[Much gloomier than the leader. Seems like a cross between Brenner, Doug and Robert Rubin. On the bright side, it certainly seems to signify a paradigm shift among part of the elite that's been holding out. On the downside, they seem to be able to rethink everything except the idea that higher wages might be a good thing when you're facing deflation. Still, it's got some intelligent stuff in it.]
ECONOMIST SPECIAL: Could it happen again?
*For the past 25 years the biggest economic enemy in most countries has been inflation. Today, in most of the world, a greater danger may be deflation*
MOST people take it for granted that prices will always rise, and understandably so. A 60-year-old American has seen them go up by more than 1,000% in his lifetime. Yet prolonged inflation is a recent phenomenon. Until about 60 years ago prices in general were as likely to fall as to rise. On the eve of the first world war, for example, prices in Britain, overall, were almost exactly the same as they had been at the time of the great fire of London in 1666.
Now the world may be reverting to that earlier normality. The prices of many things have fallen over the past 12 months or so. Not only computers and video players, whose prices have been declining for many years, but a wide range of goods from cars and clothes to coffee and petrol are, in many countries, cheaper than they were a year ago. It is conceivable that the world may be in for a new period of global deflation (meaning falling consumer prices) for the first time since the 1930s.
Talk of deflation is certainly at its highest level since then. The number of newspaper articles mentioning the D-word is running at more than 20 times the rate of a decade ago (see chart 1). Japan has been flirting with deflation for several years, but the complaint may be catching. Gary Shilling, an American economist, predicts in a new book (_Deflation_ by Gary Shilling, Lakeview Publishing Company), that American consumer prices will fall by an average of 1-2% a year over the next decade. In Britain, the Centre for Economics and Business Research expects to see falling prices by 2002. Several pundits reckon that continental Europe is heading for deflation rather sooner.
Just how dangerous would that be? The answer is, it depends. In the 1930s, falling prices locked economies into a downward spiral, in which shrinking demand, deepening pessimism, financial distress and the apparent inability of governments to put things right led to economic collapse. But deflation can also take a friendlier form when it is driven by rapid growth in productivity, for instance. Look around the world, and you see both kinds of deflation at work, and in some places a mixture of the two. That makes things horribly complicated for policymakers. A long way down
Almost wherever you look though, you see falling prices. The cost of raw materials, for a start, is plunging. Oil prices have more than halved since the start of 1997; in the past two years, The Economist's index of industrial-commodity prices has fallen by 30%. In real terms commodity prices are at their lowest since this index was first published a century and a half ago.
This long decline partly reflects technological progress that has boosted crop yields and mineral-extraction rates. But the most recent collapse in prices was largely triggered by the slump in East Asia, a big importer of raw materials. Producers in Latin America, Russia and South Africa have responded to lower prices by boosting output to keep up export revenues, but this has pushed prices lower still.
Producer prices have also fallen over the past 12 months in 14 of the 15 rich industrial economies that The Economist monitors each week in its indicator pages (see article). Currency devaluations in East Asia released a flood of cheap manufactured goods on to world markets—to which Brazil will now add. Thanks to enormous over-investment, especially in Asia, the world is awash with excess capacity in computer chips, steel, cars, textiles, ships and chemicals. The car industry, for instance, is already reckoned to have at least 30% unused capacity worldwide—yet new factories in Asia are still coming on stream.
Consumer-price inflation is also dropping, perhaps to an average of only 1% in the rich economies this year—the lowest for almost half a century (see chart 2). Consumer prices have fallen over the past year in Switzerland, Sweden, China, Hong Kong and Singapore. In the year to January, China's consumer prices fell by 1.2% and producer prices by 8%. The Chinese government has responded by introducing price controls—not to hold down prices, but to keep them up. As for Japan, its measured consumer-price inflation is slightly positive, but this reflects a distortion caused by a jump in food prices. In underlying terms, Japanese consumer prices are falling.
Even in Brazil, once famed for hyperinflation, consumer prices (as measured by Sao Paulo's FIPE index) fell by 1.8% last year. The devaluation of the real may now push up prices; but Brazil's deflation is likely to be exported to the rest of Latin America and beyond. And in the euro area consumer prices have been falling since the summer, although they are still up by 0.8% on a year ago. French and German inflation rates are teetering on the brink of deflation, at 0.3% and 0.5% respectively.
Official consumer-price indices in any case overstate inflation rates because they fail to take full account of improvements over time in the quality of goods (today's cars or televisions have many more features than 20 years ago), and because the weights given to different goods and services tend to be out of date. The overstatement is usually reckoned to be up to one percentage point a year. So any country with measured inflation of less than 1% may, in reality, be experiencing falling prices.
However, all these numbers need to be treated with care. "Deflation", like many economic concepts, is a widely misunderstood and often misused term. Its proper definition is a persistent fall in the general price level of goods and services; it is not to be confused with a decline in prices in one economic sector, or with a fall in the inflation rate (which is known as disinflation). Thus falling commodity prices do not, of themselves, constitute deflation—they are a shift in relative prices that reduces real incomes in producing countries and boosts them in importing countries. Likewise a fall in manufacturing prices is not deflation if it is offset by rising prices for services. In America, for example, the average price of goods has fallen over the past year, but the prices of services have risen by 2.5%, to produce an overall (measured) consumer-price inflation rate of 1.6%.
Kill or cure
Deflation is not necessarily bad. Indeed, productivity-driven deflation, in which costs and prices are pushed lower by technological advances or by deregulation, is beneficial, because lower prices lift real incomes and hence spending power. In the last 30 years of the 19th century, for example, consumer prices fell by almost half in America, as the expansion of railways and advances in industrial technology brought cheaper ways to make everything; yet annual real growth over the period averaged more than 4%.
Today, the computer and telecoms revolutions are similarly pushing down costs. By reducing barriers to entry and making price information more widely available, the Internet is pushing down the prices of goods ranging from cars to books, and of services from insurance to air travel. The arrival of Europe's single currency will also increase price competition in the euro area. A study by ING Barings concludes that this might trim a quarter of a percentage point off the euro area's annual inflation rate over the next five years. Further downward pressure on prices in Europe and Japan has also been caused by deregulation of electricity and telephones. All these sources of deflation are good for economies, not bad.
Deflation is dangerous, on the other hand, when it reflects a sharp slump in demand, excess capacity and a shrinking money supply—as in the early 1930s. In the four years to 1933, American consumer prices fell by 25% and real GDP by 30%. Runaway deflation of this sort can be much more damaging than runaway inflation, because it creates a vicious spiral that is hard to escape.
Thus, the expectation that prices will be lower tomorrow may encourage consumers to delay purchases, depressing demand and forcing firms to cut prices by even more. Falling prices also inflate the real burden of debt, causing bankruptcies and bank failures. That makes deflation particularly dangerous for economies that have large corporate debt—such as Japan's. Most serious of all, deflation can make monetary policy ineffective: nominal interest rates cannot be negative, so real rates can get stuck too high.
Today's deflation comes in both benign and malign guises. New technology and deregulation are pushing down prices of many goods and services around the globe, which should be good for most economies. But weak demand is also creating harmful deflationary pressures in some countries. A good way to detect this is to look at countries' "output gaps": the difference between actual output and output at full capacity.
Japan's output gap is forecast to widen to a record 7% of GDP this year. The country is on the brink of a vicious deflationary spiral, with falling prices swelling companies' real debts and keeping real interest rates high. The rest of East Asia also has huge spare capacity. Even if growth resumes this year, Thailand's GDP is unlikely to regain its level of 1996 until 2001. If so, output will in total have fallen by almost one-third relative to productive potential (as measured by the economy's trend growth rate of 7%). Meanwhile, China has 40% excess capacity in manufacturing.
None of this excess capacity is likely to be shut down quickly, because cash-strapped firms have an incentive to keep factories running, even at a loss, to generate income. The global glut is pushing prices relentlessly lower. Devaluation cannot make excess capacity disappear; it simply shifts the problem to somebody else. But in the process, global demand will contract as emerging economies are forced to raise interest rates to deter capital outflows.
The European Union has been running a modest, though persistent, output gap of around 2% of GDP for several years, but this is likely to widen in 1999 if, as widely forecast, growth falls below trend. The American economy, in contrast, is running above its productive potential. Indeed, without the recent fall in oil and commodity prices, America's inflation rate would have risen, forcing the Federal Reserve to raise interest rates. America may be enjoying some deflation of the benign variety, as a result of information technology and increased competition; but booming consumer spending and double-digit money-supply growth suggest that it will not, at least in the near future, suffer from malign deflation.
Fear of falling
Only a handful of economies are clearly experiencing true deflation. Even Japan, despite dreadful policy errors, has not experienced declines in prices as bad as those in the 1930s. America and Europe have so far benefited from cheaper import prices. Indeed, most countries are now simply enjoying price stability. This should help, not harm future growth. Yet the risk of outright deflation has clearly increased. A sharp slowdown in America or Europe could easily send overall price levels falling for the first time since the 1930s.
There are several causes for concern:
-- Global excess supply is unprecedentedly high. Output gaps are tricky to measure, but The Economist's best guess is that the world output gap is approaching its biggest since the 1930s (see chart 3). Deflation could occur even without a contraction in global output. All that is needed is a protracted period of growth below trend, which causes the output gap to widen and hence the inflation rate to fall, until it eventually turns negative. Thus, even if Asia's growth picks up this year and next, but (as widely expected) remains below trend, the region's output gap will continue to widen.
-- Nominal GDP growth in the G7 economies looks set to fall this year to around 2.5%—close to its slowest rate since the second world war. (Japan's nominal GDP fell by 3.4% in the year to the third quarter of 1998). This suggests that, on a global level, policy is too tight. Ideally, in a developed economy, a central bank that has the medium-term goal of price stability should aim for nominal GDP growth of 4-5%. This allows room for long-term growth of 2-3% and inflation of 1-2%.
-- A third danger is that lower commodity prices, while boosting real incomes in most rich economies, are hurting producers in the already troubled emerging economies. This may not be a zero-sum game. Cash-starved emerging economies are likely to cut spending faster than rich countries spend their windfall.
-- But the biggest risk of all is a failure to adjust on the part of policymakers, workers, companies and investors, all of whom are used to coping with high inflation, not deflation. In past periods of benign deflation, as in the late 19th century, everyone was used to the notion of falling prices. But today, few have had any such experience—making the risk of mistakes much greater.
For instance, in response to calls for lower interest rates, the European Central Bank (like the Bank of Japan before it) has retorted that European interest rates are already at record low levels. But real interest rates, which rise as inflation falls, are nowhere near their record lows.
Workers also need to learn the new rules of the game. If unions continue to demand big annual wage increases—Germany's IG Metall is currently seeking a pay rise of 6.5%—despite flat or falling prices, firms may have no alternative but to cut jobs. And falling goods prices could also provoke trade friction. Cheaper imports of manufactured goods from Asia, say, could trigger renewed protectionism in America and Europe, further depressing world growth.
Deflation is especially painful for debtors. Not only does the real burden of debt rise, but falling property prices also reduce the value of collateral, forcing banks to write down debts. It is worrying, therefore, argues Ian Harwood, an economist at Dresdner Kleinwort Benson, that since deflation was last experienced on a global scale, the level of private debt has risen sharply, thanks to a combination of financial deregulation with years of inflation that made borrowing attractive. Total private-sector debt is now around 130% of GDP in America and 200% in Japan, compared with less than 100% of GDP in America in 1928.
Companies too will find it hard to adjust to falling prices. Wages rarely fall, so deflation tends to squeeze profit margins. This may explain why surveys in Europe and America suggest that businessmen are so much gloomier than consumers: deflation tends to be good news for consumers, but bad news for companies. It is often easy to increase profits by raising prices in inflationary times; when there is deflation, the only way is to cut costs.
Deflation could be a particular problem for property, retailing and financial markets. Inflationary times favour property investment: inflation erodes the real value of a mortgage and delivers capital gains. In a world of falling prices, buying a house becomes less attractive than renting. Deflation also squeezes retailers' profits, because wages (a big chunk of total costs) are less flexible downwards than prices. Retailers will also see volume and profit margins squeezed as consumers delay purchases in the hope that prices will fall.
As for financial markets, consider only the alarming gap between investors' expectations of American profits, which are said to support current share prices on Wall Street, and the more likely actual path of profits as global deflationary pressures squeeze American firms. Total American profits have already fallen slightly over the past year.
Indeed this could be the factor that finally bursts America's stockmarket bubble. And when that happens, and America's consumer-spending boom goes into reverse, the economy could quickly be dragged into recession, increasing the risk that the world as a whole might tip into a period of outright deflation or even slump.
Time to reflate
There seems little likelihood that prices will ever fall by anything like as much as in the 1930s. Prices and wages are today much stickier, especially in services (which account for a far bigger chunk of economies), and policymakers reckon, post-Keynes, that they now understand better how to use monetary and fiscal weapons to prevent deflation. Yet Japan shows that the threat of deflation is real even in a modern economy if policymakers blunder.
Inflation, as Milton Friedman once said, "is always and everywhere a monetary phenomenon". So it is with deflation. It can be prevented by appropriate policies. Overly tight monetary policies, and the straitjacket imposed by the gold standard, were largely to blame for the prolonged deflation in the 1930s.
So how to respond to today's deflationary risks? The widening output gap and sluggish nominal GDP growth are both signals that monetary policy in the G7 economies, taken as a whole, is too tight. Not in America, certainty; but both Europe and Japan are operating below normal capacity. Yet oddly, as John Makin, an economist at the American Enterprise Institute, points out, these economies have done less to ease monetary policy since the middle of last year than America, whose economy least needed a boost.
Japan's monetary conditions have, in effect, tightened as a result of higher bond yields and a stronger yen, though policymakers are trying to reverse these. In the euro area, nominal short-term interest rates have been cut, but real rates are barely any lower than they were last June, because inflation has fallen. American real interest rates, in contrast, have fallen by two-thirds of a percentage point.
The world economy is, in short, precariously balanced on the edge of a deflationary precipice. Policymakers still have ample time to use their monetary and fiscal weapons to prevent deflation. The danger for some central bankers is that, having for now seen off the threat of inflation, they rest on their laurels and fail to confront the possibility of deflation. That would be foolish indeed. For history has shown that once deflation takes hold, it can be far more damaging than inflation.
__________________________________________________________________________ Michael Pollak................New York City..............mpollak at panix.com