There’s a New Enemy: Deflation

Economic policymakers have been fighting the last war so long, they can’t see they’re entering a different battle on the opposite front.

The old war was against inflation. It shaped the fears of those who watched it get out of control in the 1970s. These are the same people who now run the central banks, ministries and international lending institutions.

Yet the inflation war is over. The new enemy approaches from the opposite direction: spiraling deflation.

The generation that witnessed the worldwide Depression of the 1930s remembers what happens when deflation gets out of control. The seeds of the Depression were actually sown in the late 1920s when major industries began suffering insufficient demand. By 1927, purchases of houses, cars and consumer durables were in decline; commodity prices had turned downward and industrial production began to fall. We are on the verge of a similar global era. But we have become so accustomed to the danger of excessive demand that we no longer appreciate the danger of inadequate demand or feel the urgency of taking preemptive action.

A deflationary spiral can be as dangerous as an inflationary one. Falling prices squeeze profits, causing companies to reduce wages and cut employment. As a result, workers have less money to buy goods and services, causing prices and profits to drop further. The value of property bought on credit drops below the value of what’s owed, resulting in mounting defaults. Lenders are unable to make further loans. The crisis deepens.

A vicious deflationary cycle can also let loose a vicious social cycle, which worsens the economic one. In contrast with periods of strong demand, characterized by low unemployment and rising wages, periods of weak or receding demand lead to higher unemployment and falling wages. Deeper indebtedness combined with higher unemployment can give rise to strikes, work stoppages, changes in democratically elected governments or even violent forms of social unrest. Such social instability further slows the economy and chokes off new investment.

A large, uncoordinated global contraction is already underway. Demand has been contracting in Southeast Asia for over a year, and the consequences have been rippling outward. Many Japanese banks, awash with bad debt, are technically insolvent. They are no longer making loans to small- and medium-sized Japanese companies. Japanese companies that had relied on Southeast Asia as a market for their capital goods exports have lost a large portion of their customers.

Demand is also shrinking in much of Latin America. In an effort to maintain the “confidence” of global investors, Brazil President Fernando Henrique Cardoso last year sharply raised central bank lending rates. The result has been to flatten consumer demand in Latin America’s largest market of 160 million people, amid fears of growing unemployment. Brazil’s contraction has rippled through much of the rest of Latin America, where economic austerity is also in vogue. The United Nations Commission on Trade and Development reports that real wages continue to fall throughout much of Latin America, and inequality is widening. The maintenance of adequate demand requires a large and growing middle class, which Latin America may be in danger of losing.

Double-digit unemployment continues to haunt much of Europe. Yet the predominant policy moves there have been contractionary as well. Government deficits have been slashed in order to qualify for the euro, the single European currency. German and French central bankers have been asserting that their short-term rates of 3.3% should be the benchmark for the European Central Bank in 1999.

The U.S. economy remains reasonably healthy. Unemployment is lower than it has been in almost a quarter of a century. But there are danger signs here as well. Job growth slowed considerably in September. Since March, more than 150,000 manufacturing jobs have been lost. Consumer confidence has dropped over the last three months, with a larger dip last month. Average hourly wages rose just 1 cent in September, down from previous months. Exports continue to plummet, and corporate profits are beginning to feel the shock. The stock market continues to slide.

The sluggishness of wages is especially significant given the importance of American household spending in maintaining the forward momentum of the economy. It means that the economy is being propelled largely by household debt--including credit cards, personal loans and mortgages--which continues at record levels. While it constituted 60% of disposable income at the start of the 1970s, household debt now exceeds 90%. Accordingly, personal bankruptcies have also risen to a record level, as have defaults on credit cards.

Economic policy in the United States is not countering the global contraction. Not only has federal spending been slashed and the budget balanced, but the Clinton administration recently touted a $70-billion surplus for the fiscal year just ended. The White House insists on “saving” the surplus to avoid possible shortfalls in the Social Security trust fund 34 years from now.

As inflation has subsided, real short-term interest rates, set by the Federal Reserve Board, have in effect risen. Even with the Fed’s small rate cut last week, real short-term rates continue to be higher than the long-term rates set by the market.

Consider, then, the large picture: An East Asia of toppling currencies and bank insolvency, rising unemployment in Latin America’s largest economy and falling real wages throughout the rest of Latin America, continued double-digit unemployment in Europe and a rapidly approaching limit to the capacity of American consumers to take on more debt.

Yet rather than leaning in the opposite direction, public policies are intensifying the contraction. Central bankers, financial ministers and International Monetary Fund officials, acting rationally in their own specific spheres of responsibility, aren’t seeing the larger picture. Instead of discussing a new “global architecture” for international finance, they should be taking concrete steps to prevent the contraction from turning into a global recession. Here are three.

First, reduce global interest rates. Last week’s decision by the Fed to lower short-term interest rates by a quarter-point was a symbolic gesture. The Fed is scheduled to meet twice more before the end of the year. It should phase in a full percentage point cut. Germany’s Bundesbank should follow suit. This week, in Washington, Hans Tietmeyer, head of the Bundesbank, hinted at the possibility of an interest rate cut. But it needs to be more than symbolic. Europe should cut by a full point as well.

Second, shift to deficit spending. This is no time for fiscal austerity. The major nations of the world should be stimulating the global economy. Europe should relax the strict budget requirements for eligibility in the European monetary union. Similarly, and for the same reason, the United States should use its budget surpluses for tax cuts and for additional spending. Although Japanese interest rates are about as low as they can go, Japan must embark on a major package of spending measures. Bank reorganization there is essential, but it will take time. Deficit spending on a large scale must begin immediately.

Third, cease conditioning Third World loans on sharp cuts in public budgets and the imposition of higher interest rates. These measures-insisted on by the IMF and the U.S. Treasury- are smothering the very economies they’re seeking to help and intensifying the global contraction already underway.

Changing the direction of public policy is easier than changing the attitudes behind the policies. Policymakers who for years have sought to preempt spiraling inflation must now be equally aggressive in preempting spiraling deflation.