The Dilemma of Declining Prices
By Christopher Farrell
Inflation, thy name has long been mud. Since the end of World War II, consumers have constantly fretted about rising prices. The consumer price index rose at an average annual rate of more than 4% from 1950 to 2000. In the late 1970s and 1980s, central bankers became the most powerful public guard dogs protecting against inflation. Federal Reserve Chairmen Paul Volcker and Alan Greenspan earned the accolades of financiers, managers, investors, and policymakers for their vigilance. A vast library of academic literature has sprung up around understanding inflation and techniques for containing this chronic malady of a modern industrial economy.
Yet, 2002 may go down as the year that America rediscovered deflation, a broad-based decline in prices. For decades, the term "deflation" had been relegated to the remote backwaters of economic history and a few Chicken Littles who warned about a coming economic Armageddon.
No more. Major newspapers around the world have published 2,397 stories about the risk of a general decline in prices since 1998, vs. 776 stories about the phenomenon from 1992 to 1997. Retail prices for everything but autos are down 2% from a year ago -- one of the biggest drops for such a broad category since the Great Depression, says Mark Zandi, chief economist at Economy.com. The gross domestic price deflator, a broad gauge of inflation, hovers near a 40-year low at 1%.
The possibility of deflation has also caught the attention of the other major industrial nations, too. Japan has been mired in a prolonged deflationary slump following the collapse of its bubble economy in the late 1980s. American and European industry dreaded competing against the Japanese corporate juggernaut in the 1980s.
It turned out, though, that much of Japan's economic activity was fueled by record sums of debt. The country's financiers borrowed on their stock holdings to buy everything from Van Goghs to U.S. golf courses, while Japan Inc. bought market share overseas with borrowed money. Leveraged financing paid for Japan's monumental real estate speculation. When the asset bubble burst in the late 1980s, deflationary pressures deepened, the banking system fell into insolvency, and monetary policy, despite 0% interest rates, packed no stimulatory punch.
Deflation can be malicious. As Japan has discovered, the traditional levers of monetary policy are less effective. The problem is that the real (inflation-adjusted) interest rate rises as nominal interest rates approach zero. High real interest sharply increases the cost of paying down debt for both business and households, and bankruptcies soar.
NO PRICING POWER.
Meanwhile, corporate profits dissipate as consumers hold off on major purchases, knowing that they'll get a cheaper price by waiting just a few more weeks or months. Companies desperately maneuver to conserve cash by laying off workers and delaying investments. "The fact of falling prices injures entrepreneurs," John Maynard Keynes wrote 70 years ago in Social Consequences of Changes in the Value of Money. "Consequently, the fear of falling prices causes them to protect themselves by curtailing their operations."
The risk now is that the U.S. economy will follow Japan into a downward deflationary spiral. Deflationary forces are gaining strength, even as the U.S. economy remains fragile from the nasty aftershocks of September 11 and the Nasdaq implosion. Many industries face global overcapacity, especially with China emerging as the world's low-cost producer.
America's chief executive officers complain bitterly that they can't hike prices, forcing them to shore up profit margins by avoiding risky endeavors, such as hiring workers and making major investments. The price slide toward near-deflation is the primary factor behind an anemic stock market. And the Federal Reserve Board seems to have little room for maneuver, with the inflation rate hovering close to zero and its benchmark interest rate at a low 1.75%.
But it may not be time to panic. The similarities between Japan and the U.S. are overblown. America's speculative excesses in the late 1990s pale next to Japan's insane valuations the previous decade. Yes, dot-com stock prices reached stratospheric heights in the late 1990s. Yet at one point in the 1980s, the land beneath the Imperial Palace in Tokyo was estimated to be worth more than all of California.
Economists at Merrill Lynch point out that real prices for homes in Japan rose at a rate five times greater than those in the U.S. during the 1986-91 period. The highly decentralized U.S. economy is more flexible and resilient than Japan's rigidly bureaucratic system. America's banking industry is healthy, despite some signs of strain, and there's no widespread credit crunch in the capital markets. Economic growth has averaged 3% so far this year, and productivity growth a stunning 5%.
Even corporate profits are up over a year ago. The Fed can cut its benchmark interest rate by several more quarter points before hitting zero -- and markets and consumers continue to watch closely for directional clues, indicating that Fed actions still matter.
More likely, the reemergence of deflation marks a secular turning point in the economy. The price level is likely to remain unchanged for the next decade or so, after averaging out short cycles of rising and falling prices. After all, the wholesale price index remained essentially unchanged from 1790 to 1945. If this forecast is right, consumers, investors, managers, and policymakers will have to adjust to a world where the overall level of prices is as likely to go down as up.
History may not repeat itself, Mark Twain once said, "but it sure does rhyme." The latter part of the 19th century was an era of deflation. It was also a period of remarkable political and cultural upheaval. Deflation spurred the creation of a radical political movement called Populism that called for the value of the dollar to be based on a silver standard as well as a gold standard. This "bi-metal" standard would ease the crushing burden of debt and help raise deflated prices, the Populists argued.
The big Eastern corporations, which had huge economic stakes in gold, bitterly opposed the silver plan. In 1896, Democratic Presidential candidate William Jennings Bryan delivered his famous "Cross of Gold" speech. Deflation was so common that The Wizard of Oz, written by former South Dakota newspaperman L. Frank Baum in 1900, is riddled with allegorical references to deflation and inflation.
Then, as now, the driving force behind falling prices was rapid technological change and business innovation in an intensely competitive economy. "The effects of these periodic setbacks [deflationary contractions] was to compound for businessmen a major problem set in secular motion by the new national competition and technological change -- namely, how to cope with declining prices," writes Stuart Bruchey in Enterprise, a history of American capitalism.
Today, price levels are telling us much about the evolution of the global economy, how technology is changing business, and the political/economic debates that will roil Washington for years to come. Rapid technological change usually fosters rapidly falling prices. Managers are learning that the relentless pressure of deflation means that companies must continuously review all aspects of their business to make sure they're doing whatever it takes to offer customers high-quality goods at low prices.
Investors are only now grasping the effects of deflationary pressures. Real stock-market returns may range between 4% and 6% for the next decade, a far cry from the double-digit return expectations of the 1990s. Consumers are starting to understand that they won't experience sticker shock every time they buy a new car or even pick up a box of cereal -- but they do have to worry about keeping a job or saving for their retirement. Falling prices will create enormous political pressure in Washington for legislators to establish trade barriers and regulate industries, both time-honored tactics for propping up prices.
THE FED'S REAL TASK.
Deflation will have a dramatic impact on the Fed, too, as it struggles to figure out the implications of deflation for monetary policy. (For an intriguing look at its recent research, read "Preventing Deflation: Lessons from Japan's Experience in the 1990s," available on the Fed's Web site.)
Recent criticisms of Fed Chairman Alan Greenspan for supposedly missing the dangers of the the late 1990s bubble are misplaced, however. The fundamental monetary-policy issue of the coming decade isn't about when and how to prick an asset bubble. No, the troubling problem for the Fed will be developing adequate tools to prevent incipient deflation. One look at Japan is a clear signal that the price of a misstep has gone up considerably.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online
Edited by Douglas Harbrecht