Economists' No. 1 nightmare: a downward spiral
By: Eric Pfaner International Herald Tribune
For 20 years, the world's economic policymakers have fought a relentless war on inflation. They have gotten so good at the job that some of them now long for the days when prices in industrialized countries rose by a predictable handful of percentage points each year. Price increases are falling ever closer to zero, with inflation rates already negative in Japan and threatening to head that direction elsewhere, too.
Deflation - sustained decreases in prices over an entire economy - may sound attractive to consumers hoping to snap up bargains. But to economists, it is the No. 1 nightmare scenario as the global economy struggles to bounce back from a stubborn downturn. .
"It's not bad if supermarkets are fighting it out over the price of baked beans," said Paul Donovan, global economist at UBS Warburg in London. "The problem is when nobody wants to buy baked beans." .
If falling inflation remains simply that, there is little problem. Low inflation brings stability. But if it tips over into deflation, the global economy could sink into a situation more reminiscent of the 1930s than any postwar recession and recovery, some analysts fear. .
In the United States, an index of inflation tied to the main gauge of economic output - the so-called GDP deflator - is already at its lowest rate since the recession that immediately followed World War II, Donovan said. .
In countries from Canada to Norway to New Zealand, similar measures are also at very low levels. Prices of some goods in Britain already are dropping, though robust gains in worker compensation have kept the price of services, and overall inflation, positive. In the euro zone, inflation remains stubbornly higher, but that is mostly because of big price increases in countries such as Spain and Ireland, whose economies have benefited mightily from the new currency; in core economies, particularly Germany, where the economy is in near recession, inflation is very low. .
In China, producer price inflation has been negative for more than half a decade, despite strong economic growth. .
The fear with deflation is that instead of rushing out to grab bargains, many consumers wait, assuming that falling prices mean even greater bargains down the road. Meanwhile, their paychecks shrink, too, or jobs are cut, and debt burdens from home mortgages grow heavier; at the very least, the positive aspects of modest inflation, which erodes debt burdens over time, disappear. .
Even worse, there is relatively little that policymakers can do through conventional steps such as cuts in interest rates, particularly as those rates push closer to zero, too, in the United States. .
That is why even a remote threat of global deflation - as opposed to the localized variety, such as the horror story that Japan has lived with for the better part of the last 12 years - makes the professionals nervous. And since the collapse of the technology stock bubble, the threat has grown from remote to at least possible; Donovan puts the chances at 20 percent to 30 percent. .
The outside chance of global deflation - or at least the talk about it - is the main thing that makes the current economic slowdown, and the sluggish recovery that most economists still predict as their main scenario, different from other economic cycles in the postwar period. .
"The economic profession has been surprised a little bit by the current downturn," said an international monetary official who insisted on anonymity. "They're trying to come to grips with something that increasingly looks like it will be different." .
Publicly, economic policymakers in the United States and Europe have stuck to forecasts that economic growth, even if subdued, will take hold next year, easing any threat of a deflationary spiral. .
"We are not close to the deflationary cliff," the Federal Reserve chairman, Alan Greenspan, said this month in congressional testimony, after the Fed reduced its main interest rate, the federal funds rate, to 1.25 percent from 1.75 percent. .
The Fed has cut interest rates a dozen times during the current downturn in an effort to get the economy restarted, and Greenspan emphasized that the latest move was aimed only at helping the U.S. economy through a "soft patch." .
But it is possible that the Fed is more concerned than it publicly lets on. In a study published this year, several economists on the Fed staff looked at Japan's experience with deflation and drew conclusions and recommendations from it. .
The economists urged aggressive monetary action when there is even a small worry about the prospect of persistently falling prices. . "When inflation and interest rates have fallen close to zero, and the risk of deflation is high, such stimulus should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity," the economists wrote. .
That may help explain why the Fed has taken such aggressive action to lower borrowing costs, even when indicators of economic growth suggest that the sky is not, in fact, falling. The Bank of Japan, by contrast, has come under heavy criticism for moving too little, and too late, to deter deflation in the early 1990s. And the European Central Bank, which has cut interest rates far more sluggishly than the Fed, frequently repeats the mantra that it attempts to pursue a monetary policy "appropriate" for current economic conditions, rather than seeking to act preemptively. .
But the study also found, perhaps not surprisingly, that deflation is hard to predict, yet the remedy of raising awareness holds its own dangers. Talking about economic threats can become a self-fulfilling prophesy, just as excessive hype helped inflate the dot-com bubble. .
So far, deflation is primarily a problem for Japan, but there are some danger signs emerging elsewhere. Already the world suffers from excess industrial capacity, the main reason that prices of mass-produced goods, from cars to computer chips, are under such pressure. In an increasingly globalized economy, China's vast production potential - still far from fulfilled, if falling prices are any indication - means some deflationary pressures will only grow as its membership in the World Trade Organization eliminates barriers to trade. .
Call it the dark side of globalization. As China gears up for greater production, there are signs that it is using rock-bottom costs to lure factories, and jobs, away from areas that once did the same to the world's industrialized nations. .
In the 1990s, the North American Free Trade Agreement spurred vast growth in the maquiladoras of northern Mexico - foreign-owned factories that opened in an environment of favorable labor costs and geographic proximity to the world's biggest market, the United States. But, in recent months, many of these factories have closed, with many moving to China; more than 15,000 jobs have shifted in this way, according to a list compiled by UBS Warburg. .
Yet many of those goods still head for the United States, accounting for a surge in trans-Pacific shipping, even as truck and rail traffic between Mexico and the United States languishes. Economists say as much as 10 percent of that shipping volume may be headed to Wal-Mart Stores Inc., the U.S. retailer known for its low prices, providing further disinflationary pressure, even if shoppers may cheer for now. .
One reason economists are worried about the fragility of any global economic rebound, compared with other postwar recoveries, is the degree to which it depends on the spending power of U.S. consumers. Economists say European policymakers have not helped by keeping interest rates too high for sluggish Germany, even as the rules governing monetary union limit fiscal spending in the 12 nations that use the euro. .
"What's different now is the extent to which the U.S. is the engine of global growth, this feeling that the U.S. has to lead," said Val Koromzay, director of country studies in the economics department at the Organization for Economic Cooperation and Development. .
So far, American leadership has generally been a bright spot, rather than a cause for alarm, economists say. Though U.S. businesses cut back spending after the technology stock collapse, consumers kept going. And with rapid, sizable cuts in interest rates and steps to loosen the fiscal spending tap, policymakers in Washington have charted a decisive course that has made the rest of the world look flat-footed. .
Yet there are limits to how much policy can do when negative sentiment takes over. With the federal funds rate at 1.25 percent, the Fed is getting dangerously close to the zero percent level at which the Bank of Japan has essentially held rates since the mid-1990s - largely to no avail. .
After hitting zero, central bankers can take some unorthodox steps to, in effect, print money. (Negative interest rates - in effect, charging bankers to hold onto money rather than lend it out - works only if a country imposes capital controls; in an open economy, money simply heads elsewhere.) .
But such measures would be called on only in an extreme situation. More likely, many economists still say, is sluggish growth that may fall short of historical patterns and disappoint investors but that manages to keep the global economy, even if only barely, out of a deflationary spiral. .
If the United States works through its "soft patch" and leads the global economy out of the downturn, talk of deflation will prove that the "global gloom and doom is overdone," as John Llewellyn, chief economist at Lehman Brothers in London, put it. .
"As recessions go, this was actually a very shallow one, both in the United States and globally," he said. LONDON The "d" word is back. "Deflation," that is. .
For 20 years, the world's economic policymakers have fought a relentless war on inflation. They have gotten so good at the job that some of them now long for the days when prices in industrialized countries rose by a predictable handful of percentage points each year. Price increases are falling ever closer to zero, with inflation rates already negative in Japan and threatening to head that direction elsewhere, too. .
Deflation - sustained decreases in prices over an entire economy - may sound attractive to consumers hoping to snap up bargains. But to economists, it is the No. 1 nightmare scenario as the global economy struggles to bounce back from a stubborn downturn. .
"It's not bad if supermarkets are fighting it out over the price of baked beans," said Paul Donovan, global economist at UBS Warburg in London. "The problem is when nobody wants to buy baked beans." .
If falling inflation remains simply that, there is little problem. Low inflation brings stability. But if it tips over into deflation, the global economy could sink into a situation more reminiscent of the 1930s than any postwar recession and recovery, some analysts fear. .
In the United States, an index of inflation tied to the main gauge of economic output - the so-called GDP deflator - is already at its lowest rate since the recession that immediately followed World War II, Donovan said. .
In countries from Canada to Norway to New Zealand, similar measures are also at very low levels. Prices of some goods in Britain already are dropping, though robust gains in worker compensation have kept the price of services, and overall inflation, positive. In the euro zone, inflation remains stubbornly higher, but that is mostly because of big price increases in countries such as Spain and Ireland, whose economies have benefited mightily from the new currency; in core economies, particularly Germany, where the economy is in near recession, inflation is very low. .
In China, producer price inflation has been negative for more than half a decade, despite strong economic growth. . The fear with deflation is that instead of rushing out to grab bargains, many consumers wait, assuming that falling prices mean even greater bargains down the road. Meanwhile, their paychecks shrink, too, or jobs are cut, and debt burdens from home mortgages grow heavier; at the very least, the positive aspects of modest inflation, which erodes debt burdens over time, disappear. .
Even worse, there is relatively little that policymakers can do through conventional steps such as cuts in interest rates, particularly as those rates push closer to zero, too, in the United States. .
That is why even a remote threat of global deflation - as opposed to the localized variety, such as the horror story that Japan has lived with for the better part of the last 12 years - makes the professionals nervous. And since the collapse of the technology stock bubble, the threat has grown from remote to at least possible; Donovan puts the chances at 20 percent to 30 percent. .
The outside chance of global deflation - or at least the talk about it - is the main thing that makes the current economic slowdown, and the sluggish recovery that most economists still predict as their main scenario, different from other economic cycles in the postwar period. .
"The economic profession has been surprised a little bit by the current downturn," said an international monetary official who insisted on anonymity. "They're trying to come to grips with something that increasingly looks like it will be different." .
Publicly, economic policymakers in the United States and Europe have stuck to forecasts that economic growth, even if subdued, will take hold next year, easing any threat of a deflationary spiral. .
"We are not close to the deflationary cliff," the Federal Reserve chairman, Alan Greenspan, said this month in congressional testimony, after the Fed reduced its main interest rate, the federal funds rate, to 1.25 percent from 1.75 percent. .
The Fed has cut interest rates a dozen times during the current downturn in an effort to get the economy restarted, and Greenspan emphasized that the latest move was aimed only at helping the U.S. economy through a "soft patch." .
But it is possible that the Fed is more concerned than it publicly lets on. In a study published this year, several economists on the Fed staff looked at Japan's experience with deflation and drew conclusions and recommendations from it. .
The economists urged aggressive monetary action when there is even a small worry about the prospect of persistently falling prices. .
"When inflation and interest rates have fallen close to zero, and the risk of deflation is high, such stimulus should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity," the economists wrote. . That may help explain why the Fed has taken such aggressive action to lower borrowing costs, even when indicators of economic growth suggest that the sky is not, in fact, falling. The Bank of Japan, by contrast, has come under heavy criticism for moving too little, and too late, to deter deflation in the early 1990s. And the European Central Bank, which has cut interest rates far more sluggishly than the Fed, frequently repeats the mantra that it attempts to pursue a monetary policy "appropriate" for current economic conditions, rather than seeking to act preemptively. . But the study also found, perhaps not surprisingly, that deflation is hard to predict, yet the remedy of raising awareness holds its own dangers. Talking about economic threats can become a self-fulfilling prophesy, just as excessive hype helped inflate the dot-com bubble. .
So far, deflation is primarily a problem for Japan, but there are some danger signs emerging elsewhere. Already the world suffers from excess industrial capacity, the main reason that prices of mass-produced goods, from cars to computer chips, are under such pressure. In an increasingly globalized economy, China's vast production potential - still far from fulfilled, if falling prices are any indication - means some deflationary pressures will only grow as its membership in the World Trade Organization eliminates barriers to trade. .
Call it the dark side of globalization. As China gears up for greater production, there are signs that it is using rock-bottom costs to lure factories, and jobs, away from areas that once did the same to the world's industrialized nations. .
In the 1990s, the North American Free Trade Agreement spurred vast growth in the maquiladoras of northern Mexico - foreign-owned factories that opened in an environment of favorable labor costs and geographic proximity to the world's biggest market, the United States. But, in recent months, many of these factories have closed, with many moving to China; more than 15,000 jobs have shifted in this way, according to a list compiled by UBS Warburg. .
Yet many of those goods still head for the United States, accounting for a surge in trans-Pacific shipping, even as truck and rail traffic between Mexico and the United States languishes. Economists say as much as 10 percent of that shipping volume may be headed to Wal-Mart Stores Inc., the U.S. retailer known for its low prices, providing further disinflationary pressure, even if shoppers may cheer for now. .
One reason economists are worried about the fragility of any global economic rebound, compared with other postwar recoveries, is the degree to which it depends on the spending power of U.S. consumers. Economists say European policymakers have not helped by keeping interest rates too high for sluggish Germany, even as the rules governing monetary union limit fiscal spending in the 12 nations that use the euro. . "What's different now is the extent to which the U.S. is the engine of global growth, this feeling that the U.S. has to lead," said Val Koromzay, director of country studies in the economics department at the Organization for Economic Cooperation and Development. .
So far, American leadership has generally been a bright spot, rather than a cause for alarm, economists say. Though U.S. businesses cut back spending after the technology stock collapse, consumers kept going. And with rapid, sizable cuts in interest rates and steps to loosen the fiscal spending tap, policymakers in Washington have charted a decisive course that has made the rest of the world look flat-footed. . Yet there are limits to how much policy can do when negative sentiment takes over. With the federal funds rate at 1.25 percent, the Fed is getting dangerously close to the zero percent level at which the Bank of Japan has essentially held rates since the mid-1990s - largely to no avail. .
After hitting zero, central bankers can take some unorthodox steps to, in effect, print money. (Negative interest rates - in effect, charging bankers to hold onto money rather than lend it out - works only if a country imposes capital controls; in an open economy, money simply heads elsewhere.) .
But such measures would be called on only in an extreme situation. More likely, many economists still say, is sluggish growth that may fall short of historical patterns and disappoint investors but that manages to keep the global economy, even if only barely, out of a deflationary spiral. .
If the United States works through its "soft patch" and leads the global economy out of the downturn, talk of deflation will prove that the "global gloom and doom is overdone," as John Llewellyn, chief economist at Lehman Brothers in London, put it. .
"As recessions go, this was actually a very shallow one, both in the United States and globally," he said. LONDON The "d" word is back. "Deflation," that is. .
For 20 years, the world's economic policymakers have fought a relentless war on inflation. They have gotten so good at the job that some of them now long for the days when prices in industrialized countries rose by a predictable handful of percentage points each year. Price increases are falling ever closer to zero, with inflation rates already negative in Japan and threatening to head that direction elsewhere, too. .
Deflation - sustained decreases in prices over an entire economy - may sound attractive to consumers hoping to snap up bargains. But to economists, it is the No. 1 nightmare scenario as the global economy struggles to bounce back from a stubborn downturn. .
"It's not bad if supermarkets are fighting it out over the price of baked beans," said Paul Donovan, global economist at UBS Warburg in London. "The problem is when nobody wants to buy baked beans." .
If falling inflation remains simply that, there is little problem. Low inflation brings stability. But if it tips over into deflation, the global economy could sink into a situation more reminiscent of the 1930s than any postwar recession and recovery, some analysts fear. .
In the United States, an index of inflation tied to the main gauge of economic output - the so-called GDP deflator - is already at its lowest rate since the recession that immediately followed World War II, Donovan said. .
In countries from Canada to Norway to New Zealand, similar measures are also at very low levels. Prices of some goods in Britain already are dropping, though robust gains in worker compensation have kept the price of services, and overall inflation, positive. In the euro zone, inflation remains stubbornly higher, but that is mostly because of big price increases in countries such as Spain and Ireland, whose economies have benefited mightily from the new currency; in core economies, particularly Germany, where the economy is in near recession, inflation is very low. .
In China, producer price inflation has been negative for more than half a decade, despite strong economic growth. .
The fear with deflation is that instead of rushing out to grab bargains, many consumers wait, assuming that falling prices mean even greater bargains down the road. Meanwhile, their paychecks shrink, too, or jobs are cut, and debt burdens from home mortgages grow heavier; at the very least, the positive aspects of modest inflation, which erodes debt burdens over time, disappear. .
Even worse, there is relatively little that policymakers can do through conventional steps such as cuts in interest rates, particularly as those rates push closer to zero, too, in the United States. .
That is why even a remote threat of global deflation - as opposed to the localized variety, such as the horror story that Japan has lived with for the better part of the last 12 years - makes the professionals nervous. And since the collapse of the technology stock bubble, the threat has grown from remote to at least possible; Donovan puts the chances at 20 percent to 30 percent. .
The outside chance of global deflation - or at least the talk about it - is the main thing that makes the current economic slowdown, and the sluggish recovery that most economists still predict as their main scenario, different from other economic cycles in the postwar period. .
"The economic profession has been surprised a little bit by the current downturn," said an international monetary official who insisted on anonymity. "They're trying to come to grips with something that increasingly looks like it will be different." .
Publicly, economic policymakers in the United States and Europe have stuck to forecasts that economic growth, even if subdued, will take hold next year, easing any threat of a deflationary spiral. |
