GET THE VALETUDINARIAN HIS SMELLING SALTS:

-ESSAY: The Roots of Deflation (Christopher Farrell, 5/14/04, Business Week)

Deflation in America reflects fundamental changes on the economy's supply side. At the same time, a new international monetary system has evolved that contains a bias toward lower prices. Deflation is built on three fundamental changes dating back to the late 1970s and early 1980s: (1) the embrace of market capitalism at home and abroad; (2) the spread of information technologies; and, most importantly for understanding the economy of the next half-century, (3) the triumph of the financier. None of these factors is new, but what is surprising is how powerfully each change has informed and reinforced the other.

First is globalization -- that abstruse, abstract word frequently invoked by everyone from politicians to business executives to trade protesters. Globalization is really the spread of market capitalism. Communism's collapse in Eastern Europe and the former Soviet Union, the embrace of freer market's by China's profit loving mandarins, and the turn toward market capitalism by many authoritarian governments in the developing world led to enormous increases in global commerce, international investment, and immigration flows. For instance, in 1980, only 25% of developing countries were manufacturers. By 1998 that figure had swelled to 80%. Trade as a percent of America's GDP -- the sum of exports and imports of goods and services -- was 13% in 1970. It is now around a third.

The U.S. has absorbed more than 1 million immigrants a year for the past two decades. More than 12% of the American workforce was born overseas, and almost one in five residents speak a language other than English at home.

Taken altogether, competition for markets, profits, and jobs is white-hot, keeping managers and employees on their toes, encouraging creativity and pursuing efficiencies. Capitalist competition and innovation are a force for low everyday prices. Global excess capacity for all manners of goods and services, old and new, is pulling prices down. "That excess capacity is a function of decades of development strategy by successful emerging economies, whereby they sought to create enough capacity to satisfy fully their own domestic needs plus a margin left over to serve export markets," says James Griffin, consulting economist at ING Investment Management. "This goes beyond a low-frequency cycle; it is more like an era."

It is this ratcheting up of capitalist competition that accounts for the rise of the second major factor behind deflation: the Internet and other advanced information technologies. The integrated circuit was invented in the late 1950s, IBM revolutionized computerized data processing with the development of the 360 series in the mid-1960s, and Time Magazine named 1982 the "Year of the Computer" as personal computers gained widespread acceptance. Yet it wasn't until the 1990s, after a long gestation period and the commercial development of the Internet, that business finally started figuring out how to harness the power of high-tech gear by reorganizing the workplace. The Information Age came into being because intense price competition forced management to invest in high-tech gear to boost efficiency and shore up profits.

Innovation doesn't have a straight-line impact on growth. Picture this: a chart with an S-shaped curve. Whenever a major new technology is introduced into an economy or workplace, workers and managers struggle to master unfamiliar skills. Learning how to exploit a frontier technology takes years of experimentation and organizational reshuffling. Over time, though, both management and labor move up the "experience curve." Gains in output per worker showed up in lower prices and higher quality that, in turn, put additional downward pressure on prices. The beauty of the economic impact of the high-tech sector is that it actually lowers inflation as prices drop.

The third factor is a new international monetary system that washed out inflation. The new system is based on a shared commitment among central bankers that their job is to prevent inflation and keep prices stable. And the commitment needs to be firm and credible since the link between currencies and a commodity like gold and silver was severed in the 1970s. Nations adopted a "fiat" system where the value of a dollar, mark, franc, yen, or other currency was backed by the full faith and credit of government.

Central bankers made a number of devastating mistakes in the early years of fiat money. But eventually central bankers in Washington and London, traders in New York and Shanghai, and investment bankers in Frankfurt and Chile, came to share a common ideology or worldview: Inflation is always bad. In America, Paul Volcker and his successor Alan Greenspan gradually contained inflation through a long, cumulative process called disinflation, or lower inflation rates. The CPI for the major industrial nations peaked at more than 13% in 1980; by 2003, CPI inflation had declined to an average of less than 2%. The comparable figures for the U.S. were 14% and 1.5%. Business and consumer expectations of higher prices moderated over the years.

The commitment to price stability goes far beyond the abilities and desires of any central bank. Alan Greenspan and his peers have no choice but to contain inflation since the global capital markets are even more important than monetary policy in dampening inflationary pressures. Investors abhor inflation since it degrades the value of their investments. So, in today's tightly integrated capital markets, linked satellite and fiber-optic communications networks that span the globe, financiers will flee any currency that shows signs of inflation. The global stock and bond markets are a "giant voting machine" that limits the ability of governments or central bankers to tolerate inflation. Investors force central bankers to stick with anti-inflation strategies.

Put it this way: Does anyone really believe the Fed will tolerate a sustained rise in the overall price level? To be sure, there's a debate among economists whether the Fed should have tightened a month or so ago or whether it should still wait few more months. The Fed is still a credible inflation fighting institution.

Deflation is not synonymous with depression. The conventional notion that a persistent decline in prices is always a disaster, an economic disease to be avoided at all costs, a depression in the making, is wrong. University of Minnesota economist Timothy Kehoe examined the record of deflation in 15 countries over 100 years. There were indeed a number of episodes when nations experienced both deflation and depression. But it was more common for economies to grow during periods of deflation.

Hyper-deflation, say a 1930s deflation rate of 5% to 10%, is ruinous. Period. The record is mixed when it comes to mild deflation, say a rate of 1% to 2% a year. Sometimes, mild deflation signals a vigorous, healthy economy. What matters are why are overall prices persistently falling. Bad deflation stems from a "demand shock" perhaps a bankrupt banking system or some other trauma that pushes a weak economy into a downward deflationary spiral. Good deflation can co-exist with strong economic growth when the primary cause is a "supply shock" coming from a string of major technological innovations that push costs and prices down, strong productivity improvements, consumer and business gains from freer international trade, and the like. "Such benign productivity-driven deflation was a common occurrence during the last part of the nineteenth century, when people routinely looked forward to goods getting cheaper," says George Selgin, economist at the University of Georgia.

You have to go back to the 1800s to find examples of persistent supply side deflation, especially in the late 19th century. Like now, the last third of the 19th century and the early years of the 20th century were defined by the rapid emergence of an integrated world economy. International trade flourished. The volume of world foreign trade per capita was more than 25 times greater at the end than at the beginning of the 19th century. It was an era of astonishing technological and organizational innovation. Immigrants crossed borders in astonishing numbers. This was also the period of the international gold standard. A shared belief, a commitment to the economic and political benefits of the gold anchor, facilitated international commerce and investment, and kept the price level stable to down.

Deflation and better everyday circumstances went together in America. The wholesale price level fell about 1.5% annually between 1870 and 1900. Living standards improved as real incomes rose by 85%, or about 5% a year. The U.S. economy grew threefold as America went from an agricultural republic to an industrial empire. In the 1860s, America's industrial output lagged behind Germany, France, and Great Britain. By 1900, the U.S. had became the world's leading industrial power with a combined output greater than its main European rivals. The supply side of the economy, including trade, technology, business organization, and immigration, put enormous downward pressure on prices. Writes George Edward Dickey in Money, Prices, and Growth, The American Experience, 1869-1896: "Such a supply or cost-induced deflation does not have the same deleterious effects as a demand-induced fall in prices.... Deflation in this case is a direct result of the rapid growth of output and is not an inhibitor to growth.... The nineteenth century American experience demonstrated that economic growth is compatible with deflation."

What about stock and bond returns? Stocks returned an average of 8.5% a year and bonds 6.6% from 1870 to 1900. Hardly a disastrous return on investment considering that the long-term return on stocks averages 7% and bonds 3.5% since 1802, according to data compiled by Jeremy Siegel, professor of finance at the Wharton School.

Innovation, creativity, and risk taking are the essence of capitalist growth.

So long as the Fed understood that it was the threat of raising rates that counted and doesn't actually follow through.

Posted by Orrin Judd at July 9, 2004 11:11 AM