August 2003
By ROBERT PEGG
In a speech before the Economic Club of New York City last December, Fed Chairman Alan Greenspan suggested that deflation could be more injurious to economic growth than inflation. Deflation refers to a decline in the general price level usually caused by a sharp decline in money or credit supply or a severe slowdown in the economy.
Although the term is sometimes confused with disinflation, the latter means a falling rate of inflation, not an outright decline in price levels. While there have been specific down price adjustments in certain products over time, the U.S. economy has not experienced an outright decline in the aggregate price level since World War II, except for a brief period in 1949. On the other hand, the inflation rate in the U.S. has fallen steadily since the early 1980s.
Although most economists who study inflation and deflation say that the U.S. faces little real threat of deflation, there clearly are signs that price growth has slowed. Not only are the consumer and producer price indices at historically low levels, but the closely watched gross domestic product price index is at its lowest rate since 1950.
Sometimes falling prices can be good for the economy, especially if they result from productivity gains that allow businesses to produce more goods more efficiently. This process lowers the prices of goods and improves everyone's standard of living. However, when prices fall because people cannot buy, this may lead to a vicious cycle of consumers postponing spending because they believe that prices will fall further. At that point, businesses cannot generate profits or pay off their debts, leading them to cut production and workers, who are then forced to lower spending and demand, which in turn lowers prices and so on.
There is little question that severe deflation would damage the U.S. economy. During the Great Depression, the price level in the nation fell by more than 20 percent between 1929 and 1933. During the same period, the nation's gross domestic product fell by nearly 33 percent, while wages and salaries fell by 45 percent. How vulnerable is the U.S. to that kind of deflation? Throughout the 1990s, the inflation rate has been low and falling thanks to globalization, robust productivity gains and aggressive monetary policy. The annual rate of price appreciation for the economy averaged 2.1 percent in the 1990s, compared with seven percent in the 1970s and 4.3 percent in the 1980s.
Some economists compare the U.S. experience to Japan, which since the early 1990s has endured a serious recession and a general deflation. However, most economists still believe that there are major differences between the two economies that will keep the U.S. out of a deflationary spiral, similar to Japan. Nonetheless, there are a number of alarming similarities. Both countries had asset-price bubbles; both had central banks that raised interest rates at one point to stop those bubbles. Both countries have companies and households saddled with debt and both countries suffered from a period when companies overspent followed by a sharp pullback of corporate investment.
The Federal Reserve Board is aware of these similarities and has adopted a policy to fight deflation. Although the Japanese experience shows that deflation is hard to predict, policy makers there seemed to take a blind eye to deflationary forces that were gathering. As a result, in Japan bad real estate loans piled up in banks, overcapacity never cleared up, and price levels were forced to decline. Despite companies going out of business left and right, the Japanese government never took the tough steps to deal with the inefficiencies in their economy. The Bank of Japan slashed interest rates and boosted the money supply. But Japanese banks refused to lend, making new investmentÑessential for getting the country out of a recessionÑimpossible.
There are several good reasons to think why deflation won't happen in the U.S. These include an underlying flexibility in the U.S. economy and financial markets, the availability of new debt and risk management methods and the soundness of the banking system. This time it appears that the Federal Reserve was ahead of the curve, although the current economic weakness has not been painless. However, the possibility of deflation clearly invokes close scrutiny by financial regulators, academics and financial analysts.
About the author: Mr. Pegg is president of Kirkbride Asset Management, the New York City-based investment advisory firm which serves businesses, institutions and private individuals.