Economic woes will be our biggest headache

US economy has probably gone into deflation. The latest Consumer Price Index is -1% , marking perhaps the beginning of deflation. Please do not think that deflation is good, even though deflation has been defined as a persistent reduction in the level of prices of goods.

Deflation may lead to economic depression. Since the prices of goods are persistently becoming lower, people will defer any purchase, and that reduces demand for goods. The whole economic activity will therefore slow down. With slowly down of economy, prices of goods tend to go down further , thus forming a spiral in which recovery can be difficult and end result is a prolonged depression.

Worse, since many companies and factories will go bust, unemployment will increase. Even those companies that are able to continue to do business may have to resort to downsizing, and retrenching their workers. In the Great Depression of the 1930s, unemployment rate went up to 25%, which means that 0one in 4 of the workforce has no job…And when people are hungry, all sorts of social problems will erupt.

With economic activities slowing down in the United States, Europe and Japan, demand for goods manufactured in Asia as well as demand for services will be reduced, and Asian countries which depend on exports to these countries will suffer greatly. These will include SIngapore and unfortunately, Malaysia as well.

In Malaysia, economic woes will be our biggest headache in 2009.  

A friend was complaining to me that life is getting tougher and tougher and he is finding difficulties in making ends meet. He lamented that when the petrol prices went up 40 %, his petrol bill went up by almost a hundred dollars but he was still able to ‘tahan’, and now that petrol prices have come down, he is finding it even more difficult to make ends meet even though he is now footing less for his petrol compared to 3 months ago. I told him that when the petrol pump prices were hiked up 40 % from 1.92 to 2.70, the whole economy has adjusted within a short time to 2.70 level, with prices of goods and services shot up. Inflation was officially 8 % but I suspect it is even more than that.

NOw even though petrol may come down to 1.85- cheaper than before- do not hope for goods to return to 1.92 level, unless of course deflation sets in, and that will be a real worry for Malaysia.  I told him that when economy contracts, companies will become insolvent, and that will lead to banks becoming insolvent. Asset prices will drop and everyone with property will become poorer as a result. Money supply will shrink. People will think twice to save money in banks , fearing that banks may go bust and they would seek alternatives such as gold. With less deposits, there will be less funds to lend,and economic activities will come down further.

To counter that, government may need to spend to stimulate economy. The problem in our country is that with commodity prices dropping (palm oil from 4500 to 1450 recently), the govenrment will be hard pressed to find funds to spend. By cutting EPF contibution in the hope of stimulate people to spend more to counter recession is not enough.

It is perhaps imperative now for the government to reduce taxes to stimulate private consumption and hope that this will prevent economy to go into a recession.  Cutting taxes however will reduce government revenue, and with operationg expenditure so highas a proportion of our total budget, a meaningful cut may not even be feasible. The operating expenditure must be trimmed if we want to cut taxes to stimulate private consumption.

At the same time, perhaps it is now time to do away with NEP, since allowing market forces to act without any distortion will be more efficient and will lead to more private investments by those who are still holding plenty of cash.

This is the time to act and act decisively.