THE THREAT OF DEFLATION?

Peter S. Goodman, of the New York Times wrote an interesting piece entitled "Fear of Deflation Lurks as Global Demand Drops (NY Times Oct 31, 2008) Goodman states that "...a new threat may be gathering force within the American economy..the prospect that goods will pile up waiting for buyers and prices will fall.." The results, called "deflation" suffocates fresh investments and cause joblessness and may lead to a long-term economic downturn.

The word "deflation" itself gives economists the jitters. Why? Because it was deflation that caused the greatest hardships of the Great Depression of the 1930s. The same phenomenon accompanied Japan's "lost decade" when its stock boom collapsed and its real estate bubble burst at the end of the 1980s.

Deflation is a general and sustained decline in the price level of an entire kind of asset or commodity and is the opposite of inflation. According to classical economic theory it is an economy in which both money-supply and availability of credit decrease. That sounds a lot like what might be occurring here in the US--too much production in relation to available resources. During the classic era of British economics, Adam Smith (1723-1790) and David Ricardo (1772-1823) described this phenomenon as a "general glut". I like that term, since it is so descriptive of what actually is occurring. In 19th century Britain, as labor became specialized, it sought a higher standard of living and to achieve that end, produced more and more product. Because increased amount of goods lowers prices, producers had to raise production to increase income, which in turn, lowered prices further. The process begins a vicious cycle or feedback loop which moves the economy increasingly toward deflation or a "general glut". Whether that simple scenario can occur in a modern economy is questionable, however, there is a very recent and well known example.

It is the Japanese "baburu keiki" or "bubble economy" of 1986 to 1990. The aftermath of this event continued on into the early part of this century and is chilling in its similarity to our present economic situation. Japan, a nation of hard-working frugal people with a strong tradition of saving, pulled themselves out of the ashes of WWII to become the Miracle Economy of the east. By the early 1980s, the USA and Japan accounted for 40% of the entire world economy (See: Jim Impoco, NYT Oct 18, 2008). For the post-WWII Japanese government it was easy to employ tariffs and taxes that encouraged people to save--since it was something that Japanese tended toward naturally. As a consequence, during this period banks were flush with cash and credit was cheap and easy to obtain. By 1986 with easy credit and a surging economy, Japanese companies could more easily invest in capital improvements-- than their overseas competition. With their highly efficient production, came lower prices for their goods and a larger share of overseas markets. The trade surplus increased to engorge banks with money---money which was then available for investment and of course for speculation. Speculators and investors were particularly active in the Tokyo Stock Exchange where shares surged, and later much of the income was reinvested in the real estate market as well. At the zenith of the real estate bubble it is said that some choice properties in the Ginza district in Tokyo were selling for a whopping $139,000 per square foot! (According to www.urbandigs.com the present average price per square foot for a Manhattan apartment (2008) is $964 (http://www.urbandigs.com/2006/03/price_per_squar.html). The result of this massive growth was that between 1986 and 1991 Japan had expanded its GNP by nearly one trillion dollars, or about the value of the entire French GDP of that period.

Then early in the new millennium, both the stock bubble and the real estate bubble burst at the same time. The government mostly denied there was a problem. The were no major outward signs of great distress. The economy spluttered along, but there was little growth. There were periods where the economy appeared to grow, then it would stall and contract a little. That situation continued for more than a decade. Called in Japan, "the lost decade" only in 2003 has the economy fully recovered.

Could that happen to us? It's possible but there are some differences...they Japanese were not aware of deflation and let it happen. We are forewarned by their experience. There are some other differences too. But nothing that can reassure us. Japan was the world's largest creditor nation when their twin stock and real-estate bubbles burst...but we are the world's greatest debtor nation. (In fact, today we (USA) had to borrow $2 billion dollars just to keep the US government running. No that is not just for today. That is what we do every day...we are borrowing each day to keep our nation afloat. Let's see 360 days x 2 billion dollars = 720 billion...Yep that's what our deficit is.)

If a general glut, deflation era and "lost decade hits" us, we face problems that the Japanese didn't have. We owe foreign nations lots of money, at the same time we borrow heavily from these same creditors and instead of fanatical savers and frugal spenders, Americans are profligate spenders and scanty or negative savers. The picture doesn't look too promising.