Deflation - A positive counterpoint...
The Good Deflation
Falling prices can be sign of economic strength
By SHLOMO MAITAL
from Barrons
THE SPECTER OF DEFLATION -- falling prices, shrinking profit margins, rising unemployment and bearish sentiment -- is stalking America. Or so some highly respected economists would have us believe: Princeton economist Paul Krugman refers to "the Japanese quagmire" and warns "there is now a significant risk that we will find ourselves similarly trapped." Morgan Stanley chief economist Stephen Roach believes the state of the world economy is "scary" and "appalling," and like Krugman warns of a deflation where nobody wants to spend or borrow. Roach says the stock-market rally is doomed and foresees weak earnings in the second half of 2003. University of California economist J. Bradford DeLong fears that "by the summer of 2004...the U.S. will have joined Japan in deflation."
And if that isn't bad enough, earlier this month the Basel-based central bankers' club, the Bank for International Settlements, cited the Great Depression of the 1930s as an example of what could happen today if the larger industrial economies failed to fight deflation.
But America is not Japan, and the current decade will not be a bad echo of the 1930s.
Like good and bad cholesterol, there is good and bad deflation. Bad cholesterol causes heart disease. Good cholesterol prevents it. Bad deflation is demand-side deflation, caused by contracting demand -- declining consumer spending and business investment, leading to recession and unemployment. This is the deflation Japan suffers. It is bad because it pinches profits, cuts revenues, hurts stock prices and slows economic output. America had it from 1930 to 1933, when the money supply fell by 30% in four years as banks went belly-up.
Demand-side deflation, economist Abba Lerner once said, is 100 times worse than demand-side inflation. Demand-side deflation is like the films Terminator 1, 2 and 3 rolled into one.
In sharp contrast, good deflation takes place on the supply side: Prices are driven down by expanding supply, in turn driven by falling costs, in turn driven by rising productivity. This is the variety of deflation that America now enjoys. Such deflation enhances profits, boosts demand, spurs growth and exports and ultimately increases real wages. Good deflation is more Santa Claus than mugger or robber. Good deflation is supply-side economics for real.
The Key is Productivity
Unfortunately, we never see a pure version of one kind of deflation or the other. Like good and bad cholesterol, wherever deflation appears it is always a mixture of good and bad, demand-side and supply-side. But we can say something about the mix. We can say that Japan's deflation is mostly demand-side while America's deflation is mostly supply-side.
How can you tell the difference? By looking at productivity -- output per hour or per dollar of capital.
In the dozen previous U.S. recessions since World War II, productivity growth was zero or negative. Companies stockpiled workers in anticipation of economic recovery. But during 2001 and 2002, productivity growth (measured by the rise in output per hour in the business sector) averaged nearly 5% -- higher even than during the bubble years of 1998 and 1999. For the first time in 50 years, productivity growth accelerated during a recession.
Moreover, much of this productivity growth was of a profit-fattening, free-lunch variety known as total factor productivity, a key benchmark Fed Chairman Alan Greenspan is known to track microscopically. And most important, this productivity spurt is not a passing stroke of luck. It is long-lasting, driven by fierce efforts of American companies to slash costs and restore profitability. And they are succeeding -- so well, in fact, that ordinary Americans are puzzled. If the economy is so good (GDP growth), they wonder, why is the job market so bad (6.4% unemployment, highest rate in years)? The answer: productivity growth. Fewer workers make more goods.
Rising productivity may cost jobs in the short run, but it creates them in the long run. Stagnant productivity costs even more jobs. Consider Germany. Manufacturing wages there are 15% higher than in the U.S. and Japan, but productivity is lower. Result: Germany's June unemployment rate was 9.4% and manufacturing is fleeing offshore at an alarming rate. Germany has serious demand-side deflation; its supply curves are a shambles; the strong Euro is ruining its exports; the doggedly-inactive European Central Bank is in utter denial.
Different Story
America is not Japan. Japan's consumer price index has fallen every single month but one since May 1999. America's CPI hasn't fallen (when measured year-to-year) since 1955, and in the past 40 years has never risen by less than 1%.
Ordinary Americans get the true picture better than some economists. They don't believe we are headed for a prolonged period of falling prices. Fed Governor Ben Bernanke notes polls showing that the future rate of inflation expected by Americans is close to 3%, as it has been for two years. Rising long-term interest rates corroborate this.
Ordinary Japanese are also getting it. The Japanese government has stubbornly refused to clean up the financial mess that has strangled the economy in the wake of the collapse of property and stock prices in 1989-90. Until it does, the prudent Japanese people, seeing no evidence of vision or leadership, will hang on to their money rather than spend it, however much new money and deficit spending the Bank of Japan and Finance Ministry pump.
Prime Minister Junichiro Koizumi was swept into office on the basis of his promise to implement "structural reforms without sanctuaries, accompanied by pain." But there has been more pain than reform -- and the pain comes from inaction rather than from action.
Told for decades to save, the Japanese are now told to spend. They refuse. They are clinging to the money created by the Bank of Japan, because money in Japan is increasing in value every day. If your money buys 2% more next year than today, because prices will be 2% cheaper, deflation pays you interest even if the banks don't.
The Japanese brought demand-side deflation upon themselves. After the collapse of the property bubble, many families and businesses had debts that far exceeded their devalued assets. When a version of this happened in America in the savings-and-loan crisis, the resulting mess was cleaned up quickly. The government seized assets, sold them off, bankrupted ailing banks and businesses, sent a few crooks to jail and everything started fresh, so that deserving new businesses could get loans. The process is like a tooth extraction -- painful but mercifully short. In Japan this process has barely begun. Dynamic new businesses cannot get loans, because banks use available credit to lend to bankrupt businesses, so they can pretend they are paying their debts and avoid the pain of write-offs. This is self-deception. The rotten tooth is still there. And the Japanese people know it.
Global Impact
Capitalism cannot function under deflation, some economists claim, citing the Great Depression of 1930-39, when prices fell yearly and unemployment soared to 25%. But that was demand-side deflation. Global capitalism does well under supply-side deflation. Countries that have it become globally competitive and prosper. True, supply-side deflation is quite unusual. But we never had Web-based supply chain management, enterprise resource management software, or wireless networked computers before.
There is a video game invented in Germany with a device that fits on participants' hands and inflicts real physical pain -- whip lashes, burns -- when you lose. This pain is real. The masochistic pain we inflict on ourselves by unfounded fear of bad deflation is not -- unless enough people grow fearful and turn it into Japanese-style demand-side deflation.
This is the deflation America had in the Great Depression. Its roots lie in fear and pessimism. As President Franklin Delano Roosevelt said vividly, in such times, it is fear itself that is the most to be feared. It would be tragic if the unfounded fears of deflation created the very result doomsayers warn against.
America has rising productivity. Japan and Europe don't. America's economy is recovering. Japan's and Europe's economies are standing still. America has good deflation. Japan and Europe have the bad variety. So let's cheer for American supply-side deflation. The more of it, the better.
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SHLOMO MAITAL is Academic Director of TIM-Technion Institute of Management, Tel Aviv, Israel. |
