The Dismal Science

Deflation Nation

Could falling prices send the U.S. into a Japanese-style recession?

Will America’s economic future look more like Dell or Kmart? Both built their businesses on price cutting. Dell cut prices by outsourcing the design and production of personal computers and captured enough global demand to become the world’s largest PC seller. Kmart cut prices, but at the cost of less choice for consumers and declining service, and found itself losing customers and piling up debt.

The macroeconomic version of price cutting is deflation, and some economists are now suggesting the U.S. economy is on the verge of a deflationary cycle. If so, are we headed on the path of Dell or Kmart?

Disinflation—a falling but still positive inflation rate—is often good for an economy, and even mild deflation—in which that rate drops below zero—may be no worse than mild inflation, if it reflects rising productivity. For example, technological advances and strong demand have enabled the semiconductor industry to steadily improve the power of chips so, in effect, the price of a given chip steadily falls. Imagine a version of the same thing on an economy-wide scale, and you have benign deflation.

But deflation also can be malignant, as Japan demonstrates. There, a collapse in stock and real-estate prices triggered falling demand and rising unemployment. Consumers cut back, and so did firms; and as the economy slipped into recession, normal inflation receded. The downward spiral continued as banks called in loans collateralized by the stocks and real estate now worth a fraction of their former value. Bankruptcies spread, demand and employment fell further, and prices and wages began to actually fall. And the Japanese government found itself virtually powerless. Even as the Bank of Japan cut interest rates to stimulate the economy, the deflation was increasing the real cost of borrowing and investing. (A 1 percent nominal interest rate is a 3 percent real interest rate if prices are falling 2 percent.) When nominal interest rates hit nearly zero, the economy found itself in a classic “liquidity trap,” in which high real rates and stagnant growth continue to discourage investment and spending, and the central bank can’t reduce nominal rates further to do anything about it. That left Japan in a spiral of rising debt and stagnation.

Gold bugs and their supply-side sympathizers have warned about the dangers of American deflation for a long time. Now, mainstream economists like Princeton’s Paul Krugman and University of California Berkeley’s Bradford DeLong also think it could happen here. In June, the Federal Reserve Board published a discussion paper about what Japan’s recent experience can teach the United States about averting deflation.

The numbers are getting worrisome. The consumer price index, which rose 3.4 percent in 2000, inched up just 1.6 percent in 2001. Over the four quarters up to June of this year, it increased barely 1 percent. This is strong disinflation, heading toward deflation.

Economists were not surprised, because inflation or deflation can often be foreseen by looking at the gap between an economy’s potential and what it actually produces. The economy’s potential to produce more goods and services depends on how fast workers’ productivity increases and how fast the work force expands. For example, when productivity grows 2.5 percent a year and the work force grows 1 percent a year—roughly what happened in the latter ‘90s—the economy’s potential grows 3.5 percent. When the economy grows faster than its potential, economists expect inflation.

That’s what we got in the latter ‘90s. GDP growth outstripped the economy’s underlying potential growth, causing modest inflation. CPI increases grew from 1.7 percent in 1997 to the 3.4 percent of 2000. But that mild inflation fell sharply as soon as the boom ended, because strong, structural forces in our economy have been pushing prices down. Increased trade has been one of those forces: Imports increased 62 percent from 1995 to 2000, reducing prices for a wide range of products, from apparel to electronics. In other sectors like communications and transportation, deregulation has intensified competition, again lowering prices.

The dwindling power of organized labor is another factor. As cheap imports put downward pressure on wages in import-sensitive industries and deregulation did the same for airlines, telecommunications, and other businesses, unions had to struggle to prevent wage cuts. Productivity increases have helped cut inflation, especially innovation in information technologies: According to Commerce Department analysts, IT improvements shaved one full percentage point a year off inflation in the latter 1990s.

These deflationary elements are now reinforced by the growing gap between the economy’s actual production and its potential. Our current total GDP is 3 percent to 4 percent less than what it would have been had the economy produced up to its potential over the last two years. (The difference adds up to $3,000 per American household.) According to the conventional model, when the economy’s actual production is one percentage point less than its potential, inflation will fall one-quarter percentage point. And using this model, Krugman recently forecast that the U.S. economy could experience actual deflation by 2004; other economists think it could arrive in 2003.

We could elude deflation entirely with a resumption of strong growth, but that’s hard to imagine in the near future. Consumers have taken a multi-trillion-dollar hit in the stock market, and their household debt as a share of GDP is the highest on record. Nor are we likely to get help from foreign demand: In Europe, Japan, and Latin America, growth is slowing—and in many of these places, prices are falling, too. Business investment, the engine of the ‘90s boom, is also unlikely to revive strongly.

Still, there’s no reason to expect the United States to endure anything like the spiral of deflation, debt, and bankruptcy that has gripped Japan. U.S. stocks did experience a bubble, but there’s little evidence of another one in real estate that could burst. Moreover, U.S. bank capital standards are quite strict, leaving no prospect here of a Japanese-style banking crisis. Deflation won’t make us stronger, as price cutting did for Dell; nor will it drive us to a Kmart-type bankruptcy, as it nearly has in Japan. Rather, the mild deflation that seems most likely here will probably dampen growth in the short term, but maybe with some long-term benefits.

On the positive side, the retrenchment that deflation usually breeds can weed out inefficient producers and spur companies to drive for greater efficiency, which is helpful for future productivity. But in the near term, deflation will probably dampen enthusiasm for spending. When consumers and companies expect prices to fall, they’re more inclined to put off their purchases. Moreover, every downward tick in the price level raises real interest rates, increasing business’s real cost to invest. Falling prices also raise the cost of keeping inventories, another blow to investment.

The Fed can try to chase this syndrome by cutting short-term rates, but if it cuts too far it may find itself approaching zero and a liquidity trap, like Japan. In fact, the Fed has already cut the federal funds rate by 450 basis points since January 2001, to just 1.75 percent. Until strong growth resumes, that leaves a little room—but not a lot—to cut rates further if a nasty shock like a Mideast war or an oil interruption deals another blow to growth and employment.