Economists' No. 1 nightmare: a downward
spirall
"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."
Eric Pfanner International Herald Tribune
Tuesday, November 19, 2002
iht.com
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. |
