As economic fears creep higher, dreaded 'D' word lurks in wings
By John Waggoner and Adam Shell, USA TODAY
>>Until recently, talk of deflation and recession has been the domain of doom-and-gloom newsletter writers and fringe economists. But mainstream economists are starting to talk about deflation with dead seriousness. "I haven't been writing about this for 14 months to stand out from the crowd," growls Roach. Says Dalio: "It's no longer viewed as a kooky point of view."<<
The four horsemen of the Depression aren't here yet, but you can hear the faint hoofbeats of at least three of them. Unemployment, now 6%, is up from 3.8% in April 2000. Prices for many goods and services are falling, both here and abroad. Japan is in a decade-long deflationary recession, and Germany is close to joining it. Financial collapse, of course, is conspicuously absent.
The odds for depression are still long. Ver-r-r-r-y long. It's the worst-case economic scenario. But economic news this year has suddenly put it on the minds of economists and investors alike. Should you be worried? Probably not. Most economists are forecasting economic growth this year, and the nation has far more financial safeguards than it did in the 1930s. But even the remote possibility of depression sends shivers up and down the financial markets.
Death by 1,000 price cuts
Depression is an economic slowdown accompanied by falling prices. Its hallmarks: Rising inventories. Falling demand. Rising unemployment. Lower wages.
Let's be clear: The economy has been growing the past six quarters. No one is predicting a return to the Great Depression, when a quarter of the nation was out of work. But even the slightest chance of a deflationary recession gives economists the shivers. Deflation "is a very serious issue and an issue which we at the Federal Reserve are paying extensive attention," Federal Reserve Chairman Alan Greenspan told Congress Wednesday. "Even though we perceive the risks as minor, the potential consequences are very substantial and could be quite negative."
Greenspan sent tremors through the markets April 30 by saying, "substantial further disinflation would be an unwelcome development." He's not the only one worried about the potential for deflation. "I'd say the odds have gone up to about 30%," says David Jones, economist at DMJ Advisors.
What is it about deflation that worries economists so? Deflation is particularly insidious because consumers and businesses tend to postpone buying, on the assumption that prices get cheaper. That just makes the economy weaker and pushes prices down further in a deflationary spiral.
Some prices are already falling. The stock market is down more than 40% since March 2000. The producer price index, which measures inflation at the wholesale level, fell 1.9% in April, its largest monthly decline ever. Even stripping out the volatile food and energy sectors, the PPI was down 0.9%. The consumer price index has risen 1.8% the past 12 months, but many economists feel that overstates inflation by a percentage point or more.
Pushing prices down:
•Too little demand. Consumer spending has kept the economy afloat, but it's growing at half the rate it did in the 1990s, says Stephen Roach, chief U.S. economist at Morgan Stanley. Slowing demand: Personal bankruptcies rose to 1.5 million the 12 months ended March 31, a record. And consumers normally ratchet down spending when unemployment has been rising — as it has been this year.
•Too much capacity. Companies invested too much in new plants and equipment in the 1990s: U.S. manufacturers are operating at just 72.5% now, down from 82.4% in 2000. Too much capacity usually augurs price-cutting. "It's a breeding ground for pressures on pricing," Roach says.
•Too much global competition. Countries such as China can produce goods much more cheaply than the USA can. "The big impact from China is still to come," says Ed Yardeni, chief investment strategist at Prudential Securities. And some companies are shifting information workers, such as software designers and even stock analysts, to low-cost countries such as India.
Another worry: Deflationary pressures in Japan and Germany could drag the USA down with them. Japan has been in a deflationary recession for a decade, and the International Monetary Fund says the likelihood of mild deflation in Germany is high. "Germany is starting to look a lot like Japan," says John Lonski, chief economist for Moody's Investor Services.
What's particularly disturbing is that the Fed's efforts to jump-start the U.S. economy don't seem to be working.
The Federal Reserve has slashed interest rates 12 times the past three years to kick-start the economy, to little avail. Under normal conditions, when the Fed cuts rates, it stimulates the economy by lowering borrowing costs for consumers, increasing the demand for goods and services and boosting the value of assets such as stocks, bonds and real estate. But with short-term rates at 1.25%, the Fed has little firepower left.
"When lower borrowing costs are no longer enough to stimulate demand, prices have to come down," says Ray Dalio, chief investment officer at Bridgewater Associates, an investment firm that manages $40 billion. Lower prices cut into corporate earnings. It's a vicious cycle. The nightmare scenario that wakes economists in a cold sweat:
• Deflation and recession in Japan and Europe reduce demand for U.S. exports, weakening the U.S. economy further. This is already happening: The U.S. trade balance, the broadest measure of our international transactions, hit a record 5% of U.S. Gross Domestic Product the fourth quarter, as exports fell and imports increased.
• The value of the U.S. dollar plunges. A weak dollar is supposed to help U.S. exporters because U.S. goods become cheaper abroad. But it also could discourage foreign investors from buying U.S. Treasury securities, which we use to fund our deficit. The Treasury would then have to raise interest rates to attract investors, which could slow growth further and collapse the housing market — so far, one of the few areas of price inflation in the economy. "Housing will be a mess, and it will start when rates rise," says Richard Russell, editor of Dow Theory Letter, a La Jolla, Calif. newsletter.
• Companies begin defaulting on debt. Deflation means that corporate revenue falls, profit falls — but debt payments remain the same. Each payment gets progressively more difficult, and is paid in progressively more valuable dollars. Bankruptcies mount, unemployment soars, and the financial system, particularly banks, starts to crumble. "Debt deflation is the most lethal strain," says Morgan Stanley's Roach.
Some worry that current federal economic policy could make matters worse. Although the Treasury department denies it, most of Wall Street believes that the White House has abandoned its strong-dollar policy. A weaker dollar will help U.S. exporters, but it would hurt European exporters. In other words, any U.S. economic gains would be at the expense of our major trading partners.
One of the most prominent worriers about a weak dollar: Greenspan. The Fed chairman was recently reported to have assured the Germans that the U.S. was not deliberately trying to push down the dollar. Greenspan specifically referred to the damage a weak dollar did to the economy during the Depression.
President Bush's tax cuts could make matters worse, because they would increase the federal budget deficit. That, in turn, could drive up interest rates as the government floods the market with bonds to finance the deficit. "For every $100 billion in deficit, you get a 0.25% percentage point increase in long-term Treasuries," says DMJ's Jones.
How likely?
Fortunately, most economists don't think depression is faintly possible — particularly one like the Great Depression, with its apocalyptic connotations of soup kitchens as ubiquitous as Starbucks stores and a jobless rate at 25%.
Bridgewater's Dalio believes there is a one in four chance of what he calls a "deflationary depression." He describes that as more of a Japan-like problem: a long period of low growth, periodic recessions, high unemployment, and poor stock performance.
Prudential's Yardeni doesn't even think that full-blown deflation is likely. Lower oil prices, tax cuts, low interest rates and the weaker dollar should all provide enough stimulus to get the economy moving again, he says. The IMF agrees: It says deflation is unlikely in the USA, Great Britain, and China. Nevertheless, any risk of deflation is alarming — far more so than inflation, which ravaged the country in the 1970s. "When you're faced with deflationary risk, you have to treat it as a certainty and hope you're wrong," says Morgan Stanley's Roach. "You have to err on the side of being overly stimulative."
How can you protect yourself? Treasury securities are one time-tested deflation cure. They have no risk of default, and the interest payments they make become more valuable every year. And the Fed may try to buy long-term Treasuries to lower rates and stimulate the economy.
Until recently, talk of deflation and recession has been the domain of doom-and-gloom newsletter writers and fringe economists. But mainstream economists are starting to talk about deflation with dead seriousness. "I haven't been writing about this for 14 months to stand out from the crowd," growls Roach. Says Dalio: "It's no longer viewed as a kooky point of view."
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