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Expectations of Economic Deflation Are Highly Inflated

The folks worried about falling prices are helping to spur growth.

June 16, 2003|Everett Ehrlich

Every so often some economists decide that everything they ever learned was wrong and, from that moment on, everything is going to be completely different.

Twenty years ago it was the idea that cutting taxes radically would pay for itself. Predictably, the nation's largest peacetime deficits resulted. Five years ago it was the idea that the Internet made companies valuable even if they produced no profit and very little product. Unsurprisingly, the stock market nose-dived soon thereafter.

Now, the idea is deflation -- that prices are going to fall steadily just as they've risen steadily for all of our lives.

Want to bet how this turns out?

Everyone agrees that sustained deflation would be a very bad thing. If people expect prices to fall every year, then why buy anything now, why invest in anything now and why not keep your money stuffed in a mattress as it continually grows in value?

But the fact that deflation is bad doesn't mean it is imminent.

The proponents of impending deflation have their reasons. The first is that Iraqi oil supplies will trigger a global glut. Another is that productivity is so strong throughout the economy. And then there's the global deflationary monster, China, whose 1.3 billion people work for beans and will soon make all the world's cars, computers and cat litter.

How can global prices do anything but fall in the face of these unrelenting pressures?

Hold on. Let's say oil prices fall from their current level of about $27 to, say, $5 a barrel. Fine -- what do they do next year, fall another 20 bucks? Lower oil prices aren't sustained deflation; they're a one-shot deal. And dollars to doughnuts you'll take the money you saved at the gas pump and buy something else, and the price of whatever it is will go up.

But what about productivity? Doesn't it force prices to fall? Sure, productivity allows firms to sell for less, but if higher productivity led to deflation, prices would have fallen for all of human history. Productivity growth isn't a problem -- it's a miracle. If it weren't for productivity growth, we'd all have the standard of living of mule drivers and wood cutters.

A more productive worker earns more in the marketplace and in turn spends more. And spending more keeps prices stable, if not rising.

Which leaves the idea that China will export its own poverty to us through lower prices for everything.

China has certainly been a prodigious exporter, but most of its success has come at the expense of low-wage Asian and Latin American nations that make similar products. So China's products are not lowering world prices so much as out-competing the products of other low-wage producers. The stuff China makes is already cheap. Moreover, at some point, China won't be a low-wage producer. China's currency is officially pegged to the dollar, but the pressure to allow it to appreciate is substantial. When it inevitably does, China's products will become less cheap. It's all part of the Chinese economy growing up.

Today, deflation is the economy's biggest worry. Even Alan Greenspan acknowledges that it would be a bear. But the best argument against deflation is that the U.S. economy is about to grow, and, ironically, the deflationists have all but assured that growth.

In response to their worries, the Fed has made money cheap, because everyone knows that's the way to fight deflation. So now financial markets, caught in the thrall of the deflationary and "slow growth" crowd, are confident that the Fed is going to keep money cheap to fight deflation not only this quarter and this year but this entire decade.

Already, the rate of return on 10-year Treasury bonds is 3.11% -- 3.11%, that's all you get. Somebody must think that's an acceptable interest rate, because somebody is lending the government their money at that rate.

But I'll tell you who thinks that's cheap -- everybody who's refinancing his or her house, often for the second time. People are running to borrow at these rates. And the corporations refinancing their debts think it's cheap too.

Those very low interest rates mean that households and corporations will have low borrowing costs for years to come, setting the stage for more rapid -- non-deflationary -- growth. The deflationists who lent their money to them at these interest rates will prove the losers when rates rise again after the economy starts to grow, the way it always does.

The strength of the deflationists' conviction will save the economy from the danger they foresee. It's an irony only an economist could love.

Everett Ehrlich, a former undersecretary of Commerce in the Clinton administration, is senior vice president and director of research of the Committee for Economic Development, a nonpartisan, business-based economic policy think tank.

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