Deflation: The Clear and Growing Danger
businessweek.com:/print/bwdaily/dnflash/nov2002/nf2002118_7388.htm?db
If Washington doesn't apply stimulative measures to revive the moribund economy, the consequences could be catastrophic
Now what? The U.S. economy is slumping, with consumer confidence at a nine-year low and business-hiring plans on hold. The prospect of war with Iraq is depressing entrepreneurial capitalism's competitive spirit. The Federal Reserve Board did take out an unusual recovery-insurance policy by cutting its benchmark interest rate -- the federal funds rate -- a surprising half-percentage point, to 1.25%.
Yet the tool of monetary stimulus is losing its effectiveness with the fed funds rate hovering at its lowest level since July, 1961. Now, with the midterm elections over, and the Republicans gaining a dramatic margin of power, Congress and the White House need to prime the sputtering economy's pump quickly.
It's time for Washington to abandon the tired, nasty politics of partisan gridlock. Forget ideas such as lowering the capital-gains tax rate, which would do little to stimulate the economy. The same goes for a business-investment tax credit. Instead, money should go toward supporting lower- and middle-income households that need some extra income to make ends meet in troubled times.
CUT PAYROLL TAXES. "Most likely, it will be feeble economic performance that really facilitates a new tax bill in the guise of fiscal stimulus," mused an economist at UBS Warburg. "Congressional Republicans, sensitive to criticism that they are too helpful to the rich, perhaps would push to focus more relief for the middle and working classes this time around."
For instance, unemployment benefits should be extended rather than allowed to expire. A temporary payroll-tax cut is a tactic promoted by Mark Zandi of Economy.com. Earnings of up to $80,000 are subject to a 6.25% tax that goes toward Social Security, with an additional 1.45% targeted toward Medicare. Employers match the taxes withheld from their employees. A cut in payroll taxes would be easy for administrators to engineer. It would largely benefit low- to middle-income households. Small-business owners could get a break on their payroll tax burden, too.
The federal government could also send more money to cash-strapped state governments so that state workers don't find pink slips in their mailboxes in the coming months. "A fiscal stimulus package totaling some $150 billion to $200 billion, in addition to the stimulus already slated to occur, would go a long way to jump starting the flagging economy," says Zandi.
"LETHAL VICIOUS CIRCLE." This is no time for gridlock. Swift action on the fiscal side is called for, with the risk of debt deflation in the U.S. greater than at any time since the 1930s. Debt deflation is an especially dangerous economic condition because rapidly falling prices make the financial effort of making debt payments increasingly onerous.
Heavily indebted business and consumers "then go into arrears and are forced to cut back further on their costs and other expenditures in order to meet their interest payments," says Stephen Roach, chief economist at Morgan Stanley. "This further depresses an already-weakened state of aggregate demand, exacerbating deflation and perpetuating an increasingly lethal vicious circle."
Global deflation is gathering momentum. Prices are falling in Asia. Prices of goods in China have declined, on average, by some 20% over the past five years and by 16% in Hong Kong, according to Stanley's Roach. Switzerland's year-over-year consumer price index has slipped into negative territory. Economists are sharply reducing forecasts for fourth-quarter GDP in the U.S.: Many now see growth of 1% or less, vs. 3.1% in the third quarter.
STALWART SUPPORTER. Americans are also carrying a heavy debt burden. For instance, the household debt-service burden, the amount of aftertax income households must put toward principal and interest payments, is around 14%, just shy of the record burden of the mid-1980s. But statisticians at the Fed reported in 1998 that nearly one-fifth of households with earnings of less than $50,000 had a debt-service burden of greater than 40%, notes Zandi of Economy.com.
So far, the Fed has been the economy's stalwart supporter. Chairman Alan Greenspan has convinced his colleagues to aggressively slash the fed funds rate, by 4.75 percentage points in 2001 and an additional half-percentage point this year. U.S. fiscal policy has buttressed the economy, too, as a $250 billion federal budget surplus in 2000 was transformed into a $160 billion deficit in fiscal 2002.
Still, fiscal-policy management has been largely inept. The Bush Administration's tax cut, largely skewed toward the wealthy in future years, has done little for the economy. Its economic summit in Waco, Tex., was a joke. And both Congress and the White House have failed to deal forcefully with the recent spate of corporate-accounting scandals.
TOO HIGH A PRICE. Deflation is still considered a remote possibility by many economists and policymakers. But remember President Herbert Hoover, who famously forecast in 1930 that, "prosperity is just around the corner." At the time, his was a reasonable bet, since the economy had declined in only seven of the years from 1869 to 1929. Only once during that time did business activity contract for two consecutive years.
Of course, it turned out to be a disastrous forecast for the country -- and a mistake that eventually cost him the nation's highest elected office. Now, like then, if America's leaders underestimate the prospects for deflation, the price the nation must pay in terms of economic damage would be too high. Deflation is a fearful risk. Washington should pull out the stops now to prevent its emergence. |
