From Scott.............
Time to Deflate the Deflation Story
Thursday November 8, 2:55 pm Eastern Time
SmartMoney.com - Idea of the Week
By Rebecca Thomas
FOR MY regularly downbeat assessment of the U.S. economy, I've been nicknamed the ``prophetess of gloom'' (thanks, Dad). And in truth, I am a skeptic of the powerful V-shaped recovery scenario endorsed by Wall Street.
This recession, I truly believe, will be deeper and longer-lasting than the pundits promise.
But my bearishness stops there.
A spooky theory making the rounds right now has the U.S. embarking on its first deflationary cycle since the Great Depression. To the fear-mongers who are peddling this notion, I say: Find something else to fret over. In
the words of Adam Posen, a senior fellow at the Institute for International Economics, a nonpartisan Washington think tank, ``Deflation is not something Americans should worry about.''
To avoid any confusion from the get-go, let's first make sure we all understand what deflation really means. When prices are decelerating (i.e.,rising more slowly), as they are now, that's called disinflation, not deflation. Disinflation is a common byproduct of recession because
waning demand results in fewer cost pressures and less pricing power ? but it's also temporary. When the economy improves, prices accelerate again.
The same can't be said of deflation ? an outright contraction in the overall level of prices. In a deflationary environment, consumers are reluctant
to buy anything because everything will be cheaper tomorrow; and businesses, faced with increasingly lower prices, are forced to reduce jobs to protect profits. The result is a persistent deflationary spiral in which more layoffs lead to less consumer spending, which leads to lower prices,
and so on. Though deflation has haunted Japan for five of the last six years, it's a rarity here in the West. The last time consumer prices fell from one year to the next in the U.S. was 1954. To find a period in which prices fell steadily for a significant time period, you have to go back to the years before World War II.
Yet you'd think deflation was again a serious threat, given the recent buzz. Earlier this month, Morgan Stanley chief global economist Stephen Roach? a renowned Wall Street bear ? told his clients that, because recessions and asset bubbles trigger deflationary forces, the U.S. economy could
experience ``a whiff of deflation over the next couple of years.'' Then in a front-page article Wednesday, The Wall Street Journal asked whether the U.S. economy ``is at risk of emulating Japan's long swoon.''
Floyd Norris didn't even ask. Last Friday, the astute New York Times columnist spotted a whiff of deflation at the consumer level, as measured by the personal consumption expenditure, or PCE, deflator. True enough, the
deflator shrank at a 0.4% annual rate ? the first quarterly price contraction since 1954 ? in the third quarter. But what Norris didn't note was that this decline was due primarily to an accounting fluke related to insurance-benefit calculations post-Sept. 11. By another measure ? the consumer price index, or CPI ? inflation is running at a three-month annualized rate of positive 0.7%.
To be fair, some sectors of the economy are experiencing falling prices. Raw industrial commodity prices, as measured by the Commodity Research Bureau, have fallen to a 16-year low, and the National Association of Purchasing Management reports that its index of manufacturing prices is at its
lowest level since 1949. But as Michael Evans, chief economist at the American Economics Group, a Washington consultancy, points out, ``there's a big difference'' between declines in commodity prices and a contraction in
consumer prices at large. You can't have deflation when wages are still growing at a decent 3% to 4% annual clip, medical costs are increasing at double-digit rates, and real-estate taxes are rising as state and local governments attempt to boost flagging revenues, he explains.
(Also remember that broad deflation never materialized during the Asian financial crisis of 1997-98, the last time commodity prices went into a tailspin. A number of Wall Street's bears ? including two SmartMoney.com pundits, Morgan Stanley's Barton Biggs and Ed Yardeni of Deutsche Banc Alex. Brown ? began ringing deflation alarm bells back then, too.)
Undoubtedly, price weakness will spread beyond the industrial sector as the recession takes firmer hold. The Commerce Department may indeed report next Friday that the CPI actually declined in October ? though it'd still be
well above 2% on a year-over-year basis. And the Economic Cycle Research Institute's (ECRI) Future Inflation Gauge dropped to a 26-year low in October, suggesting that U.S. inflation will decline further in the coming months.
But economists at ECRI will be the first to tell you that the modern-day U.S. economy has no place for deflation. ``Deflation is possible only if there are extended periods of time that are dominated more by recession than by expansion,'' as has been the case in Japan, says the research firm's managing director, Lakshman Achuthan. ``If someone tells you deflation is coming, they also need to tell you that the next 10 years will be dominated by recessions.''
And for gobs of reasons, that just isn't likely to be the case. For one, business cycles have become less volatile as our economic focus shifts from manufacturing to services ? which are less susceptible to economic downturns. (Think about it: In a recession, aren't you more likely to defer
a trip to the car dealership than a doctor's visit?) For another, the social safety net implemented during the New Deal works as an automatic stabilizer, assuring that the poor and unemployed don't stop spending during bad times.
Although such structural changes have also occurred in Japan, there are other big differences that make the analogy to Japan ``entirely inappropriate,'' says Evans. Most important, U.S. policy makers have learned from Japan's mistakes. While the Bank of Japan raised interest rates
for more than a year after the Nikkei peaked in December 1989 ? and then lowered them only at a snail's pace ? the Federal Reserve has been quick on its feet, lowering the fed-funds rate by 4.5 percentage points in just 10 months. Says John Vail, chief strategist at Fuji Bank, ``You can rest assured that the Fed will be a lot more aggressive than the BOJ in eliminating some of the deflation problems.'' The same could be said for Congress. While Japan was raising individual taxes as recently as 1997, our legislators are committed to lowering the tax burden for businesses as
well as consumers.
What's more, the Japanese economy is full of structural rigidities that just don't exist here. Whereas the U.S. banking system was purged of its lemons after the savings-and-loan crisis, Japan has been reluctant to close
banks still burdened with bad loans related to the real-estate bubble of the '80s. And whereas Japanese businesses have been slow to eliminate excess capacity
and workers, U.S. capitalism encourages the swift reallocation of resources to more productive uses. ``It took a huge number of policy mistakes and an almost antimarket system to bring about deflation in Japan,'' says David
Jones, chief economist at Aubrey G. Lanston. ``None of that's true here.''
We have enough things to worry about in the U.S. these days. Let's not make deflation one of them. |
