THE ECONOMIST: Of debt, deflation and denial

FOR decades inflation was the bogeyman in rich countries. But now some economists reckon that deflation, or falling prices, may be a more serious threat—in America and Europe as well as Japan. That would be decidedly awkward, given the surge in borrowing by firms and households in recent years. Particularly worrying is the rise in borrowing by American households to finance purchases of houses, cars or luxury goods. Deflation would swell the real burden of these debts, forcing consumers to cut their spending.

Policymakers in America and Europe have been quick to dismiss any fears of possible deflation. Bond markets, on the other hand, reckon that the risk is mounting: bond yields have fallen to historical lows. Many products, from clothes to cars, are certainly cheaper than they were a year ago. But full-blown deflation requires a persistent fall in the overall price level. The recent fall in the prices of durable goods has been offset by rising prices of services; so outside Japan, average prices continue to rise, albeit at the slowest pace for decades. As measured by the GDP deflator, the best economy-wide gauge, America's inflation rate has fallen to 1.1%, its lowest for 40 years. Its consumer-price index has risen by 1.8% over the past 12 months, but prices have fallen in half of its 16 main product categories—the biggest proportion since the current series started.

The world is still awash with excess capacity, in industries from telecoms and cars to airlines and banking. Until this is eliminated, downward pressure on inflation will persist. A good measure is the output gap, the level of actual minus potential GDP. Historically there has been a close relationship in most countries between the size of the output gap and changes in the inflation rate (see chart). When the output gap is negative (ie, actual output is below potential), inflation usually declines. The OECD estimates that America's GDP is about 1% below its potential. If growth remains at or below its trend rate of around 3% over the next two years, the negative output gap will persist into 2004, pushing inflation even lower. It would not take much to tip into deflation.

Optimists argue that deflation is much less likely today than in the 1930s because services now account for a bigger slice of the economy. The prices of services tend to be more resistant to dropping than the prices of goods because they are more labour-intensive, and wages rarely fall. However, Stephen Roach, an economist at Morgan Stanley, observes that service-sector inflation is now much weaker than usual. The rate of increase in the services component of America's GDP deflator fell from 3% in the year to the fourth quarter of 2000 to 2.2% in the second quarter of this year. In the previous six recessions, service-sector inflation actually increased over the comparable period.

Although Mr Roach reckons that deflation is a serious risk, economists at Salomon Smith Barney argue that fears of it are vastly overdone. Incompetent monetary policies were largely to blame for deflation in America in the 1930s and in Japan today. Outside Japan, they argue, no central bank would tolerate a persistent decline in prices. A recent paper by economists at the Federal Reserve draws lessons from Japan's deflation and concludes that, when inflation is unusually low, central banks must be especially alert to the risk of deflation and cut rates by more than is normally justified by inflation and growth rates.

The Fed is at least aware of the risks. However, not all central banks may be either willing or able to learn from Japan's mistakes. Germany probably faces a higher risk of deflation than America. The ECB's interest rate of 3.25% is broadly appropriate for the euro area as a whole, given its inflation rate (2.2%), the size of the output gap, and the bank's chosen inflation target of “less than 2%”. But the ECB seems unlikely to cut interest rates until inflation dips below 2%. And its inflation target is arguably too low. Research by the IMF and the Fed suggests that, if central banks aim for inflation below 2%, the risk of deflation rises markedly. If the ECB had an inflation target with a mid-point (rather than a ceiling) of 2%, it could now trim interest rates.

Even then, however, rates would still be too high for Germany. Since it is the highest-cost producer within the euro area, a fixed exchange rate tends to cause price convergence by forcing inflation to be lower in Germany than in the rest of the euro area. Germany's core rate of inflation (excluding food and energy) has averaged 0.6 percentage points below the euro-area average over the past three years; it is now a full point lower, at 1.1%.

Since interest rates are the same across the whole of the euro area, this implies that real rates will be higher in Germany and growth consequently slower. Germany's output gap, at an estimated 2.5% of GDP, is the second biggest after Japan among the G7 countries, and it is likely to widen. Deutsche Bank recently cut its growth forecast for Germany to only 0.1% for this year and 0.6% in 2003.

Back-of-the-envelope calculations suggest that, if the old Bundesbank were setting interest rates to suit Germany alone, they would now be below 2%. Worse still, not only is Germany unable to cut interest rates, but the EU's stability and growth pact also obstructs any fiscal easing. Nor can it devalue its currency. Stripped of all its macroeconomic policy weapons, Germany now runs a serious risk of following Japan into deflation.

Deflation is not necessarily bad. If falling prices are caused by faster productivity growth, as happened in the late 19th century, then it can go hand in hand with robust growth. On the other hand, if deflation reflects a slump in demand and excess capacity, it can be dangerous, as it was in the 1930s, triggering a downward spiral of demand and prices.

Today, both the good and bad sorts of deflation are at work. Some prices are falling because of productivity gains, thanks to information technology. But the weakness of profits suggests that most deflation is now bad, not good. Deflation is particularly harmful when an economy is awash with debt. Total private-sector debt is now much higher than when deflation was last experienced in the 1930s. Falling prices not only increase the real burden of debt, they also make it impossible for a central bank to deliver negative real interest rates, because nominal rates cannot go below zero.

If deflation causes real debts to swell, debtors may have to cut spending and sell assets to meet their payments. This can unleash a vicious spiral of falling incomes, asset prices and rising real debt. Irving Fisher, an American economist, described this process in a famous article in 1933 entitled “The Debt-Deflation Theory of Great Depressions”. He described how attempts by individuals to reduce their debt burden by cutting costs could paradoxically cause their debt burden to swell. Unable to increase prices to boost profits, firms have to cut costs, either by reducing labour costs and hence household income or by buying less from other firms. This is sensible for an individual firm, but it reduces demand in the economy, thwarting the desired improvement in profit, leading to another round of cuts and putting further downward pressure on prices.

America's corporate sector is already suffering deflation, with the price deflator of non-financial businesses falling in the past year for the first time since the second world war. Many firms that borrowed heavily in the late 1990s, expecting rapid revenue growth to finance their debts, are now in trouble. Ed McKelvey, an economist at Goldman Sachs, worries that corporate-sector deflation could create wider deflation if firms try to slash labour costs.

When Japan was the only country with deflation, one sure cure might have been a big devaluation of the yen to push up inflation. But for the world as a whole, this is not an option. Global deflation could be even harder to budge.

Many products, from clothes to cars, are certainly cheaper than they were a year ago. But full-blown deflation requires a persistent fall in the overall price level

The truck I bought in 1987 can be had for about the same $ amount today (though it's truly more if there has been deflation).

The part that gets me is why does a cheeseburger and iced tea cost 5 bucks?

wages rarely fall

No, the wages stay the same right up until the layoff. It happened here recently. The biggest employer in town told the union that the employees would have to accept a 20% pay cut if the company were to stay in business. They refused, and went on strike.

All 400 of them are on the dole, now.

On deflation. I've noticed a couple of trends. Tools are getting cheaper and cheaper. A Milwaukee [a top-of-the-line American toolmaker] Hole-Hawg drill or Sawzall reciprocating saw cost less now than they did 30 years ago. You can buy lesser-quality tools for a fraction of what they cost thirty years ago.

OTOH, food prices are going way up where I live. Fresh vegetables cost about 50% more than last year, I believe.

And something that I still don't understand. The price of beef on the hoof is the same or less than it was 30 years ago. But the price of hamburger is roughly 5 times what it was back then. I still haven't figured out how the ranchers can stay in business.

Thank God that beer is still affordable!

Deflation is particularly harmful when an economy is awash with debt.

I think this statement should read "Deflation is harmful ONLY when an economy is awash with debt. "

Inflation is the real enemy. Inflation causes savers to stop saving. That means no capital for capitalism to use. The best recent example is afghanistan where a large sack of money is needed to buy a loaf of bread and where they recently changed the money lopping off a number of zeros.

Without starting a flame war, I'll opine that advances in technology and manufacturing processes (and materials and design) allow manufacturers to produce better goods for less money

I get tired of hearing about Japan's deflation being anything that any other country would have to worry about. Deflation is a symptom. The real problem is nationwide socialist corruption. In the 80's it was perfectly normal for a Japanese bank to create a child company and then loan the child company money for real estate which was overvalued anywhere from 10 to 1000 times with 0 intention of paying it back. With the exception of a few scapegoats who were given slap on the wrist sentences, the bandits are still in power. It's theft pure and simple. Estimates of the cost of these corrupt schemes is between 400 billion and 2 trillion US$. It makes Enron look like a petty pickpocket. Granted Americans can be docile (2 terms of Clinton), but if that crap went on in the U.S. there would have been a revolution. Japanese sheeple are like American sheeple in deep comma.

Deflation is harmful ONLY when an economy is awash with debt.

Good point. There has been an escalating credit bubble for over 70 years since the last series of wholesale defaults. As von Mises pointed out, there are only two "solutions": try to keep the bubble going (resulting, ultimately, in a collapse of the entire system) or deflation. In either case, as you correctly point out, the initial inflation is the disease. Deflation might be (probably is) the least painful cure.

In some cases, that's true. But the Milwaukee tools I mentioned are identical (as far as I can tell) to the ones produced 30 years ago. Maybe there are some subtle improvments that are internal. Cheaper gears, cheaper motors, who knows?

Their website did mention that they moved production from Wisconsin to Mississippi and Arkansas. Also they were bought out by a Swedish company in 1995.

And yes, the Milwaukee tools I bought thirty years ago are still running just fine.

Good post. I read this article in the Economist already. There are good arguments as to why we will see deflation. Don't expect the stock market to rebound either.

I have recently read this book:
Conquer the Crash
It makes some valid analyses and has good information despite the fact that it's sloppily written. The mathematical mistakes begin on page 14 in the hardcover version.(The percentage calculation errors actually soften the argument - the true picture is bleaker.)

You can click on my link and download the first chapter for free.

It confirms a lot of fears I have had. Gets a bit into Elliot wave and revives Kondratieff cycles...

Like anything, you can't treat it as gospel, but it does raise interesting issues and expands upon the theme of this article.

Maybe you should ask the people in the 30's and the 70's which decade was worse.

The creation of capital in this country today is as easy as using the Feds magic checkbook, if people borrow. The Fed will take inflation anyday, at least they can control it, they cannot control deflation.

Hehehe. Maybe this Euro thing wasn't such a bad idea after all! Note that Germany cannot wriggle her way out of this with monetary policy, and therefore will have to do so (or fail to do so) with pro-growth regulatory/labor/business policy. Liberal (leftist) European governments have for years used monetary policy shenanigans to enable (and cover for the failure of) their socialistic policies. America did the same under LBJ/Nixon/Ford/Cahtah. Tightening of monetary policy was a key component of the Reagan revolution, and helped immensely to push along and underscore the efficacy of other elements of his conservative agenda. Something similar is happening in Europe due to the Euro.

What's the difference between increasing bang-for-buck (seen most dramatically in the computer industry over the last 20 years) and deflation?

I think what you're referring to can be explained by volume units of sale, ie. computers are cheaper but they sell more of them, and thus can increase margins.

The kicker is when a cost (like labor) is outsourced or sent offshore.

There have been a lot of studies on this question. The Boskin Commission made an estimate of how much CPI is overstated due to the 'more bang for the buck' principal you describe. For example, if a Red Delicious apple was in the CPI in 1970 and today, you are basically talking about the same apple. It makes sense to compare the prices of the two products to see whether apples have gotten more expensive, and by how much. But if a color television was in the CPI basket in 1970 and is still in the basket in 2002, it still doesn't tell you too much to compare the prices, because the 2002 television is a very different animal than the old one was. It may be three times more expensive, but how can you calculate how much better it is in terms of picture quality, sound quality, cable readiness, remote control and so on? The Boskin Commission actually put a number on this product enhancement creep, but I can't remember what it was.

I don't think the computer bang-for-buck increase is explained by volume. It is explained by continuing advances in technological capability (making more smaller transistors for the same amount of money or less).

I'm referring to the fact that you can now spend less than $5,000 and get a computer that is more capable than a 1980 mainframe costing $10,000,000 or more. This has nothing to do with the production volume of 1980 mainframes.

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