Case 7.6
Disinflation in Europe and Japan
An erosion of market power?
Compared to their US and Japanese rivals, European businesses used to have a reputation for
raising prices to make more profits. In an economic environment where inflation was
endemic, business could easily hide from its inefficiencies and adopt this short-term strategy.
However, following the recession of the early 1990s – Europe’s worst recession since the
war – attitudes and practices seem to have changed, and potentially for the better. European
business seemed to be adopting a more competitive way of doing business. The result,
especially in the early 2000s, when demand was growing relatively slowly again, was that
prices fell in many sectors.
This process was known as ‘disinflation’. It resulted largely from changes in the external
business environment. Here slow growth, financial restraint by central banks attempting to
keep inflation within limits, and fierce global competition led many firms to question whether
price rises are necessary or justifiable.
One of the main sources of competition was from low-cost countries, such as China and
India. Cheap imports from these countries put downward pressure on competing industries in
Europe. What is more, outsourcing call-centre, back-office and IT work to developing
countries put downward pressure on wages. This downward effect on prices and wages has
been dubbed the ‘China price’ effect.
Japanese business found itself in a very similar position to many European countries. It
too experienced a lengthy recession, in which prices fell as businesses tried to shift unwanted
stocks. In addition, the high value of the yen and the subsequent reduction in the cost of
imports stimulated a huge rise in foreign competition, which succeeded in forcing prices
down yet further.
The benefits of disinflation
Are general reductions in prices a good thing or a bad thing? The answer to this largely
depends upon whether you are a consumer or producer, whether you are looking at the short
or long term, and whether any price reduction is met by higher productivity gains and not
redundancies.
In the short term, consumers will clearly benefit from lower prices: in effect, their real
income will rise (assuming no corresponding fall in wages). Over the longer term, both
producers and consumers are likely to gain as lower underlying rates of inflation enable
governments to reduce interest rates. For business this means cheaper capital and greater
opportunities for investment and growth.
The down side to disinflation is whether it can be achieved without a massive impact
upon levels of income and employment. If businesses simply respond to lower prices, and
hence profit margins, by making workers redundant, income levels may begin to fall,
stimulating a downward spiral of demand. Thus the key to successful disinflation is to offset
falling prices with greater efficiency. Those firms unable to meet these new stringent
efficiency goals will not be able to generate profits from higher prices, and will invariably
become ripe for takeover by those that can.
A return of inflation?
The US and other OECD economies staged a rapid recovery after 2003. Between 2004 and
2006, OECD countries’ economic growth averaged 3.1 per cent. These rates, however, were
dwarfed by China and India, which experienced growth rates of 10.1 per cent and 8.4 per cent
respectively over the same period.
The rapid growth in aggregate demand in many OECD countries put upward pressure on
prices and wages. At the same time Chinese prices were no longer having the same downward
effect on prices in the rest of the world. Indeed, rapid growth in the Chinese economy was
beginning to reinforce this upward pressure. As The Economist of 24 June 2006 stated:
China's excessive growth is not only of domestic concern. With much of the world increasingly
worried about inflation, questions arise about what an overheating Chinese economy could do to
global prices. It seems strange to worry about China exporting inflation – as Mervyn King,
governor of the Bank of England, did recently – when the country's consumer-price inflation is less
than 1.5% and its vast manufacturing (over)capacity has led to a steady drop in global goods
prices from shoes to electronics. For the past few years, China's deflationary impact on
manufactured goods – known as the “China price” – has outweighed its inflationary effect on
commodities and capital goods.
But that balance may be changing, argues Jonathan Anderson, an economist at UBS in Hong
Kong. “Current data [in China] show that we are on the verge of an inflationary correction that will
have a cyclical impact at home and abroad,” he says. After being squeezed between rising input
costs and falling factory-gate prices, China's manufacturers are starting to raise prices to rebuild
margins – and getting away with it because both domestic demand and exports are still far
stronger than they were two years ago. Add in higher domestic food and energy prices and
surging labour costs, and the China price may soon be a good deal higher.
So is the effect of globalisation no longer having a disinflationary effect? The answer is a
qualified no. It is true that the rapid growth in China and many other developing countries is
helping to drive up commodity prices and also helping manufacturers to raise prices
somewhat. But the world economy is generally becoming more competitive. Manufacturers in
Europe, Japan and North America are still acutely aware that their scope for raising prices is
very limited and many are still being undercut by cheaper imports.
Questions
1. If prices and wage rates are forced downward, who are likely to gain and who are likely to
lose?
2. What attitudes should trade unions take in such an environment if they are seeking to
maximise the interests of their members?
3. What new strategies have businesses been forced to adopt in order to maintain profits in a
low-inflation economy?
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