This Time, It Really Is a New Economy
By Christopher Farrell
The strong recovery is finally here. The economy's momentum is unmistakable, despite the East Coast blackout, the jump in long-term interest rates, the spike in gasoline prices, and a mammoth federal budget deficit. Orders are up, and business is investing for growth. Profit margins among the approximately 2,300 companies that have reported second-quarter results are now close to pre-recession levels, according to consulting firm Economy.com. The stock market has largely held onto the gains of recent weeks. Apoplithorismosphobia is receding, too. That's Greek for fear of deflation or, perhaps more correctly, the fear that deflation signals a depression, say Mark Thornton, senior fellow at the Ludwig von Mises Institute in Auburn, Ala.
So is that it? Can we safely put away our books on the Great Depression, 19th century deflations, and Japanese economic history? Hardly. Deflation isn't a temporary consequence of the 2000-03 downturn. It's a signal that the age of inflation is over. Deflation's emergence reflects the spread of market capitalism and the rise of the global financial markets. Both trends will only gain influence in coming years.
Prices have risen by some 1,000% -- or an average annual rate of 4.1% -- during the lifetime of baby boomers, the inflation generation. Put somewhat differently, it now takes $945 to have the same purchasing power as $100 in 1946. Little wonder everyone thinks inflation is an economy's natural condition.
Yet from 1776 to 1965, America's price level was essentially flat. Inflationary outbursts were mostly associated with major wars, an eruption quickly extinguished in peacetime. The injection of inflation into the post-World War II economy, including the double-digit rates of the 1970s, was "a break in our entire peacetime history," notes Peter Bernstein, the dean of finance economists.
Adds J. Bradford DeLong, an economist at the University of California, Berkeley, and formerly Treasury Deputy Assistant Secretary for economic policy in the first Clinton Administration: "It is the inflation of the 1970s that is the significant exception."
America's overall price level is poised to remain relatively stable, on average, with a slight downward bias. One hundred dollars today may well be worth the same amount 10 years from now or even in 20 years.
That's not the same thing as saying the value of money won't change along the way. As we all know, on average, Lake Erie never freezes, and the stock market returns 10% a year. Price stability on average translates into brief, virulent bouts of inflation and long periods of slight deflation, marred by brief frightening plunges in the overall price level.
Take the period from 1870 to 1920. Consumer price inflation averaged 0.7% a year for that 50-year time span. From 1870 to 1896, overall consumer prices fell by around 1.5% annually, with deflation far worse in some years, such as the depression of 1893. Consumer prices rose unevenly by 2% a year from 1896 to 1914, soared during World War I, and collapsed during the brief depression of 1920-21. Indeed, the 56% price drop from May, 1920, to mid-1921 may be the steepest in U.S. history.
The trend toward deflation is a secular undertow of the global economy. Capitalism is spreading worldwide, a phenomenon that intensely increases the competition for markets and profits. When markets are large and laws allow people to easily build companies and keep their profits, more and more talented people become entrepreneurs, innovators, and wealth creators -- and that competition puts relentless downward pressure on prices.
The global financial markets also won't allow for resurgence in inflation. And technologies like the Internet allow consumers to shop for the lowest price anywhere in the world.
Of course, the notion of proposing a major change in the economy isn't in favor these days. Wall Street money managers are fond of quoting the legendary octogenarian investor John Templeton, who said: "The four most expensive words in the English language are 'this time it's different.'"
Investors have been burned by too many new eras, new economies, and new fashions. Yale University economist Robert Shiller scornfully dissected "new era" proclamations in Irrational Exuberance, his exquisitely timed warning against an overvalued stock market. New Yorker writer John Cassidy's bestseller Dot.con, a marvelous retelling of the manic Internet boom and bust, dismissed the New Economy enthusiasm of the past decade.
Yet every once in a great while, the established economic order is indeed overthrown. Within a span of decades, technological changes, organizational upheavals, and new ways of thinking transform economies. The other day I was looking through some history books, and I was stunned to see the changes in the economy and society of Marshall Wyatt Earp, who fought the legendary Gunfight at OK Corral in the cow town of Tombstone, Ariz., in 1881.
To get a visual sense of what life was like back then go see the movie Open Range, Kevin Costner's homage to the Western epic. Horses and horse-drawn carriages were common, the railroad the main link between regions, indoor plumbing extremely rare, and the frontier still beckoned. Yet when Earp died in Los Angeles in 1929, that city had cars, electricity, indoor plumbing, radio, and TV. Earp summered in L.A. and rubbed shoulders with Hollywood actor friends. Now, that's a long way from the OK Corral.
This time is different, too. The U.S. is still in the middle of the transition from a world of persistent inflation to one of persistent deflation. The transformation will affect how Americans look at the world, what public policies get argued about, the innovations that get created, and the quality of everyday life.
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 Beth Belton