The fact that it’s being asked reflects a dramatic reversal. In 1979 inflation (as measured by the consumer price index) was 13 percent in the United States. In France, Italy and Britain it was 12, 20 and 17 percent, respectively, according to the Organization for Economic Cooperation and Development. In 1998 inflation in those countries was 1.6 percent (U.S.), 0.3 percent (France), 1.5 percent (Italy) and 2.7 percent (Britain). Behind these figures lies an intellectual revolution.
What was discarded was the notion that easy money could, by stimulating borrowing and spending, expand production and reduce unemployment. Just the opposite occurred. By fostering inflation (“too much money chasing too few goods”), it upset the economy. Companies thought they could pass along higher costs in higher prices. Workers expected that ever-higher wages would more than offset inflation. The Federal Reserve lurched between loose policies (which raised inflation) and tight policies (which tried to quell it). In the 1981-82 recession, short-term interest rates reached 22 percent; monthly unemployment peaked at 10.8 percent.
It was this harsh episode–and the growing conviction that the Fed would resist any run-up of prices–that gradually purged most inflationary expectations. The same thing happened in Europe. But hardly anyone imagined that the process might lead to deflation. This possibility is no longer outlandish. The Economist recently put deflation on its cover. And last week German Finance Minister Oskar Lafontaine warned against deflation.
Let’s define our terms. Just as inflation is the persistent rise of most prices–not just some prices going up–deflation is the persistent fall of most prices. We don’t have that yet in the United States. Last year’s low inflation blended price increases and decreases. College tuition was up 3.9 percent, hotel rates 3.8 percent and used cars 3.5 percent. Meanwhile, gasoline was down 15.4 percent, computers 35.8 percent and women’s clothes 1 percent. What we’ve had is “disinflation”–a drop of inflation.
So have most countries. But not all. In Japan and China there’s modest deflation. In Japan consumer prices have dipped slightly in recent months, and wholesale prices declined 4.4 percent in 1998. In China retail prices have dropped for 14 months, says economist Nicholas Lardy of the Brookings Institution. More conspicuous has been the deflation of globally traded raw materials. At $10 to $12 a barrel, oil prices are at 1977-78 levels; soybean prices are the lowest since 1976.
Economist Rosanne Cahn of Credit Suisse First Boston attributes U.S. disinflation to three causes: worldwide over-investment, which has created surpluses; deregulation of some industries (airlines, communications, financial services), which has intensified competition, and weak bargaining power by workers, which has enabled companies to hold down labor costs. But deflation–where it exists–seems to stem from one main cause: gluts. There’s too much supply chasing too little demand.
Even in 1995, China reported that production capacity for more than 900 major goods (from telephones to film) was almost twice demand, says Lardy. Japan’s industrial output in 1998 was slightly lower than in 1989, says Douglas Ostrom of the Japan Economic Institute. Because industry had expanded, he reckons that factories operated at about 82 percent of capacity. As for raw materials, Asia’s slump has depressed worldwide demand and led to oversupply.
If mild, deflation is tolerable. Lower prices expand people’s purchasing power. Saudi Arabia and Texas may lose from lower oil prices, but consumers–paying less for gasoline–may spend more for toys or software. The effects on the economy may cancel. But at some point, the damage to producers may overwhelm any benefit to consumers. If prices sink too low, companies can’t cover costs or service debts. They fire workers, cancel investment or go out of business. The process can feed on itself, as the buying power of distressed companies–or countries–shrinks. Or consumers may postpone purchases because they think prices will drop further.
In the 19th century, the United States experienced the tamer deflation. After the Civil War, wages and agricultural prices slowly declined. Although this did not stop economic growth, it did feed unrest among farmers, who felt squeezed between falling prices and fixed debts. In the Great Depression, most of the world suffered the sharper type of deflation. From 1929 to 1932, U.S. wholesale prices plunged about 32 percent. Bankruptcies and unemployment soared. Production collapsed.
The obvious ways to stop deflation are to curb supply or expand demand. As noted, the first is painful and possibly self-defeating. But inevitably, it’s occurring. Even some Japanese companies are shutting plants and resorting to layoffs. Expanding demand is more fun. For this reason, The Economist correctly urges the European central bank to cut interest rates and chides the Bank of Japan for not expanding the money supply faster. But these blunt approaches may not fully erase oversupply.
The largest bulwark now against worldwide deflation is the festive U.S. economy. Indeed, its irrepressible growth last week pushed up long-term interest rates on fears (yup!) of higher inflation. But there are contradictory signs. Since early 1998, industrial utilization (the share of factory capacity being used) has declined. This suggests possible surpluses that could depress prices, profits and production. For now, deflation remains a specter. But should the specter become reality, we can be sure that deflation–like the inflation before it–will unsettle the social and political order.
