Global: This Deflation Is Not a Monetary Phenomenon
Stephen Roach (New York)
Morgan Stanley
May 21, 2003
Don’t listen to the monetarists. They would lead you to believe that both inflation and its diabolical mutation — deflation — are simply monetary phenomena. As long as central banks have control over the printing press, goes the logic, rest assured — they will never abdicate control over the aggregate price level. I would argue, instead, that the current perils of deflation have little or nothing to do with your favorite monetary aggregate. Today’s strain of deflation risk is first and foremost a story of the cyclical imbalances and structural flaws in real economies — problems that are far from amenable to the so-called monetary fix. That’s especially the case in the United States, where the deflation debate now rages.
As most of the world has finally caught on to the risk of deflation, it’s worth reviewing why. It’s not just that America’s price statistics are now flashing ominous warning signs. It’s that the analytical underpinnings to the case for deflation suggest there could well be more to come. As I see it, there are three powerful forces at work — the first being the business cycle. Recessions, by definition, are deflationary events. So, too, are subpar recoveries. A cyclical downturn opens up a gap between aggregate supply and demand that alleviates pressure in labor and product markets. In a subpar recovery — defined as growth in aggregate demand that falls short of the potential gains on the supply side of the equation — that gap remains wide. Basic economics tells us that a cyclical overhang of aggregate supply reduces pricing leverage.
That’s precisely the case today. America’s most recent recession has been followed by an anemic recovery. As a result, unemployment has continued to drift up, and capacity utilization rates have continued to fall. But there’s an important twist: The recession of 2001 commenced at an exceedingly low inflation rate — 2.3% inflation as measured by the GDP price index in late 2000. That means the US economy entered a period of cyclical distress very close to the hallowed ground of price stability. In that context, the implications of a recession and its subsequent subpar recovery entail a far closer brush with deflation than would have been the case had the US been running a higher pre-recession inflation rate.
The bubble — and the post-bubble shakeout that has ensued — is the second key macro underpinning to the case for deflation. The bubble led to bloat on the supply side of the equation — fostering excessive hiring and capital formation. Tantalized by the allure of skyrocketing Nasdaq multiples, US businesses went for scale and scope — just what the apostles of the New Economy were urging. The bubble popped and yet the legacy of excess supply lingers — precisely the point underscored by an unusually low capacity utilization rate. At the same time, there has been a post-bubble compression of aggregate demand growth, as the wealth effect now works in reverse. In the three years since the bubble popped in early 2000, growth in personal consumption has averaged 2.7% — 40% slower than the 4.4% pace recorded over the 1996–99 period. The legacy of the bubble — subpar growth in aggregate demand in the context of lingering excess supply — reinforces the cyclical pressures on pricing leverage.
Globalization is the third leg of the stool. Not only has trade liberalization expanded aggregate supply in tradable goods markets, but there has been a comparable development in the once-non-tradable services sector. The globalization of services — the newest and potentially the most powerful piece in this equation — reflects three developments: global deregulation, which transforms administered pricing into market-determined prices; surging cross-border M&A activity that has led to the creation of huge multinational service providers; and the Internet, which has facilitated the growth of IT-enabled service exports (i.e., software programming, consulting, design, engineering, etc.) from places like India. In the long run, the supply-led impetus of globalization generates incremental income that supports increased aggregate demand. But today’s world is far from that long run. Instead, it is coping with the impacts of the first-round effects of globalization on the supply side, which further exacerbate the global imbalance between supply and demand.
This framework of analysis points to two strains of anti-deflation remedies — a pruning of the excesses of aggregate supply or an increase in aggregate demand. The so-called monetarist fix is aimed squarely at the demand side. As Fed Governor Ben Bernanke argued late last year, “By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation” (see “Deflation: Making Sure ‘It’ Doesn't Happen Here,” Remarks by Governor Ben S. Bernanke before the National Economists Club, Washington, D.C., November 21, 2002).
Here’s where I have a major disconnect. In my view, there is far more to the ability of a central bank to get policy traction than a theoretical linkage between the quantity of money and the prices of goods and services. That’s especially the case in a post-bubble US economy that is lacking in pent-up demand in the very sectors that typically respond the most to monetary stimulus — consumer durables, residential construction, and business capital spending. It’s also the case in an economy that is feeling the full force of deflationary pressures from the business cycle, the bubble, and globalization. So where does the money go? In an overly-indebted, saving-short US economy, liquidity injections can easily be diverted away from the real economy into balance-sheet repair. The monetarist diagnosis of the causes and cure for deflation sweeps each and every one of these considerations neatly under the rug.
Nor does the monetarist framework have the track record that is deserving of such blind worship. In particular, I well remember Milton Friedman’s celebrated warning of the perils of renewed double-digit inflation when M-2 growth surged to 13% in early 1983. For the record, CPI-based inflation plunged from 6.2% in 1982 to an average of 3.7% over the 1983–85 period — precisely the opposite of the monetarist forecast. That’s not to say that monetary targeting is irrelevant. It can provide an anchor that enhances central bank credibility and thereby helps control inflationary (and deflationary) expectations. But that’s theory. It’s the practice of monetarism that is so vexing. In particular, regulatory changes have blurred the distinction between transactions and saving balances — making the ups and downs of the monetary aggregates all but irrelevant in imputing any connectivity to the real economy or its price structure. For its part, the Federal Reserve has now given up on monetary targeting altogether — no longer providing Congress with projected ranges on prospective growth in the money stock. It is both ironic and puzzling that the same Fed now claims that the monetarist prescription is the ultimate answer to America’s deflationary conundrum.
Meanwhile, America is moving further down the slippery slope toward deflation. On a year-over-year basis, the core CPI has slowed to just 1.5% — nearly a 40-year low. Over the past six months, the disinflation has been even more acute, with the core increasing at only a 0.9% annual rate — a sharp deceleration from the 2.0% pace of the preceding six months. The goods component of the core is already in outright deflation, with prices contracting at a 2.4% annual rate over the past six months versus a 1.1% deflation rate over the previous six-month period. Moreover, disinflation is intensifying in the services sector — consistent with my belief that this is where the pricing dynamic may be changing the most. The rate of price change in core services has slowed to a 2.3% annual rate in the six months ending April 2003 — down sharply from the 3.4% pace of the preceding six months. Within services, outright deflation is now evident in hotel charges, public transportation, and information processing. America has yet to tumble into outright deflation. But the cushion is getting thinner by the day.
Lest I be accused of fixating on the image in the rear-view mirror, it’s the prognosis of the future that I find so disconcerting. The confluence of forces that have given rise to this outcome — the business cycle, the bubble, and globalization — remains very much in place. Barring the immaculate conception of policy traction in a post-bubble US economy, the case for a prompt and sustained resurgence to a vigorous aggregate demand path remains a weak one, in my view. Meanwhile, an increasingly self-absorbed world seems to be flirting with the perils of competitive currency devaluation as a means to temper deflationary pressures. If anything, that makes the future even more worrisome. Deflation risks should be viewed as a wake-up call for a dysfunctional global economy. Global rebalancing is the only way out. Monetarism is not the answer.
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