How Perceptions, not Data, Spark Deflation

Stunned by free-falling Asian currencies, real estate and stocks just months after they augured an era of endless prosperity, many observers are cowering as if the Ebola virus has resurfaced. Will Asia’s “contagion” spread? Can “healthy” economies inoculate themselves against the plague of deflation--the uncontrollable collapse of prices and wages that, without warning, destroys the aspirations of millions?

To an unprecedented degree, the answer depends more on perceptions, and faith about the future, than “hard” economic or technical facts. In an international world in which it’s possible to buy interests in entire regions that are completely removed from personal experience, the value of anything all too often reduces to a few buzzwords--”multimedia,” “work ethic” or “low capital costs.” When the media, and investors who skillfully exploit global whims, declare such hype unfashionable, economic bubbles from Wall Street to Wuhan pop in a heartbeat.

To be sure, some believe Asia’s troubles stem from far more fundamental forces. They assert that capitalism, especially in industrializing countries like China, Japan or Indonesia, irrationally produces far too many automobile, electronics and other factories than are required to satisfy global demand. With too many producers chasing too few buyers, prices and wages worldwide are relentlessly driven downward. First Asia, then everyone else will be sucked into a deflationary spiral.

Others retort that the world has repeatedly prospered despite periods of overcapacity. In the 19th century, most Americans worked in agriculture or textiles, industries that today employ less than 3% of the nation’s population. When new technology eliminated older jobs, mechanized industries--and now computers and the Internet--took their place.

Ultimately, this debate is about faith, not science. Pessimists, like the newly elected French socialists, believe humanity is at the end of history; since the number of jobs can’t possibly grow, all a responsible government can do is shorten work hours and ration employment. Optimists, like Massachusetts Institute of Technology economist Paul Krugman, promise that if there are too many car companies today, the economy will have no trouble finding something useful for people to do tomorrow.

But who can say whether we have finally run out of ideas and are at the cusp of a deflationary era, or if hitherto unimaginable industries will generate fabulous prosperity?

Nobody knows, especially in a world where what happens in a Malaysian jungle affects the price of Iowan wheat. Given this kind of complexity, how we value things becomes a matter of nostrums, generalities and fads that can prove shockingly inaccurate, even in short time frames.

Take South Korea’s meltdown, perhaps Asia’s most tragic. Over the last four decades, the Korean economy raised the living standards of a war-torn, impoverished people to among the world’s most prosperous levels. The country’s business and government built an industrial juggernaut that was a model for achieving steady growth.

But while the world has unequivocally decided to sell the Koreans short, there’s startling confusion about precisely why the country’s now such a horrible bet. One theory is that government lost control of big business, which, freed from enlightened state oversight, squandered assets on wasteful projects. Another is that the government had too much power, shielding Koreans from market mistakes until it was too late.

What really happened is that the country’s growth-at-all-costs philosophy fell out of favor in an era of Alan Greenspan-led, above-it-all central banks. The media became infatuated with self-indulgent, Silicon Valley cyber-businesses rather than the smokestack industries that form the bedrock Korean economy. Coupled with the kind of unattractive cities many Asian nations have unfortunately built, and a rigid social structure few cosmopolitan pundits enjoy, a spate of key opinion makers declared that Korea was no longer a winner.

Much the same process swiftly transformed Southeast Asia from industrial miracle to basket case. The official line--there’s (gasp!) cronyism and corruption in countries like Thailand or Indonesia--is utterly unconvincing. That’s been a staple in the region for decades.

Instead, a combination of an environmental disaster in the Sumatra rain forest, culturally unpleasant traits like racism and a lack of urban, coffee-shop amenities prized by opinion makers resulted in a stream of bad press. Despite having assembled one of history’s most dynamic, diversified and advanced manufacturing conglomerations, as popular sentiment turned, wealth simply evaporated throughout the region.

Asia’s experience is eerily similar to the hype-induced deflationary pressures that recently pummeled California, especially in the south. When defense-led layoffs hit the state in the early 1990s, the same kind of media dog pile now burying Asia crushed earthquake-prone, municipally bankrupt, crowded, socially dysfunctional California. Property values and confidence plummeted amid predictions that double-digit unemployment rates would persist for years.

The state’s turnaround has been even more spectacular than its deflation. According to the Census Bureau, Los Angeles County is now the country’s top job creator. The Urban Land Institute rates Los Angeles the nation’s best-performing real estate market. Post-bankrupt Orange County was voted the best place to live in America. The Bay Area’s economy is one of the hottest in the world.

All this highlights a new, potentially devastating feature of the modern economy: the threat of uncontrolled, unwarranted deflationary media and investment attacks. As California’s experience shows, wild swings in wealth, and the welfare of millions of people, can be provoked by a narrow, parochial media feeding a surprisingly uninformed, but powerful investment community.

Wall Street’s astonishing about-face on the relative value of large- vs. small-company stocks, for instance, shows just how capricious even the most highly powered expert advice can be. For three years, big-time analysts justified huge premiums for the stocks of giant corporations in part because they felt companies with overseas branch offices were better “globalized” than smaller firms that simply exported products directly.

Around Labor Day, however, the Southeast Asian economic bubble burst. The same analysts suddenly touted small-company stocks precisely because they were not exposed to the now-scary global economy. Billions of dollars shifted overnight from large- to small-company stocks on such “logic.”

Can communities defend against deflation? A strategy that clearly doesn’t work is to attack the media and investors, as did Malaysia’s Prime Minister Mahathir Mohamad, who was widely condemned as a boorish whiner. The politics of deflation demand subtler approaches.

One is to anticipate and visibly adopt the “success” criteria favored at any given moment. Unlike most Asian nations, for instance, Britain shrewdly decoupled the Bank of England from Parliament when Tony Blair became prime minister to emulate the much-in-vogue U.S. Federal Reserve system. But while such efforts can produce reams of positive ink, trend followers risk future catastrophe if economic fashions change and they don’t, or can’t, react.

Another is relentlessly applying modern public-relations techniques to position a region as both an economic powerhouse and home of the lifestyle elements that media elites adore. In the past, Southeast Asia, and most recently places like New York, Seattle and Ireland, scored fabulous successes with this strategy. The cost is that when reality intrudes--financial services or electronics sectors retrench, for example--the resulting disillusionment, and deflation, can be especially brutal.

A third approach is understatement. The world is dotted with regions like Los Angeles, Texas or Florida that achieve spectacular growth, often after periods of deflation, but are largely ignored in ways that minimize asset appreciations that make them vulnerable to future deflationary shocks. Strong fundamentals without hype, in fact, or even with a sense of skepticism, may well be the safest long-term strategy in today’s economy.

In all probability, Asia’s turmoil does not herald a worldwide depression but is just the latest example of how hype profoundly affects values in the global economy. Perhaps as this new risk is better understood, worldwide “circuit breakers,” similar, perhaps, to the trading curbs used on many stock exchanges to contain volatility, will be implemented to mute unwarranted runs on a country’s assets. Meantime, more and more nations are likely to discover that the line between a BMW economy and that of a bullock cart is disturbingly thin.