In the last issue of the Graziadio Business Review, Professor Donald M. Atwater discussed how deflation is defined and measured within an economy and noted the signs to which business people should be sensitive, as well as provided some practical advice on steps to take should deflation seem likely. In this article, Professors Crawford and Young compare the U.S. situation with those of Japan and Germany.
Inflation’s evil twin, deflation, has reared its ugly head – at least as a point of discussion. Alan Greenspan, chairman of the Federal Reserve Board of Governors, broached the topic of deflation in a briefing to Congress in May 2003. He stated that deflation was currently more of a worry than was inflation, although he thought the chance that the U.S. economy would face deflation was remote. His statement made deflation a hot topic for the first time since the 1930s when the economies of the world faced global deflation.
Although the Federal Reserve (Fed) admits deflation is a remote possibility in the United States, the Fed has been vigilantly watching for any signs of a downward spiral in wages and prices. The announcement following its October 28, 2003 meeting repeated the fear “…that inflation becoming undesirably low remains the predominant concern for the foreseeable future.” The worry is that falling prices and wages will create expectations of further price decline and delay expenditure on consumption and investment, thereby prolonging the current economic slowdown.
What is Deflation?
From Econ 101, deflation is a persistent decline in the general price level of goods and services. We can detect deflation by examining the difference between actual and potential Gross Domestic Product (GDP). Potential GDP is an estimate of what the economy could produce if available resources, especially labor, were efficiently utilized. With deflation, aggregate spending is below that required for full employment, and potential GDP exceeds actual GDP.
Deflation can be classified as benign or malignant. Benign deflation is associated with an increase in productivity (often from the increased use of technology), which drives down prices. Malignant deflation is connected to weak demand that causes a downward spiral in prices. Insufficient demand, coupled with excess capacity, means firms are forced to reduce prices to move their inventories. Profits decline, and the demand for labor decreases. As unemployment soars, wages fall with prices, and the downward wage-price spiral continues.
Even benign deflation leads to a weakness in profits since increases in output due to productivity are offset by decreases in prices. Firms try to cut costs and increase the bottom line by reducing employment. Companies adjust the quantity of labor instead of the price of labor, i.e. wages. Individual pay usually does not shrink, although raises may get smaller. Initially, neither wages nor output declines as unemployment increases. Companies remain focused on generating output through increased productivity, not from hiring additional employees. Over time, however, the subdued job market should limit the growth of wage increases as well.
What circumstances permit deflation to take over an economy? There is evidence that a rigid market structure and inappropriate government policies can cause deflation. This theory will be evaluated by examining three cases – those of Japan, Germany and the U.S. With Japan suffering from chronic deflation and Germany in stagnation, will the U.S. be next? How should one plan?
Japan–An Example of Deflation
In the 1980s, the Japanese economy was considered to be the model of the future. Other countries studied it and tried to adopt its practices. Yet by the early 1990s, Japan had begun the slow plunge into recession and deflation. The Japanese slide was facilitated by a rigid market structure in which change was slow, resources did not easily move to more productive and profitable uses, and profitability was protected by a regulated price system.
The deflationary forces appear to be driven by the price structure, not by low demand or a decrease in asset prices. Within the domestic Japanese markets, consumers pay premium prices even for globally traded products. Compared to U.S. prices, Japanese prices in the service sector are high, with food prices four times higher, wholesale and retail prices typically two to three times higher, and restaurant and hotel prices substantially higher than those in the U.S. Because of these high domestic price levels, there is no place for prices to go but down – particularly in a global economy with few trade barriers and free movement of resources.
Evidence suggests that asset price deflation has been the result, not the cause, of the economic problems in Japan. The market structure limited the number of available acceptable investment opportunities. The stock market and land were among the few channels available to absorb the capital that Japan was creating. Therefore, funds flowed into these markets and caused prices to increase above economically viable levels, resulting in an “asset price bubble.” When the market meltdown began and the bubble burst, the impact was tremendous. The long-term return on the Japanese stock market, the Nikkei, dropped from 15 to 16 percent in the 1980s to the current 8.5 percent. Residential real estate prices lost one-third of their value between 1990 and 2003, and commercial real estate lost almost one-half its value in the same period.
Deflation is now a concern, though it was once thought to be healthy for the Japanese economy – since lower prices would improve the lives of consumers. Falling prices continue to put pressure on the Japanese job market as firms cut employment to prop up profits. Lower profits have made it difficult for corporations to service their debts, and some firms have been forced into bankruptcy. Banks that carry the loans of the heavily indebted corporate customers are hurt by the bankruptcies, and the Japanese financial system faces destabilization.
The initial response of the Japanese government was to apply “Band-Aids” to individual problems without an economy-wide solution. Senior politicians without the courage to act on real reform watered down initial proposals for bank reforms, including plans to deal with bankruptcies, nationalization of banks, and capital injections.
There are some encouraging signs now in Japan after more than a decade of stagnation. Deflationary pressures seem to be easing. The stock market appears to be rallying, corporate profits are up, and GDP grew at an annual rate of 2.3 percent in the second quarter of 2003. However, analysts warn against too much optimism. Prices continue to decline, particularly in computer products. The unemployment rate hovers at near record rates, and banks face an estimated $295 billion in bad loans.
Germany–the Next Japan?
While deflation seems unlikely in Europe as a whole, Germany faces just that risk after three years of stagnation. The German economy is confronted by an asset bubble similar to the one faced by Japan. Furthermore, there is some evidence that the “bubble is bursting.” The DAX index (the German stock market index) has lost 70 percent of its value over the last three years. German banks are reporting poor profitability, and debt for the non-financial private sector has increased to 160 percent of GDP. Internal and external structural problems have limited the ability of the government to take action to stabilize the economy.
Rigid labor and product markets characterize the German economy. The post World War II German economy was built largely on the cozy alliance of business, government, and labor. It is characterized by consensus, with trade unions participating in management and occupying half the seats on the supervisory boards of big firms. This consensual approach has helped Germany avoid labor unrest, but it has also created a labor market with high wages, inflexible labor laws, and generous social benefits.
In the product markets, German businesses consist of both large industrial giants and the mid-sized Mittelstand (three million mostly family-owned firms). Considered by many Germans to be the heart of their economy, the Mittelstand face global competition just as do the industrial giants. However, the Mittelstand often lack the managerial experience and/or financial strength to successfully compete with larger companies. To limit competition (and innovation), a variety of regulations have been enacted ranging from limitations on the days and hours of operation to prohibitions of discounts and lifetime guarantees. In addition, many large German companies have created webs of cross-holding and reciprocal board memberships similar to those in Japan. These relationships have in some cases limited competition and the free movement of resources to their most productive uses. To date, Germany has done little to reform the rigidities of its markets. However, the Schroeder administration has recognized the problems and has launched a reform package, “Agenda 2010,” to address some of the issues.
Germany limited its ability to use fiscal and monetary tools to stabilize its economy when it joined the European Monetary Union. The European Central Bank, not the banks of individual countries, sets interest rates for the euro zone. Therefore, Germany cannot use monetary tools to control its economy. Its use of fiscal policy (creating deficits or surpluses through the use of the government’s taxing and spending powers) is also constrained by the EU Stability Pact, which does not allow budget deficits of more than three percent of the GDP. European economic policies, including relatively high interest rates as compared to those in the U.S., seem contradictory to the needs of an economy facing a recession and possibly deflation. This economic situation is aggravated by the appreciation of the euro against the dollar. An appreciating currency is equivalent to a tighter monetary policy because higher relative prices lead to a downturn in demand. This is the policy that would be used to fight inflation, not potential deflation.
Will the U.S. Follow?
Many of the characteristics of classic deflation can be seen in the U.S. today:
- Productivity has surged, thereby contributing to the lack of hiring since 2001.
- Unemployment dropped slightly to 6.1 percent in September 2003, and 57,000 jobs were created for the first gain in eight months. However, more than one million jobs have disappeared since November 2001.
- Some assets (particularly housing) appear overpriced.
- The U.S. trade deficit continues to grow, hitting $41.8 billion in May 2003.
- World production may be outpacing demand, particularly in some sectors such as capital goods and consumer durable goods.
Some Positive Economic Indicators:
Positive signs are visible in the U.S. Consumers have not postponed their purchases with the expectation that prices will fall further. Instead, U.S. consumer spending (which accounts for about two-thirds of all economic activity) increased one percent in July, 2003 and 1.1 percent in August. This is partially the result of an increase in available funds from refinancing home mortgages at lower interest rates (monetary policy) and tax cuts (fiscal policy) implemented by the Bush Administration. However, consumer spending fell 0.3 percent in September, a decrease that possibly reflects the diminishing impact of the tax cut.
In addition to activity in the consumer sector, business and construction spending also seem to be increasing. New orders surged in August 2003, thus boosting U.S. factory activity for the second month in a row. Construction spending in July climbed to the highest level since the beginning of the year.
Impediments to Deflation
Appropriate monetary and fiscal policies should help to prevent deflation. Chairman Greenspan recognized the risk early, and the Fed lowered short-term interest rates to 45-year lows.The Bush Administration implemented a combination of decreased taxes and increased government spending (mainly for the military) to stimulate the economy.
The structure of U.S. markets also aids in fighting deflation. Competition reallocates resources, reshapes sectors, and continually transforms the economy. Change tends to raise productivity and wages and adds value to products, thereby providing some sectors with the ability to raise prices. While the U.S. faces depressed prices in capital goods and consumer durable goods, as does Japan, prices in the service sector accelerated at the end of the 1990s. The rate of increase has only recently slowed. Rising prices in the U.S. service sector have more than offset falling prices of goods.
Does the U.S. face deflation? Should businesses focus on increasing productivity and limit new hiring? Should consumers postpone spending to take advantage of the potential fall in prices? Given the ability and willingness of the government to implement monetary and fiscal policy and the competitive structure of U.S. markets, the answer is probably “No.” The mildness of the recession and strong third quarter growth are probably the best argument against the likelihood of deflation in the U.S. Instead, it appears that without an unforeseen shock, the economy is on course for recovery, and, to quote the Fed, inflation seems to be under control for the foreseeable future.
 Los Angeles Times, October 29, 2003: C-4.
 Los Angeles Times, August 13, 2003: C-1.
 Ralph Byrns and Gerald Stone, Economics, 6th ed. (Harper Collins College Publishers, 1995): 154.
 Ibid.: 226-228.
 Gail Foster, “Straight Talk”, The Conference Board, July/August 2003: 1.
 Ibid.: 4.
 Ibid.: 6.
 Economist, February 16, 2002.
 Economist, November 2, 2002.
 Los Angeles Times, August 12, 2003: C-7.
 Economist, November 9, 2002.
 Economist, January 11, 2003.
 The New York Times, October 27, 2003: A-15.
 The Wall Street Journal – Online, August 1, 2003.
 Los Angeles Times, October 5, 2003: A-26.
 Foster, p. 2.
 Los Angeles Times, November 1, 2003: C-1.
 Los Angeles Times, September 3, 2003: C-3.
 New York Times, September 4, 2003: C-9.
 Foster, p.1-4.