Deflation: inflated concerns

A heated discussion about deflation currently preoccupies the financial media (1). But what is it actually about?

It is worth distinguishing between two main developments: deflation in the narrow sense of falling prices, and ‘deflation bust’, in the sense that deflation is taken to represent economic crisis. The notion of ‘deflation bust’ sums up the pervasive mood of pessimism that permeates discussion of the world economy at the moment. Such an idea does not simply hint that the world economy is weak – which is undoubtedly true – but implies some kind of fundamental economic crisis.

Is this really the case? An examination of the deflationary trends apparent today indicates that economic pessimists may be taking things too far.

Falling prices

A recent advert produced by the car manufacturers Fiat uses the slogan ‘To get a better deal on a Fiat you’d have to go back to 1992′ (2). Other companies, such as the UK DIY chain B&Q, have produced similar adverts (3). So far as the deflation discussion relates to falling prices, it is undoubtedly the case that some deflation is taking place.

To grasp the trend towards falling prices on an empirical level, it is worth distinguishing between countries, and sectors – in particular, goods versus services.

The main nation to start experiencing widespread deflation over recent decades is Japan. Several countries then followed, including China, Hong Kong and Switzerland. Other countries, including Britain, have experienced lower inflation but not deflation on a generalised price level.

On a sectoral level, the prices of manufactured goods have been falling while service sector prices have been rising (4). For example, cars and computers have become cheaper while education and healthcare costs have become more expensive.

There is a relationship between the country and sector factors. For example, the emergence of China as the world’s fourth largest industrial power has contributed to the deflation in the price of manufactured goods. It is hard to miss the surge of manufactured goods produced in China that are available on Western high-streets or in shopping malls. One prominent commentator has even noted that ‘China’s prices are becoming global prices’ (5).

Clearly, if prices fall as a result of more efficient production methods, that it a good thing. It was what orthodox economists would characterise as increased supply, and means that more people can afford to buy more goods more cheaply. So at least part of the story of falling prices can be characterised as ‘good deflation’, relating largely to the formation of new areas of production in the world economy, with the potent combination of high productivity and plentiful cheap labour.

But if prices are falling for other reasons – what economists would characterise as a lack of demand – it can be a problem. So what makes today’s falling prices appear as a symptom of crisis?

Basis for fear

There are several different reasons why the advent of falling prices can be viewed with anxiety. But none of them is sufficient adequately to explain real developments.

One reason is economic contraction. If there were a sharp decline in output, in Gross Domestic Product (GDP), this would certainly signal strong tendencies towards economic crisis. But there does not seem to be any sign of such a trend today. During the Great Depression, economic output in the USA fell 29.4 percent from its peak in 1929 to its trough in 1933 (6). Today, by contrast, there does not seem to be any concerted decline in output.

So what is the pessimists’ case? The UK chancellor Gordon Brown said, in his pre-budget report (PBR) delivered in November 2002, that the world was suffering the ‘worst global slowdown for nearly 30 years’ (7). The PBR filled out this argument in more detail:

‘During 2001 growth slowed significantly and simultaneously in the US, Europe and Asia for the first time for almost 30 years, and the world’s three largest economies – the US, Germany and Japan were all in recession.’ (8)

All of this is true – but the chancellor neglected some important caveats. The recessions tended to be shallow – for example, in 2001 the US economy still grew by 0.3 percent overall (9), and in 2002 there was a recovery. The Organisation for Economic Cooperation and Development (OECD) forecast that the American economy was set to grow by 2.3 percent in 2002 (10).

In fact, the PBR does mention the recovery: ‘During the first half of 2002, a recovery in world trade and industrial production provided clear evidence that a global economic recovery was underway.’ But the report took pains to emphasise several ‘buts’: ‘However, the immediate outlook for the world economy has weakened in recent months as corporate accounting scandals, further falls on world equity markets, developments in the Middle East and rising oil prices have compounded existing uncertainty over world economic prospects.’ (11)

In other words, it seems that the UK Treasury was more concerned about the prospects for the financial markets and general economic uncertainty than with output itself.

Another reason why falling prices can be viewed with anxiety relates to industrial production and overcapacity. Those who followed Brown’s speech closely would notice that he made much of industrial production. He said that the world’s main economies have suffered the biggest contraction in industrial output since 1975.

But this observation, while undoubtedly accurate, does not necessarily constitute some kind of fundamental crisis. This is partly because industry only accounts for about a fifth of output of the main industrialised countries (12), which have become increasingly service-oriented. And there has been a long-term relative shift in industrial production to Asia, in particular. South Korea, Taiwan and now China have become substantial industrial nations.

The plight of financial markets raises concerns about falling prices. The main global stockmarkets have fallen by roughly half (in some cases more) from their peak in early 2000. Clearly there is a concern that the economies will somehow follow the markets into recession, possibly through what is referred to as a ‘negative wealth effect’ (investors are poorer because of their losses, so they cut back on consumption).

But this has not happened yet. On the contrary, the world’s main economies have continued to grow, albeit slowly, since the stockmarkets started to crash (13). And other forms of assets – in Britain, most notably residential property – have continued to rise strongly.

The high levels of debt in the economy clearly mean that falling prices are a problem. One advantage of inflation – from the perspective of a debtor – is that it erodes the real burden of debt. So deflation has the opposite effect – it increases the debt burden in real terms. In a highly indebted economy, deflation can hit both consumers and corporate debtors. There is also the possibility that this effect will dampen demand, and so hit economic activity still further.

However, while debt has undoubtedly grown, it is possible to exaggerate the significance of this. It is also the case that, in some ways, the financialisation of the economy can have a stabilising effect. For example, securitisation – in which companies raise credit on the capital markets rather than through borrowing – means that banks are less vulnerable to bad debt problems in an economic downturn.

There is also some concern that the lowering of inflation, and particularly deflation, limits the effectiveness of state economic policy. In particular, it becomes increasingly difficult to pursue conventional monetary policy when interest rates get close to zero (since if there were negative interest rates, it would create the basis for a mass withdrawal of deposits from banks). There are further fears about the consequences of increasing state spending and so countering crisis by means of fiscal policy.

But in practice, the American economy has experienced a large fiscal boost – and indeed, the fear of deflation provides a convenient form through which the American authorities can present fiscal intervention as a pragmatic reaction to events such as 11 September.

In these respects, the fear of deflation represents a concern that the economy is getting out of control of the policymakers. But this worry is also overdone. For there are other ways of pursuing monetary policy besides lowering interest rates (14).

When it comes to falling prices, then, it is difficult to isolate any specific reason why today’s deflation should cause such concern. Rather, today’s anxieties are sparked by less tangible concerns – some related to the general state of the world economy, and others generated by a broader social pessimism.

Real trends

The fear of deflation can be seen, up to a point, as representing concern about the future. According to the current economic orthodoxy, the future is always beset by risks. Only a few years ago, the pressing concern was that inflation might get out of control – and since inflation represented price instability, this was seen as a Bad Thing. But now this battle has been won, the worry is that deflation could set in. No doubt stationary prices, too, would be regarded as a danger signal in today’s anxious era.

The anxiety about deflation can also be seen as a rejection of past economic strategy. Today’s supposed economic stagnation is seen as a punishment for excess ambition in the past. From this perspective, ambitious plans or targets may work in the short term, but can only bring trouble in the long term.

In this respect, the rapid rise of Japan up to the end of the 1980s and the dotcom bubble of the 1990s are both seen as examples of unsustainable excess. Today’s prudent climate caricatures such ambition as greed, and sees any problems that follow as, in the language of Gordon Brown, leading to an inevitable ‘cycle of boom and bust’ (15).

These fears about the future, and the determination to reject the economic strategies of the past, are often over-exaggerated. But that does not mean that all is going well in the world economy. At the heart of such fears is a fundamental concern about economic atrophy, for which there does seem some basis in reality. However, here, too, it is worth asking: to what extent is there real stagnation in the contemporary capitalist global economy? This can be considered by looking at several different areas. America, as the largest economy and the one with the most comprehensive statistics, provides a useful proxy for the health of the global economy.

— Output (GDP) On the level of total output, there is little sign of a crisis in the American economy. There was a technical recession last year – with three consecutive quarters of decline in output – and growth overall was only 0.3 percent. But in December 2002, the OECD forecast that the economy will grow by 2.3 percent in 2002.

–Profits (16) The figures for American profits provide perhaps the strongest evidence for the pessimists’ case. For example, The Economist has said that profit margins are at their lowest level for 60 years (17). However, it should be noted that statistics for profits are particularly unreliable. Corporate accounts often overstate profits while national accounts understate them. And a closer look at profit figures show that the suffering is concentrated in a few sectors. If technology and telecoms are removed, then operating income for companies in America’s S&P 500 stockmarket index is close to its peak (18).

— Productivity This is the favourite indicator of the optimists. Official US statistics show that worker productivity grew at its fastest rate since 1966 in the 12 months to the end of November 2002 (19) (it normally slows during an economic slowdown). According to one authoritative estimate, the level of labour productivity growth that started in March 2001 is a percentage point higher than the average for American recessions after the Second World War (20).

However, official American statistics tend to overstate the true level of productivity growth. For example, they count spending on software as investment, so it contributes to final GDP rather than a current expense (21). And they tend to concentrate only on the business sector, whereas productivity growth in the public sector tends to be slower.

Even Alan Greenspan, the chairman of the Federal Reserve, has admitted that some of the productivity growth is the result of one-off gains: ‘Much of the recent reported improvements in cost control doubtless have reflected the paring of so called “fat” in corporate operations – fat that accumulated during the long expansion of the 1990s.’ (22)

Furthermore, the rise in productivity growth is concentrated in a few sectors: wholesale trade, retail trade, securities, semiconductors, computer manufacturing and telecoms (23). So productivity growth is not as strong as the headline figures suggest – but even if it is measured on a more conservative basis it is still growing at a fair pace.

— Investment Investment also appears to have fallen sharply, but this mainly seems to be the result of direct and indirect effects of the technology boom. IT spending seems to be recovering after a poor 2001, but non-residential construction is suffering.

— Unemployment There was a cyclical rise in unemployment in the USA from the year 2000, but there certainly is not a sudden surge in the number of unemployed (24).

The picture that emerges here is essentially one of economic stability combined with financial instability. The boom and bust of the financial bubble – concentrated in a few sectors – go a long way to explaining both the apparently robust productivity figures, and the sharp drop in profitability. If such effects are excluded, the economy still looks weak but not on the verge of imminent crisis.

From the discussion of deflation, and particularly the anxieties surrounding deflation today, it is possible to identify some of the key trends in the world economy at present.

One significant trend is the establishment of new points of production. What used to be called the ‘third world’ is becoming both more and less equal to the developed west. New points of production are opening up: notably in China but also places such as Brazil, Mexico and parts of Eastern Europe such as the Czech Republic, Hungary and Poland. However, this is widening inequalities within the third world as well as within the countries that have experienced substantial development. It is also worth noting that the third world will become increasingly urbanised (25).

Restraint and anxiety over uncertainty continues to operate on many different levels. For example, there is a particularly heavy emphasis on the role of central banks and monetary policy. This development helps to explain why deflation is such a source of concern.

Given the widespread ‘financialisation’ of the economy, it is not surprising that financial asset prices can be volatile and there is more concern about debt. At present the trend seems to be more one of a shift of liquidity – for example, from the stockmarket to the housing market than an absolute drying up of liquidity (although Britain, being perhaps the most financialised of the main world economies, must be particularly vulnerable to such shifts).

We are witnessing a period of economic atrophy rather than a crisis of profitability. It is certainly the case that the pace of growth in the world economy has slowed steadily since 1973 (26). But the trend seems to be a downward drift rather than a sudden ‘crunch’. The weak pace of growth now applies to all the developed countries. Japan, for example, is now the most lethargic of the main Western nations whereas up until the end of the 1980s it was the most dynamic (27).

This helps to explain the particularly synchronised character of the 2001 slowdown. For example, according to Gordon Brown’s pre-budget report, real GDP in the G7 countries increased by 0.5 percent in 2001 (28). But in the ‘recession’ years of 1975, 1982 and 1991, global GDP grew by 1.9 percent, 1.2 percent and 1.4 percent respectively (29). In such years, slowdowns in some countries were offset by growth in others.

The world economy is still in a state of downward economic drift, complicated by financial instability, but it is not facing a ‘bust’. There is no real reason why there should be an economic crisis. The bursting of the stockmarket bubble – concentrated in a few sectors – has tended to give rise to a distorted view of the economy. It has made some indicators appear stronger than they are, and others appear weaker.

None of this means the world economy is strong. On the contrary, the atrophied global economy contains numerous areas of chronic weakness. But the evidence suggests that rather than a 1930s-style ‘bust’, there is likely to be a protracted period of economic drift combined with financial instability.

Daniel Ben-Ami is the author of Cowardly Capitalism: The Myth of the Global Financial Casino, John Wiley and Sons, 2001 (buy this book from Amazon (UK) or Amazon (USA)). He is also a contributor to Cultural Difference, Media Memories: Anglo-American Images of Japan, Continuum International Publishing Group, 1997 (buy this book from Amazon (UK) or Amazon (USA)).

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(1) The Economist has estimated, based on an analysis of the Financial Times and the Wall Street Journal, that the word ‘deflation’ has been mentioned more in the media recently than at any time since the 1930s. See ‘The recession index: Words that can harm you’, The Economist, 23 November 2002

(2) In Evening Standard, 28 October 2002 and other newspapers

(3) In a 19 July 2002 press release to accompany the campaign, Fiat pointed out that a 1992 Fiat Uno 1.0 cost £6264 on the road while the new Punto range today starts at £5995. B&Q ran a similar campaign earlier in the year

(4) Although there are exceptions – for example, the prices of IT-related services have also often fallen

(5) Stephen Roach of Morgan Stanley quoted in ‘China’s exports: how low can prices go?’, Business Week, 2 December 2002

(6) Box 3.2 ‘The Great Depression’, in IMF World Economic Outlook April 2002. Germany experienced a contraction that was almost as great as America, although Britain’s output only declined by 0.5 percent

(7) Pre-Budget report speech, 27 November 2002. Available at HM Treasury website

(8) Pre-Budget report, chapter two, p7. Available at HM Treasury website. The PBR was not the first to point to the synchronised character of the downturn. See, for example, ‘The world economy: A global game of dominoes’, The Economist, 23 August 2001. It should also be noted that Britain was an exception to this trend – it has not experienced a quarterly contraction in output for over a decade. See ‘Growth continues’, National Statistics press release, 22 November 2002 (available at the
National Statistics website)

(9) OECD Economic Outlook, December 2002, p75. However, it should be noted that the Japanese economy shrunk by 0.3 percent in 2001

(10) OECD Economic Outlook, December 2002, p75

(11) Pre-budget report, chapter two, p6

(12) For example, in 2001 industry only accounted for about 18 percent of American GDP according to the latest CIA World Factbook. However, if goods production was more broadly defined from a materialist perspective to include manufacturing, transport and utilities, construction, agriculture and mining the figure for the same year would be 29.8 percent

(13) It should be noted that it is highly unusual for stockmarkets to continue to fall during an economic recovery. For example, the December issue of the OECD Economic Outlook points out that the recent decline in equity prices is the first in any of the 18 economic recoveries since 1912

(14) See remarks by Governor Ben S Barnanke, ‘Deflation: Making sure “it” doesn’t happen here’, 21 November 2002. Available from the Federal Reserve website

(15) Enron is clearly the perfect target against which to caricature ambition. The Guardian recently serialised a book on the subject, which started: ‘Its testosterone-fuelled traders were fixtures in Houston’s strip clubs. One division of the company spent $2m on flowers alone. And its executives used corporate jets as taxis.’ (‘Bad Company’, Guardian, 4 November 2002. Even Alan Greenspan has condemned ‘infectious greed’ in the American business community (see his testimony to congress on 2 July 2002, available at the Federal Reserve website)

(16) For a useful study of profitability across several countries see Laura Citron and Richard Walton ‘International comparisons of company profitability’, Economic Trends October 2002

(17) 6 December 2001

(18) Business Week, 16 December 2002

(19) ‘Worker productivity climbs at 5.1% in 3rd quarter’, Greg Ip, Wall Street Journal, 5 December 2002

(20) The Economist, 29 August 2002

(21) The Economist, 16 November 2002

(22) Remarks made on 23 October 2002, available from the Federal Reserve website

(23) New York Times, 28 February 2002

(24) American unemployment rose from a recent low of 3.9 percent in October 2000 to 6.0 percent in April 2002, before dipping and then returning to 6.0 percent in November 2002. See the Department of Labor website

(25) See the World Development Report 2003: ‘Two billion people will be added to the world’s population over the next 30 years, and another 1 billion over the following 20 years. All of this increase will occur in developing countries, and almost entirely in urban areas’ (available at the World Bank website)

(26) A useful study of declining growth trends in different countries is HSBC Decline and fall: Bubbles, busts and deflation, January 2002

(27) This does not necessarily rule out the possibility of a resurgence of Japan if conditions change within the country

(28) Pre-budget report annex, p2. The figure for the entire OECD was 0.7 percent (OECD Economic Outlook, December 2002). However, global growth that year overall was 1.1 percent according to the World Bank – thanks to a boost of 2.9 percent growth from the developing countries

(29) ‘Defining a downturn’, The Economist, 2 August 2001. Figures are from the IMF’s World Economic Outlook