The Deflation Menace by tyndale


									The Deflation Menace
Why falling prices upset the economic order.
WE HAVE BEEN CONDITIONED to regard inflation as the silent devastator of wealth
and financial security. But deflation—defined as a drop in the general price level
throughout the economy—poses a greater risk to monetary stability and economic order.

More economists now suspect that the 2001 recession and Federal Reserve’s monetary
decisions have injected deflationary pressures in the economy. The current trend began in
1997 when the price of gold and other basic commodities began falling. Inflation in 2000
reached only 1.7%—the lowest in a decade and far below the 4.1% postwar average.(1)
In 2001, the major commodity price indices dropped 10%to 20%, and the consumer and
producer price indicators (CPI and PPI) have turned mostly negative in the last six

Deflation hazards
Falling prices would seem beneficial to consumers. This is true when competition,
innovation, new technology and/or rising productivity are driving down prices in selected
industries. But a broad-based collapse of general pricing brings structural problems.
Here’s why:

• The deflationary cycle erodes economic activity and wealth. A reduction in basic
commodity prices starts the downward spiral. Over time, materials and finished goods
prices drop. Consumers postpone buying and hoard cash as dollars become more
valuable. The contagion then affects revenues and earnings. Companies downsize or
restructure as inventories pile up. Debt defaults and bankruptcies increase. Workers
experience pay cuts or lose their jobs.

The deflationary force ripples through the economy until general prices settle at a lower
plateau. Financial and real estate markets, as well as most tangible assets, fall in response
to the price pressures. The downward adjustment is subtle because longer-term loans,
purchase agreements and contracts take time to unwind.

• Rampant deflation is hard to reverse. A recession typically brings deflationary pressure
as consumers instinctively cut spending, business inventories grow and production
capacity sits idle. If the deflationary cycle gains momentum in a sluggish economy, a
rebound cannot take hold. In extreme cases, government fiscal policy and monetary
actions by the central bank fail to spark economic growth. Reluctant consumers avoid
buying and businesses reach a point of distress which raises their borrowing costs.

Japan has battled this deflation/recession dilemma for over a decade. The government’s
attempts to stimulate growth through higher spending, financial reform and tax increases
have failed. Although interest rates are near zero, the Japanese economy is stagnant.

• Deflation hurts borrowers. Consumers and businesses feel the sting when they pay off
debt with dollars that are increasing in value while the underlying asset is losing value.
The cost of existing debt increases as the real interest rate exceeds the nominal rate.(3)
This condition also upsets the economic models upon which a business has based its
decisions on strategy, in-vestment, pricing, revenues, market expansion and return on

A positive outlook
There are conflicting opinions about deflationary potency in the U.S. monetary system.
Fortunately, price drops have been mild and some price components, including education,
health care, real estate and wages, have remained inflationary.(4) Only time will reveal
whether falling prices are deflationary signals or benign symptoms of the re-cession. The
events of 9/11 and the terrorist war have made economic interpretation and forecasting
even more difficult.

The economy appears to be moving toward recovery in early 2002. A rebound doesn’t
guarantee an end to deflation, however. Some analysts warn that a deflationary spiral
may compromise the rebound. The Federal Reserve has been increasing the money
supply in recent months, and hopefully this injection of liquidity will satisfy the demand
for new money arising from the recent tax cuts and interest rate reductions.

Some people claim that the Fed killed the 1998-99 expansion by raising interest rates
when inflation was well under control. If the Fed is fighting the wrong monetary battle,
there is risk that the central bank may raise interest rates or reduce the money supply at
the first sign of strong growth. Either action may keep deflation alive. ■
(1) In fact, inflation has been on a long-term downward trend. Inflation averaged 8.1% from 1971 to 1980;
4.5% from 1981 to 1990; and 2.7% from 1991to 2000. (Source: U.S. Labor department) (2) “Defeating
Inflation”, Wall Street Journal, 19 Nov. 2001, A1. (3) The “real” rate of interest is the nominal rate minus
inflation. In a deflationary setting, the real rate is higher than nominal rates. (4) Median CPI has provided
more inflationary weight than total CPI over the last year. (“What Deflation?”, Forbes, 24 Dec. 2001, p


Like other commodities, money fluctuates in value according to supply and demand.
Inflation arises when the supply of money in circulation exceeds demand for it.
Conversely, deflation results from an under-supply of money relative to demand.
Prices rise or fall as the dollar’s value changes relative to goods and services.
The Federal Reserve’s primary job is to maintain stable money while promoting
economic growth. The dollar’s price stability is important because markets work
best when producers, consumers, debtors and lenders make decisions based on
supply and demand for goods and services. Excessive inflation historically has been
the Fed’s primary concern. Dollar-induced price growth distorts market
information, which can bring about misallocated resources, increased risk, lower
investment and other economic ills.

Although everyone wants to avoid extreme monetary conditions, experts disagree on
the causes and remedies of unstable money. The demand-side supporters assume
that excessive economic growth causes inflation. Their remedy is to manipulate the
variables affecting economic activity, and hence, the demand for money. These
include consumption, employment, government spending, interest rates and asset
prices. Demand-siders believe that inflation is best controlled by adjusting economic

The supply-side school asserts that the money supply affects the dollar’s value.
Proponents endorse actions to maximize economic growth—such as low taxes,
minimum regulation, free trade and other market-friendly fiscal policies—and rely
upon the Federal Reserve to adjust the money supply in response to changing
demand. Properly timed adjustments help avert severe inflation and deflation by
keeping the price of money relatively constant. Many supply-siders also claim that
the price of gold and other basic commodities are useful money supply indicators. ■

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