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Commentary | PERSPECTIVE ON THE ECONOMY

There's a New Enemy: Deflation

A worldwide approach to battling the problem is needed to bring it under control.

Robert B. Reich, a professor of economic and social policy at Brandeis University in Waltham, Mass., was secretary of labor during President Clinton's first term.

October 08, 1998|ROBERT B. REICH

Economic policymakers have been fighting the last war so long, they can't see they're entering a different battle on the opposite front.

The old war was against inflation. It shaped the fears of those who watched it get out of control in the 1970s. These are the same people who now run the central banks, ministries and international lending institutions.

Yet the inflation war is over. The new enemy approaches from the opposite direction: spiraling deflation.

The generation that witnessed the worldwide Depression of the 1930s remembers what happens when deflation gets out of control. The seeds of the Depression were actually sown in the late 1920s when major industries began suffering insufficient demand. By 1927, purchases of houses, cars and consumer durables were in decline; commodity prices had turned downward and industrial production began to fall. We are on the verge of a similar global era. But we have become so accustomed to the danger of excessive demand that we no longer appreciate the danger of inadequate demand or feel the urgency of taking preemptive action.

A deflationary spiral can be as dangerous as an inflationary one. Falling prices squeeze profits, causing companies to reduce wages and cut employment. As a result, workers have less money to buy goods and services, causing prices and profits to drop further. The value of property bought on credit drops below the value of what's owed, resulting in mounting defaults. Lenders are unable to make further loans. The crisis deepens.

A vicious deflationary cycle can also let loose a vicious social cycle, which worsens the economic one. In contrast with periods of strong demand, characterized by low unemployment and rising wages, periods of weak or receding demand lead to higher unemployment and falling wages. Deeper indebtedness combined with higher unemployment can give rise to strikes, work stoppages, changes in democratically elected governments or even violent forms of social unrest. Such social instability further slows the economy and chokes off new investment.

A large, uncoordinated global contraction is already underway. Demand has been contracting in Southeast Asia for over a year, and the consequences have been rippling outward. Many Japanese banks, awash with bad debt, are technically insolvent. They are no longer making loans to small- and medium-sized Japanese companies. Japanese companies that had relied on Southeast Asia as a market for their capital goods exports have lost a large portion of their customers.

Demand is also shrinking in much of Latin America. In an effort to maintain the "confidence" of global investors, Brazil President Fernando Henrique Cardoso last year sharply raised central bank lending rates. The result has been to flatten consumer demand in Latin America's largest market of 160 million people, amid fears of growing unemployment. Brazil's contraction has rippled through much of the rest of Latin America, where economic austerity is also in vogue. The United Nations Commission on Trade and Development reports that real wages continue to fall throughout much of Latin America, and inequality is widening. The maintenance of adequate demand requires a large and growing middle class, which Latin America may be in danger of losing.

Double-digit unemployment continues to haunt much of Europe. Yet the predominant policy moves there have been contractionary as well. Government deficits have been slashed in order to qualify for the euro, the single European currency. German and French central bankers have been asserting that their short-term rates of 3.3% should be the benchmark for the European Central Bank in 1999.

The U.S. economy remains reasonably healthy. Unemployment is lower than it has been in almost a quarter of a century. But there are danger signs here as well. Job growth slowed considerably in September. Since March, more than 150,000 manufacturing jobs have been lost. Consumer confidence has dropped over the last three months, with a larger dip last month. Average hourly wages rose just 1 cent in September, down from previous months. Exports continue to plummet, and corporate profits are beginning to feel the shock. The stock market continues to slide.

The sluggishness of wages is especially significant given the importance of American household spending in maintaining the forward momentum of the economy. It means that the economy is being propelled largely by household debt--including credit cards, personal loans and mortgages--which continues at record levels. While it constituted 60% of disposable income at the start of the 1970s, household debt now exceeds 90%. Accordingly, personal bankruptcies have also risen to a record level, as have defaults on credit cards.

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