Deflation. The word comes up more and more often these days.
The Federal Reserve Board recently warned that America faces a risk of it. Japan has been suffering from it for more than a decade. Europe may be heading toward it. The entire world economy could succumb to it.
But when the dreaded word comes up in the United States, optimists here say "highly unlikely."
I'd join the optimists if the Bush administration were taking steps to avoid it. But so far, there's been no strategy. The tax cut offers little help. And the White House recently missed a big opportunity to move against deflation when the president met with leaders of the other seven major economic powers.
What is deflation, and should we be worried?
Deflation means falling prices. But, you say, prices are rising for health care, college tuition and home heating. Where's the evidence of deflation?
Almost everywhere else. The prices of cars, computers, clothing, airline fares and commodities of many kinds are dropping. The only reason health care and college tuition are rising is that these "products" include more and more things, such as increasing amounts of research on new drugs or more lavish student centers. Heating prices went up because of the Iraqi war. Now that the war is over and oil prices are dropping, heating prices will drop, too.
So what's bad about falling prices? Nothing, if prices are dropping because people and companies are becoming more productive. But if prices are dropping mainly because companies have to cut them to make sales, we may be heading for trouble.
The immediate result is shrinking profits. When profits shrink, firms lay off more workers and slash the pay of those who remain. Naturally, these people stop buying as much as before. Other consumers hold back because they figure if prices continue to drop, they can get better deals later on. All of this means fewer sales, which put an even greater squeeze on profits. This results in more layoffs and lower pay, which can turn into a vicious downward cycle.
Deflation also puts the squeeze on debtors. Although other prices drop, debts don't. Debtors have to pay back their loans in dollars that are harder and harder to earn. Not surprisingly, deflation usually means more defaults on loans. That means banks and other lending institutions have a harder time staying solvent. This adds to the downward cycle.
Here's the worst part about deflation: Central banks are powerless to cure it. If the United States went into a deflationary cycle, the Federal Reserve Board couldn't spur the economy by lowering interest rates. With prices dropping and dollars harder to earn, no one would want to borrow — even at 0% interest.
What's the risk of deflation anytime soon? Optimists point to last week's report showing that prices remained stable in May. The new tax cut will spur spending a bit by putting a little money in people's pockets. Another spur will come from exports, aided by a falling dollar. The Federal Reserve Board may help some if it lowers interest rates again on Wednesday.
But deflation is a bigger risk than the optimists are willing to admit. The basic problem is that global supplies of goods and services are much larger than worldwide demand for them — and the gap is widening. That's a sure recipe for falling prices everywhere.
Look at Japan
The world's second-largest economy (Japan) is still suffering from deflation. Unemployment there is at record highs. The third-largest economy (Germany) is slowing down. Unemployment is rising across Europe.
Meanwhile, China is pumping out more low-cost manufactured goods than ever. India and other low-wage nations are generating all sorts of cheap services, from call centers to software programming.
The United States isn't immune. Although corporate profits are growing, they grew only an anemic 1% between January and March, according to the Commerce Department's latest report.
Look closely and you'll see where those profits are coming from. Companies continue to lay off workers and keep a tight lid on the pay of those who remain. In other words, companies are maintaining profits in the face of weak demand by cutting payrolls.
This could be the first round in a deflationary cycle. The Commerce Department reports orders to U.S. factories slipped 2.9% in April from March, the largest decline in 17 months. Downward pressure on profits and prices is likely to continue. With fewer jobs and stagnant wages, Americans won't be able to buy enough to keep the economy going.
In mid-June, consumer confidence was reported down more than had been anticipated. Many American consumers have good reason to be gloomy: The country has lost more than 2.5 million private-sector jobs since the spring of 2001. That understates the problem, because the population of adult Americans has grown since then. Look at the U.S. population as a whole and you find that more than 74.5 million adults are not working — up more than 4 million since March 2001.
Washington isn't doing nearly enough to spur demand and avoid deflation. The new tax cut goes mainly to rich people, but they won't spend the extra dollars: Being rich means you're already spending as much as you want. The tax cut should have gone mostly to average working people, who would spend extra cash.
At the G-8 meetings in France earlier this month, the Bush administration failed to push the European and Japanese governments to spend more and cut interest rates further. A falling dollar won't mean much if foreigners are in no mood to buy.
I'm not predicting deflation, at least not yet. But don't put me in the optimist camp for now.
Robert B. Reich, former U.S. secretary of Labor, is Hexter Professor of Social and Economic Policy at Brandies University and the author of "I'll Be Short: Essentials for a Decent Working Society".
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