Deflation Era a Harsh Reality for Washington

Deflation. Prices and wages and the values of homes and commercial buildings are falling, not rising.

But the Bush Administration and the Federal Reserve--like all the king’s men confronted with Humpty Dumpty--can’t end the recession because they don’t understand what’s happening.

President Bush and the Senate think lower credit card interest rates will lure shoppers back to the stores, not understanding that people are scared because prices of houses--everyone’s retirement plan with windows--are declining, by a few percent on average nationwide, and up to 10% in some areas.

The Administration believes that interest rates are low, but business people don’t. Business knows that inventories are falling in value every day--metal prices have declined 2% a month in the past year. Borrowing at 7.5% to finance inventory that falls in value before you can sell it may add up to a 10% cost of capital--an expensive proposition.

Likewise, banks are understandably wary of making loans on declining collateral.

Yes, last week’s government statistics showed inflation in consumer and wholesale prices. But both numbers were misleading. The consumer price index, up 2.7% so far this year, reflects costs of health and other services that won’t keep rising much longer. And wholesale statistics counted a price hike for new cars that few dealers will be able to make stick in a soft market.

Deflation is no reason to panic. Understanding and tax cuts are needed to end the recession. Longer term, knowledge is strength. If you keep in mind that deflation will influence every business and investment, just as inflation did in the 1970s, you’ll be able to cope very well.

To be sure, houses won’t be a rising asset for many years. But other investments--equities and mutual funds--could do well. The next few years should be a period of rising business spending here and overseas, as companies strive for efficiency and profit in a tough environment. Indeed, some of the nation’s smartest investors are taking equity stakes now, looking for a payoff in five to 10 years.

It’s clouds before sunshine, as usual; the recession obscures the possibilities, and therefore must be dealt with.

Why is this recession so baffling? Because in some ways federal spending is actually causing a contraction in the economy, says economist John Rutledge, who heads his own Claremont consulting company. He and others point to the way that the federal government is bailing out bankrupt savings and loans. It’s a matter of not putting up enough money, says Rutledge.

Basically, the Resolution Trust Corp. has spent roughly $120 billion to replace deposits on the books of failed S&Ls.; At the same time, the RTC has sold off commercial and residential properties at discounts from their inflated 1980s prices. The result is contractional in more ways than one. As the RTC borrows on the nation’s money markets to replace long-lost deposits on the books of bankrupt institutions, it injects no fresh money into the economy. Meanwhile, sales of properties, necessary though they are, undercut markets for houses and office buildings.

So what is to be done? The Federal Reserve needs to pump money into the economy to compensate for the contraction, says Rutledge, a conservative economist who served in the Reagan Administration. His thoughts were echoed in a recent speech by Harvard’s John Kenneth Galbraith, the dean of liberal economists who advised the government that the time to worry about the budget deficit “can come when the recession ends.”

That rising chorus of economic opinion, along with pressure from business to get the country moving, may result in tax action next year. Perhaps a boost for take-home pay through a cut in Social Security deductions.

Beyond the recession the trend will still be deflationary, predicts Charles Clough, chief investment strategist for Merrill Lynch. With the U.S. population and labor force growing less than 1% a year, sales growth will be hard to come by and businesses will have to achieve profit increases from gains in productivity and efficiency.

Even health care leaders such as Merck & Co. will be under pressure, said Chairman P. Roy Vagelos recently. Merck will increasingly sell its pharmaceuticals through direct negotiations with health maintenance organizations and insurance companies, Vagelos said. It will have to hold down prices. So the company will economize by reducing its sales force.

Unemployment shouldn’t be a problem in a time of low population growth, but dramatic pay raises will be rare in an economizing decade.

Deflation need not mean depression. Living standards can grow in a time of falling prices and should do so if technology and business efficiencies bring productivity gains, or more bang for the buck.

That the ‘90s will make such gains is the expectation of investors such as Theodore C. Rogers, head of American Industrial Partners, which has $200 million to invest on behalf of major pension funds.

American Industrial and similar groups see no shortage of good prospects. But the terms they offer also reflect deflationary times. They’re willing to pay roughly 4 1/2 times a company’s earnings before tax and interest for an equity stake. That’s less than half the price of deals in the debt-financed 1980s--and works out to less than ordinary investors are paying for shares on the stock exchanges today.

But Rogers and his ilk, reflecting a new era, are deal makers with a difference. They offer operating expertise to the firms they invest in, and patience. They look for a payoff in five to 10 years, recognizing that when the recession is over and the excesses of recent decades are wrung out, this will be one highly productive economy. In the real world, you can put Humpty Dumpty together again.