delivering an actual real rate significantly below its neutral rate. If the authorities seek to stimulate the economy by easing monetary conditions, nominal rates may not need to test the zero bound before the economy responds in the desired way -- assuming that the transmission mechanism of monetary policy is effective. By contrast, in economies where the growth potential is estimated to be rather slow (into which category most of the world's more mature economies would fall, notably Japan), even quite mild deflation may determine that nominal interest rates ought to be reduced to zero, after which point further operation of conventional interest rate policy is effectively in baulk.

Debt deflation
The great fear is lest the economy be plunged into a downward debt-deflation spiral, of the sort so succinctly described by Irving Fisher seventy years ago. Although his context was over-indebtedness arising initially from excessive credit extension, much of it associated with speculative activity, and followed soon after by deflation, the initial trigger could equally be the over-indebtedness which arises as falling prices lift the real value of debt. Fisher described the subsequent chain of events as including debt liquidation, contraction of money, falling prices, falling net worth of businesses, falling profits, reduced output, bankruptcies, pessimism and loss of confidence. Additionally the liquidity trap may loom, where everyone is content to sit on their money rather than invest it in assets that offer little prospect of a superior real return.

It is the preference to hold liquidity over other assets, and the precautionary saving behaviour as a result of the general decline in confidence, rising unemployment, etc, that are the main forces depressing activity. Additionally, there is the prospect of simple inter-temporal substitution between consumption and saving when real interest rates rise, but the likelihood of significant postponement of expenditures may be exaggerated, since only certain elements of consumption can in practice be delayed for long, and even then delay may involve considerable disutility.

Summary
As in the case of inflation, it may be possible to live satisfactorily with some deflation, particularly if it is shortlived or has been anticipated. But the two situations — inflation and deflation - are not symmetric, notably so in the context of the zero interest rate bound, which comes into play only in the case of deflation. This suggests that the only deflation which is likely to be at all tolerable is a quite mild one.

The late nineteenth century
In the thirty years 1865-95, consumer prices are estimated to have fallen by 48% in the USA and 27% in the UK – average compound annual rates of about 2% and 1% respectively. Despite this deflation, GDP growth averaged 5-6% pa in the US (admittedly aided by immigration) and 1¾% in the UK.⁵ These were the world's two leading economies and this is one of those periods which has been referred to as a golden age. Activity was driven up and prices down by rapid increases in productivity arising from technological innovation, rising labour supply, and the surge in world trade — long before the term 'globalisation' was ever fashionable. The stock of gold did not grow fast enough to keep pace with the increase in industrial output (although as the period progressed South Africa was emerging as a major supplier of new gold); as a result, under the gold standard, with money not growing as fast as output, the price level fell. Prima facie, we can perhaps presume that, because of high rates of potential real growth at least in the US, the natural real rate of interest was sufficiently high so that the floor on real rates implied by the zero nominal floor was never, given the fairly meagre pace of deflation, a binding constraint on activity.

The Great Depression
The Great Depression of the 1930s presents an altogether different story of deflation. It was deepest in the US, where, between the third quarter of 1929 and the first quarter of 1933, real GDP fell 25% and nominal GDP about 50%. The money stock contracted by one third, despite an increase in the monetary base.⁶ A knock-on effect was felt throughout the world.

The balance of opinion nowadays is that mistakes and ignorance in monetary policy were prime causes of the Great Depression. In the years 1924-27 the world economy was sustained by US capital outflows aided by an accommodating monetary policy. But the Federal Reserve, worried above all about soaring share prices on Wall Street, started tightening early in 1928 and progressively raised its discount rate, from 3½% to 5% by May 1929, despite the fact that the US was already attracting inflows under the gold standard system, to which the appropriate response would have been a relaxation of interest rates. Also, even before the stock market crash, there were signs in 1928-29 that excess capacity was emerging in the US economy.

The Fed has been accused of being too much obsessed by the behaviour of share prices at that time and thereby of precipitating the depression. That would help explain the slump in the US. But its transmission to the rest of the world would not have been so virulent had it not been for the gold standard. How is it that the gold standard, which appeared comfortably to accommodate the deflation-boom half a century previously, now came to bear the blame for a deflation-slump?

The answer appears to lie in part with the fact that the gold standard had undergone some subtle changes. Five may be noted:

• Sterilisation. The classical gold standard depended essentially upon national monetary authorities allowing gold inflows and outflows to impinge automatically on domestic monetary conditions — with an inflow leading to monetary expansion, lower interest rates and/or faster inflation and hence a curtailment of the inflows, and vice versa for an outflow. However, during this episode both the US and France tended to sterilise their inflows and hence frustrate this adjustment mechanism. By mid-1931 these two countries accounted for 60% of world gold reserves.⁷ Their actions imposed a deflationary bias on the system, since those countries which were losing gold had little alternative but to tighten policy even if the US and France failed to ease. The Fed believed, even after the stock market crash removed one justification for caution, that credit was in ample supply, even if people weren't taking it, and saw little reason for allowing inflows to fuel it further.
• Foreign exchange holdings. Countries had begun to hold reserves in foreign exchange as well as gold. This helped to expand the effective global monetary base and compensate for any shortages in gold supply to which the hoarding by surplus countries contributed. However, this was a source of instability as soon as authorities began to lose confidence in any of the currencies and to seek to convert their currency holdings into gold.
• Wage rigidity. Socio-economic change, including increased unionisation, since the first world war meant that the downward flexibility of wages, which was a desirable if not an essential part of the adjustment process to contain real wages, was now very difficult to achieve. Real wage rates went on rising through 1930-31 in most countries, and even longer in those which stuck with the gold standard.
• Protection. In order to protect labour from the adjustment process which might require reductions in wages - in nominal terms even if not in real terms - or job losses, governments resorted to protective measures, such as import tariffs or quotas, or steps to repatriate or curtail foreign workers. This frustrated the adjustment mechanism of the gold standard system.
• Weakening of cooperation and credibility. There had been an erosion of the international co-operation which had prevailed in the pre-war era,⁸ and the pain that had been encountered in restoring the gold standard system did not help its credibility.

In addition, the responsibilities of central banks to serve as lender of last resort or to provide essential liquidity to the monetary system were not so clearly understood or defined as they are today.⁹ Central banks tended to be less able or less willing to come to the aid of the banks. The Fed, for instance, was both restricted in the assistance which it was permitted to provide via open market operations, and for some time reluctant to assist those who were perceived as having precipitated their own difficulties by reckless lending.

That the gold standard played a hand in the recession is supported by the observation that the timing of recovery of various countries from the depression appeared to be correlated to the timing of their abandonment the gold standard.¹⁰

Once the recession began in the US it was fuelled in a downward spiral by the inherent weakness of the banking system. Price deflation swelled the real burden of debts at a time when the recession in activity was anyway making life hard for borrowers. Mounting non-performing loans put the banks under pressure and, as failures began, the public moved their money away from the banks, so exacerbating the banks' liquidity problems. The situation wasn't helped by the fact that US banking comprised thousands of small banks.

Nor was the plight of the banks helped by the stance of the Fed towards them. The Fed adhered to the real bills doctrine. This prescribed that the Fed should lend to banks only against the collateral of commercial bills, drawn in relation to real economic activity. Possession of a good portfolio of such bills was regarded as evidence of a sound bank, functioning in support of the real economy. However, as recession set in and trade declined, so did the supply of this paper. Small banks, especially those in rural areas, anyway held few if any such bills, and were not even members of the Federal Reserve System. They were therefore refused help, but their failure soon had an adverse effect on confidence in banks as a whole. The process snowballed. By the spring of 1933 some 11,400 banks had failed (45% of the total by number).

Because of the banking crisis, when eventually monetary policy was eased, the financial infrastructure was poorly placed to deliver the necessary intermediation to help revive the economy.

Experience of deflation today
The extent and severity of deflation in the world today is very modest by comparison to the Great Depression. Although many economies have seen very low inflation rates in the recent past, with several recording some negative figures, there are only three major instances - China, Hong Kong and Japan - of significant deflation in the sense of a persistent period of decline in the overall consumer price level.

Of these three, China has witnessed relatively mild and more sporadic deflation than the other two. And it has not experienced a severe drop in asset prices as have Japan and Hong Hong; asset prices would anyway be expected to play a less important role in an economy at China's stage of development. The performance of the real economy in China, in terms of GDP, has not differed much during the period of stable or falling prices from that during the preceding years of significant inflation, with growth being sustained at around 7-8% pa.

Nevertheless, worries have been expressed about particular challenges which deflation may pose for China. The banks may face problems if their customers encounter difficulty in repaying debts which have grown in real terms. The development of social security, pension and insurance arrangements, which is a major agenda item at the present stage of the country's development, may be complicated, if nominal obligations unexpectedly increase in real terms (or yield assumptions prove unduly optimistic). There is also an acknowledged potential fiscal problem insofar as revenue from ad valorem taxes declines under deflationary conditions.

Hong Kong has experienced the steepest deflation, with the consumer price index now some 14% below the peak in 1998. This has been accompanied, and in part contributed to, by a decline of around 60% in property prices. During this period GDP has grown significantly (by 20% in the five years 1998-2003, on the basis the Budget forecast of 3% growth this year¹¹ ), but very unevenly and by an insufficient extent to prevent a generally higher level of unemployment. Meanwhile, consumer confidence is weak, particularly as a result of the erosion of wealth caused by the collapse in property prices. Official statistics show wages having fallen only marginally, implying a possibly marked shift in income share from capital to labour, but this series may not capture fully the adjustments which have taken place to bonuses and other fringe benefits, or through longer working hours for the same pay, nor the fact that starting pay for new recruits has widely declined, even if existing staff have not had their pay cut. Given Hong Kong's exchange rate link to the US dollar, deflation, compounded in the past year by the decline in the US dollar against other major currencies, has resulted in a notable recovery in competitiveness, as gauged by the trade-weighted real exchange rate, with signs of an associated pick-up in external demand. In a highly open economy such as Hong Kong's, this necessary adjustment process may assist to bring deflation to an end in due course, but, judging from current forecasts, perhaps insufficiently so.

The main concerns have centred around the impact of the fall in property prices. Although the banks remain sound, profitability has been under pressure in the face of extremely weak credit demand and the decline in asset prices, which has driven mounting numbers of householders into negative equity; the level of bankruptcies and rising defaults on credit card debts are also worrisome. More generally, the adverse wealth effect, together with high unemployment, has had a pervasive negative influence on consumer sentiment. There are also concerns in some quarters about the potential for continuing deflation as a result of closer integration with, and the increased competitiveness of Mainland China, although some official Hong Kong estimates suggest that this worry may be exaggerated.¹² In any case, although these developments may be contributing at present to some absolute deflation in Hong Kong, the secular adjustment of relative prices would need to take place whatever the absolute price level, and the growing integration with the Mainland economy is generally regarded as an overall positive factor for Hong Kong, given strong complementarities. The effect of deflation in reducing fiscal revenue has also been a concern in Hong Kong.

In Japan deflation has been more prolonged though less steep than in Hong Kong, and has generally been accompanied by notable weakness in economic activity. As with Hong Kong, a collapse in asset prices (which dates back to the stock market peak in 1989) has been perhaps the most important ingredient. This has in turn contributed to severe difficulties in Japan's banking sector and impairment of the financial intermediation process. Indeed, the problem of deflation is inexorably tied to that of structural adjustment. The problems facing banks and corporate business have not primarily been caused by deflation but have been exacerbated by it, as business has been confronted by rising real debts and banks have been confronted by increasing loan defaults. The inability or reluctance of banks to extend new credit has followed. The need for structural reform, especially in the non-traded sector, is widely accepted, although it is acknowledged that action on this front could exacerbate deflation in the first instance. Thus far, administrative measures to support weak sectors and delay restructuring have almost certainly averted more acute price deflation.

It is of interest to examine the sources of today's deflation and compare them with the contributory factors in the earlier historical episodes.

Monetary policy and exchange rates
With the majority of the world's leading economies nowadays operating with an inflation objective, whether explicit or implicit, of the order of 1%-3%, there is not much room for manoeuvre to avoid a dip into deflation, should some negative price shock occur. However, because of the zero lower bound on nominal interest rates and the threat of the liquidity trap, it is potentially more difficult for monetary measures to successfully cure deflation than inflation. In theory, therefore, pre-emptive action is required to head off deflation before it takes hold. But this is only possible if the seeds of deflation can be identified in advance. In practice, shocks are seldom anticipated. Most central banks have, however, avoided deflation and been remarkably successful over the past decade in meeting their low positive inflation objectives. Given the painful experience with inflation in the 1970s and 1980s, there is no significant constituency calling for relaxation of the broad policy objectives, and few are confident to argue that any favourable effect on real growth could be achieved from allowing a higher rate of inflation, other than in the short term.

Given that the authorities in each economy have sovereignty over monetary policy, those who may be experiencing unpalatable deflation should, as in the case of an unpalatable degree of inflation, be prepared to address the problem unilaterally by adjusting their monetary policy.

Hong Kong admits that its rigid monetary stance — the fixed exchange rate under the currency board - has contributed to deflation, but does not regard this as sufficient grounds for abandoning the exchange rate anchor. Some other Asian economies appear to have been content after the Asian crisis to allow the necessary downward adjustment to their real exchange rates to be effected at least partly through a reduction in the rate of domestic inflation — in some cases with some modest deflation — rather than wholly through nominal depreciation. Other significant factors there have been lower prices for some primary products and decisions to hold down administered prices. In China, for mainly structural reasons the easing of domestic monetary conditions does not appear to have much impact on the price level.

With the benefit of hindsight, Japan should perhaps have relaxed monetary policy more aggressively at an earlier stage. In addition to inefficiencies in financial intermediation, the effectiveness of monetary easing has been partly frustrated because the capital squeeze experienced by Japanese investment institutions, which are conservative in the best of times, resulting from lower asset prices, has inhibited their portfolio allocation into other currencies; consequently the yen exchange rate may not have depreciated so much as might have been otherwise expected.

Thus, while the severe monetary mistakes of the Great Depression have been avoided, the limitations of monetary policy in addressing deflation have again become apparent. In some current cases the authorities have contributed to deflation, whether deliberately or unwittingly.

Problems in the financial sector
Although some difficulties faced by banks, such as increases in non-performing loans and loss of endowment income as a consequence of low interest rates, may partly be the result of deflation, banking problems can also be a contributory factor to deflation. This has been particularly evident in Japan, where the financial intermediation that is necessary to convert monetary relaxation into increased demand, has generally been impaired by problems within the financial sector. This has been one of a number of factors frustrating the authorities' efforts to reflate the economy. There are similarities here with the banking problems of the Great Depression.

Supply-side influences
There is broad agreement that declining costs have been a more significant factor in the world economy in recent years than for several decades previously. The downward pressure has arisen partly from gains in productivity which have not — at least thus far — been reflected in wages. The productivity story relates in particular to advances in the application of information technology and, more significantly perhaps, to the rapid integration of China and some other low-wage countries into the global economy. Reductions in trade barriers and the increasing integration of the world economy have ensured that these effects are more pervasive than they might earlier have been. And the heightened competition which follows is reaching across an ever broader spectrum of markets, in services as well as in goods. There are parallels between this experience and that of the deflationary period at the end of the nineteenth century.

In China there have been some additional forces acting to contain or depress costs. The surge in inward foreign direct investment has been a catalyst reinforcing the trends outlined in the preceding paragraph. The increased exposure of the agricultural sector to world markets as a result of WTO accession has perhaps been exerting some downward pressure on rural prices and incomes. And the surplus of rural labour together with the release of labour from state-owned enterprises as that sector is rationalised have helped maintain a plentiful supply of labour for other ventures. Meanwhile, although demand for university educated persons is generally buoyant, a sharply rising trend in the numbers graduating from universities is expected to exert some restraint on the pace of advance in salaries of higher-skilled or professional personnel, despite rising demand.

Deficiency in aggregate demand
Demand weakness was not an evident factor in the nineteenth century episode, while in the Great Depression in the US it was largely self-inflicted as a result of operating too tight a monetary policy; the collapse in US demand served as an exogenous demand shock to the rest of the world.

As regards deflation today, there is some evidence of weakness in demand being a significant cause. This has arisen from a variety of factors, including the bursting of asset price bubbles and associated negative wealth effects; the downturn in the investment cycle, especially in the United States in the aftermath of the technology-related boom; and the caution induced by geopolitical developments. Much of the weakening in demand was unanticipated in terms of magnitude or persistence. And in some cases the authorities may have reacted - or may even now be reacting - too slowly or too timidly to stimulate demand.

Even for China, it can be argued that, despite robust GDP growth, domestic demand has been deficient relative to supply, partly as a result of cautiously prudent behaviour by households in saving for education, medical care, pensions, housing and so on in the new socio-economic environment, and because channels for domestic savings to finance business investment opportunities are underdeveloped.

Particularly in Japan, the downgrading of future expectations of growth (for a variety of reasons relating to economic structure, demography and the fiscal position) has arguably led to a disproportionate scaling back of consumption and investment demand, which has fuelled a deflation psychology. This process may be the obverse of that which was observed in the United States in the late 1990s, when an acceleration of trend growth led to a disproportionate increase in consumption and investment.

It is notable that in all three above instances of actual deflation, the authorities are facing not only a declining CPI or GDP deflator, but also other vicissitudes, ranging from the aftermath of a steep fall in asset prices to the process of, or need for, widespread economic or financial restructuring — an imperative which has arisen largely independently of deflation. Arguably, these factors pose greater challenges for policy than does deflation of itself.

Since deflation is essentially a monetary phenomenon, the first line of defence — or attack — against it should be monetary policy.

As noted already, there are asymmetries between using monetary policy to combat inflation and using it to combat deflation. The main asymmetry arises from the fact that no additional stimulus can be applied via interest rates once the zero lower bound on nominal rates has been reached. Another potentially important one is the downward rigidity of wages which typifies many economies.

The authorities need to focus as much on price expectations as on actual prices. In particular, even if actual deflation is current, economic agents must be influenced to expect positive inflation ahead. But, if short-term interest rates (the usual policy focus) are already at or near the zero bound, effective use of what is usually the principal tool of monetary policy is denied.

Japan is the sole recent example of an economy where this interest rate dilemma has thus far been plainly acute. The authorities have therefore pursued a policy of aggressive quantitative easing through central bank purchases of securities and occasionally foreign exchange. Ideally, such a strategy should help to redress deflation, by stimulating economic activity through reductions in longer-term interest rates, portfolio rebalancing, exchange rate depreciation and generation of positive inflation expectations. Deflation ought also to stimulate expenditure through the positive impact on the real value of monetary assets.

In Japan's case, despite a rapid expansion of the monetary base as a direct result of official operations, the strategy of quantitative easing has produced little follow-through into broad money. This reflects the fact that credit demand is weak and the banks very cautious, and relates to the broader structural problems facing the country. Nevertheless, it can be argued that the commitment to maintain essentially zero short-term interest rates until deflation ends has lowered government bond yields effectively and that the overall strategy has at least been successful in averting a plunge into a more severe deflationary spiral.

In view of the fact that quantitative monetary easing in Japan has not yet produced the desired magnitude of effect, what alternatives could be considered? Some advocate that a much larger share of the fiscal deficit should be monetised and that this be done through more aggressive purchases of government bonds in the market or even directly from the government, in a manner which would deliver yet further reductions in long-term rates. Some simultaneous expansion of the fiscal deficit — even distribution of 'helicopter money' in extremis — could be considered, although there have already been abundant criticisms of seemingly unproductive additional government spending.¹³

The exchange rate plays a potentially key role in any attempt to redress deflation through monetary policy. Under a floating regime one would expect, ceteris paribus, easier monetary policy to involve a weaker exchange rate than otherwise, which would be an important contributor to inducing positive inflation expectations through both direct import price effects and the stimulus to export demand. As noted earlier, however, the yen exchange rate has not always behaved in the conventionally expected manner, as a result inter alia of investor conservatism in Japan and market beliefs that the yen has a habitual tendency to appreciate to offset any competitiveness gains which deflation may bring.¹⁴

In the case of Hong Kong, the exchange rate is fixed against the US dollar under currency board rules which preclude any discretionary easing of monetary policy. In China capital controls allow a degree of autonomy in domestic monetary policy while the exchange rate is managed so as to hold it steady against the US dollar, as it has been for nine years now. Despite arguments for the renminbi to be revalued on competitiveness grounds and because China is allegedly exporting deflation, any appreciation would merely exacerbate domestic deflation. Indeed the prognosis is rather that more rapid monetary easing is needed in order to generate domestic inflation, or that capital controls should be relaxed, either of which would present the prospect of a weaker rather than a stronger exchange rate. Other economies fearing deflation would be unwise to think that the need to take monetary action themselves may hopefully be obviated by Chinese exports somehow becoming more expensive.

In some instances a degree of caution may need to be exercised when easing monetary policy. There is a possibility of the impact being felt too much in financial asset markets, with too little stimulus to demand for and prices of goods and services. And in some economies there may be a concern lest easing has a sharp and unpredicted effect on the price level or exchange rate, causing them to overshoot desired levels, although, since such effects operate with lags, the authorities would have some scope for pre-emptive corrective action.

Generally, however, monetary authorities may need courage to take quite aggressive action, either, in circumstances of actual deflation, to achieve the essential shift in expectations in the direction of positive inflation or, in the case where deflation is only threatening, to ensure that deflationary forces are reversed before a situation is reached where monetary policy may have lost its room for manoeuvre. It is to a large extent incumbent upon individual authorities to pursue the policies necessary to achieve their inflation or counter-deflation objectives; they should not be too reliant on external developments to come to their aid, either fortuitously or through international negotiation.

A further consideration is whether the monetary authorities should be concerned only with the price level of current goods and services, or with asset prices as well. The general consensus, as evident from practices in inflation-targeting countries, is that the CPI should be the policy target, with asset prices at most a subsidiary concern and then mainly only to the extent that they influence the CPI. The Fed's seemingly puritanical crusade against speculation which helped precipitate the Great Depression can be contrasted with its reported reluctance to raise rates in 1999 merely to curb an exuberant stockmarket, although there are some other examples from relatively recent history of the Fed's decisions taking some account of asset markets.

Most of the economic and socio-economic justification for wishing to achieve low and stable inflation relates to current prices (eg CPI) rather than asset prices. The latter are inherently more volatile, and any attempt to smooth them would probably be at the expense of some of the desired stability in current prices. In principle, asset markets should be capable of adjusting themselves to changes in fundamentals and to shocks, and that adjustment may be aided if agents are confident that basic inflation is under control. However, if the behaviour of asset markets threatens serious negative externalities — in the sense, for example, of social hardship, banking fragility or serious erosion of confidence — the authorities can be excused for using monetary policy to avert it. In other words, in normal times asset prices should not enter separately into the equation, but in extraordinary times they may with justification do so.

It is now time to examine the current deflationary experience of Hong Kong in somewhat greater detail, and consider what, if any, remedial action might be contemplated.

Since its peak in May 1998 the CPI has fallen by 14%. Factors responsible include:

In his 2003 Budget the Financial Secretary forecast that the CPI would fall by a further 1.5% this year and then rise by 1.0% in each of the subsequent four years.¹⁸ For the GDP deflator the figures are minus 2% this year followed by plus 0.5% for four years. At the same time, however, he referred to the "trend" rates of change as being 0.5% and zero respectively. This exposes some mild ambiguity as to his assessment of the longer-term outlook. But it seems reasonable to interpret the official view as being that the underlying rate of inflation for the foreseeable future lies somewhere between zero and 1% pa.

The first, obvious point to make is that such forecasts of the inflation rate are inevitably subject to a margin of error, in either direction, although the Financial Secretary provides only a point estimate and does not proffer any probability distribution around that central point. However, in the present context, given that -

- one certainly cannot be absolutely confident of positive inflation; one cannot afford to ignore the possibility of inflation under-shooting the Government's forecast.¹⁹ Does such a scenario arouse concern? Where would the pain arise? What would be the damage?

To a considerable extent life has adjusted to deflation. Consumers don't complain about falling prices in the shops. Producers and distributors may do so, but over time adjustments to costs, especially wages, have taken place.²⁰ Even taxation is being adjusted. However, there is a potentially more damaging effect on spending decisions and hence on activity through the behaviour of real interest rates.

The Financial Secretary estimates that the underlying potential growth rate of the economy is 3% pa, from which one may infer that the neutral medium-term real rate of interest is around 3%. Currently, nominal short-term interbank rates are under 1½%, deposit rates are virtually zero, and the quaintly-termed ‘best' lending rate of banks is 5% but top-class borrowers probably need pay little more than half that. But this refers essentially to short-term rates. For comparison with the neutral rate one ought to take a longer rate. The yield on Exchange Fund bills at five years is fractionally over 3%, so a prime corporate borrower may pay, say, 4%. There is scant scope for further reductions in the nominal rates at which businesses can borrow without banks putting their profitability in serious jeopardy. If markets believe the Financial Secretary's price forecast, then, with nominal rates at their floor, the real cost of borrowing for prime borrowers at medium term may now be 3% - 4%. In other words, the actual real rate may be at or marginally above the neutral rate. But, taking the inflation outlook as given, it cannot fall any further, because the nominal rate structure is bounded at zero.

This may be close to satisfactory as a long-term steady-state position but, if we accept some role for interest rates in steering the economy, it seems desirable that, in order to provide some stimulus, the real rate should be below the neutral rate at present. This could only be achieved by faster inflation.

Note that the problem would be greater if the underlying growth potential of the economy was judged to be lower than the Financial Secretary's assumption of 3%. It's worth bearing in mind that 3%, even though modest by much of recent Asian experience, is way above what most economists assume for, say, Japan, and at the top end of the range generally adopted for most advanced economies.

It has to be emphasised that the requirement is not to be able to fine-tune the real rate. That is not possible, since the authorities can determine the nominal rate only. It is rather to create the conditions in which the real rate is able to adjust within the full range needed, which may include rates significantly below the neutral rate.

One may not, however, expect a very substantial direct impact of lower real rates on credit demand and investment; evidence for Hong Kong suggests that such decisions are not particularly elastic to the real rate per se. But at the margin there would certainly be some encouragement to move out of the liquidity trap — to use idle cash for physical investment activity, against the prospect of a resumption of inflation. There might also be a significant indirect effect, working via the general economic climate and confidence. Moreover, positive inflation and lower real interest rates would alleviate any spectre of a debt-deflation spiral or of the financial intermediation process caving in, even though this has not yet been a major concern - in the way that it was, for example, in the US at the time of the Great Depression.

The degree of success of a monetary stimulus in Hong Kong would depend considerably on the impact on asset markets, especially the property market, since it is the extreme fluctuations in these which have caused both householders and financial institutions the most distress. These prices have a large bearing on the overall state of economic confidence, and it is here that continuing falls might have the most serious consequences.

Given that land is a relatively scarce factor of production in Hong Kong, one would, other things being equal, expect land and property prices to be high compared with other locations. But property is a notoriously cyclical market — not only in Hong Kong - added to which both government policies and interaction with the Mainland economy can play significant roles. In many respects the decline has been beneficial — as a necessary and inevitable adjustment which assists Hong Kong's attraction as a business location and makes home purchase affordable to a wider range of the population. But resulting pressures on the balance sheets of existing householders and of banks have become significant, and there is a good case now for wanting these prices to stabilise. Ideally, in equilibrium they should rise little or no faster than the general price level — the differential being determined by the interacting forces of supply scarcity, government policy and Mainland arbitrage. What is unclear, however, given the variety of factors which affect property prices, is how they would respond at any particular juncture to a shift in macro-monetary conditions.

In sum, the prospect of inflation persisting at or close to zero, as assumed in the Budget, already places the economy on something of a knife-edge. A continuing presence or expectation of deflation, of which there is surely a not insignificant risk, and the resulting tendency for real interest rates to be higher than desirable at this stage of the economic cycle, would certainly produce inferior outcomes compared to the situation of low positive inflation, ceteris paribus.

If further deflation does loom, the only possible means within Hong Kong's own power of averting it would be to adopt an active monetary policy. This would mean abandoning the currency board and mandating the HKMA to operate a discretionary policy aimed, in effect, at producing modest positive inflation, by allowing the exchange rate to float and conducting open market operations in the money market or the foreign exchange market to support the combination of interest rate and exchange rate judged appropriate to achieve that goal.

Drawing on the experience of other economies, such a strategy might be defined in terms of an inflation target,²¹ although, given the openness of the Hong Kong economy and the related evident difficulty which the government itself has had in predicting inflation, quite a wide band might need to be set. Openness also means that the exchange rate would be a major element in the equation, so that in day-to-day operational terms management of the exchange rate might emerge as the principal focus.

There are, however, a number of arguments, of varying validity, against such a regime change. They include the following:

Of these arguments, (g) carries particular force, and could impinge back onto some of the other factors. It would, for instance, be catastrophic to alter the system only to be swamped by a crisis of confidence and a speculative tide against the currency, which called forth a far tighter monetary stance than that from which one was trying to escape in the first place. This fear has always been a compelling reason for not changing the regime. However, now that the real costs of sticking with the peg may be higher than previously, the trade-off could bear re-examination. The following section turns to the institutional question.

The vogue, internationally, during the last quarter of the twentieth century and extending to the present has been to ensure that central banks operate at arm's length from finance ministries, in a defined, legal and transparent manner. For example, central banks in Europe which wished to be involved in the eventual governance of the euro were obliged to display sufficient independence from their respective finance ministries — which in some cases required new legislation. And the many new or restructured central banks which emerged following the breakup of the communist regimes of the Soviet Union and its satellites have mostly conformed to a basic model involving statutory autonomy in the execution of monetary policy.

One may wonder why governments have been willing to exercise delegation in monetary policy in what appears to be much greater measure than typically practised in other policy areas. Perhaps it is the strong political consensus that built up for such an arrangement following periods in which governments were too often tempted to use their influence over the central bank as a means to resolve their financing problems, invariably with inflationary consequences.

Whatever the reasons may have been be, the fact today is that observers and markets are unlikely to have full confidence in a monetary regime unless the central bank is seen to have the necessary measure of autonomy.

Discussion of the precise relationship between central bank and government necessary to deliver that autonomy lies beyond the scope of the present paper. It is clear, however, that Hong Kong is a fairly distinct exception from the usual model. For instance, the HKMA is not a corporate entity; it does not have a board of directors but is under the direction of the Financial Secretary, who is obliged no more than to consult the Exchange Fund Advisory Committee on certain matters. The HKMA does not have its own balance sheet and resources, although it adopts a government account - the Exchange Fund — de facto for that role, but the Financial Secretary controls that account. The Financial Secretary instructs the HKMA as to what monetary policy to pursue, but there are no visible safeguards against abuse of this power (albeit no evidence of past abuse either) . And the Chief Executive of the HKMA is distinct from most other central bank governors and their equivalents in not having a fixed term of appointment with clarity about grounds for dismissal and eligibility for re-appointment.

Of course, a central bank or monetary authority cannot, as a publicly owned institution, expect to be granted complete freedom to act as it chooses. There must be defined limits on its functions and clear accountability. But the HKMA is an outlier in the global context. While its achievements have been very considerable, not least in ensuring the success of the currency board system, international opinion might be sceptical if Hong Kong were to switch to a discretionary monetary policy regime within the existing institutional set-up.

The peg has been an anchor of monetary stability and a source of international confidence, and the Hong Kong economy has generally prospered under this regime since its inception twenty years ago. On balance it has until now remained the most appropriate arrangement for the particular circumstances of Hong Kong.

What has changed now is the behaviour of the price level. The hopes or expectations expressed by many back in 1998 that the deflation then commencing would be relatively shortlived have proved badly mistaken. And now, for the first time, a Financial Secretary is adopting a central assumption of no foreseeable upward trend in the GDP deflator. This must imply a significant probability that deflation may persist. Anyway, a deflation psychology appears to have taken hold, and expectations of that sort importantly influence economic behaviour. A persisting deflationary situation was never envisaged at the time the peg was established. Such a change in the environment demands a review of the framework.

It should be stressed that the problem relates to the behaviour of the absolute price level, not to competitiveness (Hong Kong's prices relative to those elsewhere). It is ill-advised to use either the exchange rate or monetary policy more generally to manipulate price competitiveness, because in the longer term competitiveness is determined by real factors. The rapid improvement in Hong Kong's competitiveness, since the Asian crisis appeared to leave it high and dry, testifies to that view. Arguments favouring a regime change merely in the hope of obtaining a competitive boost are mostly flawed.

This paper has discussed how deflation was benign during the late nineteenth century, but pernicious during the Great Depression; how it has been extremely troublesome in Japan of late, but seemingly not seriously damaging in China. Deflation need not necessarily spell disaster, but beyond a certain point it is likely to lead to inferior macroeconomic outcomes.

In Hong Kong, CPI deflation has been mixed up with a sharp fall in property prices and other cyclical and structural factors, so it's hard to say how damaging per se deflation has been. But, given the constraint of the zero interest rate bound and the implication in official forecasts that the productive potential of the economy may be advancing by no more than 3% pa, there is a significant danger of activity being held back. Certainly, modest positive inflation would be preferable to the further deflation which continuation of current policy risks. One should not be lulled into complacency by the official forecasts suggesting modest economic growth and no more deflation beyond the current year, because, if these represent the central expectation, there must be a risk of a worse outcome — which should not be ignored in the policy planning process.

The Hong Kong dollar peg is not an end in itself, although officials sometimes talk as if it was. It has provided a stable monetary environment conducive to a flourishing economy. But if there are doubts as to whether it can continue so to serve, then it should give way to an alternative regime that can better deliver the objective. However, any switch away from the present regime would pose a considerable challenge in the context of winning the confidence of the markets. As a prior requirement, therefore, some changes would need to be enacted in the status of the Monetary Authority and its relationship with government, in order to make absolutely certain that a move to a more activist system was not the prelude to a sacrifice of proper monetary or fiscal disciplines, and such resolve would need to be demonstrated in a convincing manner to the rest of the world.

Reform of the institutional nexus between the Government and the Monetary Authority is probably desirable regardless of the prevailing or intended monetary regime, but any formal discussion of such reforms might pose problems for the authorities by sparking speculation about possible imminent changes to the monetary regime.

In sum, in many respects the time has probably come for Hong Kong to be in control of its own monetary policy.²⁴ But the Monetary Authority lacks sufficient autonomy for such a regime to be sure of winning international confidence. In practical terms, any hint that a change in the institutional structure or the monetary regime was being contemplated might precipitate awkward market reactions. There is consequently a persuasive case for letting sleeping dogs lie — sticking with the peg and simply hoping that positive inflation does indeed resume. Alternative arrangements may seem attractive and could, once firmly in place, deliver superior results, but the path to them could be something of a minefield. One may therefore expect the peg to continue for some time yet.

Bernanke B S, "Essays on the Great Depression", Princeton University Press, 2000

Buiter W H and Panigirtzoglou N, "Liquidity Traps: how to avoid them and how to escape them", NBER Working Paper 7245, July 1999

Fisher, Irving "The debt-deflation theory of great depressions", Econometrica, 1933

Ha, Jiming and Fan, Kelvin, "Price convergence between Hong Kong and the Mainland", HKMA Research Memorandum, June 2002

Ha, Jiming and Leung, Cynthia, "Estimating Hong Kong's output gap and its impact on inflation", HKMA Research Memorandum, November 2001

Hall T E and Ferguson J D, "The Great Depression", University of Michigan Press, 1998

Latter, Tony "Hong Kong's Currency Board today: the unexpected challenge of deflation", HKMA Quarterly Bulletin, August 2002

McKinnon, Ronald and Ohno, Kenichi, "The foreign exchange origins of Japan's economic slump and low interest liquidity trap", HKIMR Working Paper no. 5/2000

Minford, Patrick (with Nowell, Meenagh and Webb), "Optimal monetary policy with endogenous contracts: is there a case for price-level targeting", Cardiff University, April 2001, www.cf.ac.uk/carbs/econ/webbbd/pm_fp.html

Svensson, Lars, "Escaping from a liquidity trap and deflation: the foolproof way and others", Journal of Economic Perspectives, February 2003

¹ I am grateful to colleagues in the School of Economics and Finance and to Stefan Gerlach for helpful comments and suggestions. I remain solely responsible for the opinions expressed and for any remaining errors.
² In this paper the CPI (consumer price index) will be used as a shorthand for inflation although, unless the context suggests that it is this specific measure which is being addressed, it should be regarded as loosely interchangeable with other measures of current costs or prices — as distinct from asset prices. Asset prices may nevertheless impact on the CPI: for example, residential property prices influence certain housing costs which can properly be regarded as an item of current consumption; and property prices also feed into business costs and hence indirectly into consumer prices.
³ The chosen target would ideally be selected so as to accommodate any index measurement bias — certain measures of the CPI may tend to marginally overstate the underlying rate of inflation.
⁴ See Buiter and Panigirtzoglou. Despite the theoretical attractions of schemes which in effect confiscate or invalidate currency, it is hard to imagine their practical application.
⁵ See also Latter.
⁶ See, for example, Hall and Ferguson.
⁷ As recounted by Mouré, for example, who cites examples of France being held to blame for the spread of the depression.
⁸ As analysed by Eichengreen.
9 See Hall and Ferguson.
¹⁰ See Bernanke.
¹¹ However, the Budget forecast pre-dates the outbreak of SARS.
¹² See Ha and Fan.
¹³ Such policies in any individual economy might anyway conflict with prevailing limits on fiscal magnitudes or run counter, at least in spirit, to strictures about too direct monetary financing of budget deficits. This would certainly be a consideration in drawing any parallels for Hong Kong.
¹⁴ See, for example, McKinnon and Ohno.
¹⁵ Property prices are also partly endogenous within the deflationary process.
¹⁶ See Ha and Leung.
¹⁷ See Ha and Fan.
¹⁸ In fact the Budget documentation refers in one place to the figures as forecasts and in another as assumptions. Since policy is based on them, I shall presume that they represent best efforts at forecasting.
¹⁹ The following table, drawing on figures from official Budget documentation in successive years, indicates the fallibility in forecasting the CPI, even for the current year. It also shows that assumptions made in earlier years about the future trend in the GDP deflator have already proved wide of the mark; time alone will tell whether the more recent predictions are more accurate.

	1999	2000	2001	2002	2003
percent per annum
CPI forecast presented in March Budget	- 2.0	- 1.0	nil	- 2.8	- 1.5
CPI out-turn	- 4.0	- 3.8	- 1.6	- 3.0
Assumed trend for GDP deflator over next five years, as stated in March Budget	+ 3.0	+ 2.5	+ 2.5	+ 0.4	nil
GDP deflator out-turn for year	- 6.0	- 6.2	- 1.4	- 2.7

²⁰ Hong Kong, with justification, boasts a high degree of two-way flexibility in its cost-price structures (in comparison to most other economies); this has facilitated adjustment of competitiveness under the pegged exchange rate regime; but if deflation were to persist a problem might be encountered in respect of further downward adjustment of the pay of public servants, since Article 100 of the Basic Law states that their pay and conditions shall be “no less favourable” than prior to the handover of sovereignty to China in 1997, and it is popularly presumed (though untested) that this could limit the extent of cuts in nominal salaries even if real salaries were sustained.
²¹ As an alternative to targeting a particular rate of inflation, the authorities might adopt a price level target, as proposed by Svensson, and by Minford et al. The precise form of the monetary regime that might follow, were monetary policy to be liberated, is beyond the scope of the present paper.
²² It might even be argued that adoption of a floating rate would rejuvenate the Hong Kong dollar currency market, but this alone would be spurious justification for such a move.
²³ It is perhaps worth noting that London continued to expand and flourish as an international financial centre despite successive sterling currency crises from the 1960s through to the early 1990s.
²⁴ Although the discussion in this paper has centred on the possibility of further deflation under the peg regime, there is, of course, also a possibility of significant inflation — as a result, for example, of a further or prolonged weakness of the US dollar or increases in commodity prices. Even though the peg has coped well enough in such situations in the past, a new monetary framework would by no means be inappropriate to these circumstances either. It could, for example, allow discretionary action to be taken to prevent inflation from becoming too rapid.
　

Tony Latter is Visiting Professor at the School of Economics and Finance, The University of Hong Kong.


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