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May 22, 2003

Demon Deflation: Not Here, Now

By VIRGINIA POSREL

"PAY Less for Almost Everything," blares the cover of Reader's Digest, conveniently positioned next to the supermarket cash register.

Wouldn't it be great if the article lived up to its billing, if you really could pay less for everything?

Or would it?

A generation after inflation battered the economy, Americans are being told to worry about its opposite: deflation. Earlier this month, the Federal Reserve sent a carefully worded signal that its central bankers were now less concerned about their traditional problem, avoiding inflation, than they were about deterring deflation.

"The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level," the Fed governors said.

On the heels of that statement, the federal government last week reported first a 1.9 percent drop in wholesale prices and then only a modest increase in consumer prices. The "core" rate, which excludes food and energy, was 1.5 percent.

Soon talk of deflation was everywhere, much of it highly misleading. Macroeconomics is a slippery, often contentious, field, and much of the popular discussion of deflation has been confused about the nature of the potential problem and, hence, of its solutions.

Deflation, as one Fed governor, Ben S. Bernanke, explained in a November speech, "is defined as a general decline in prices, with the emphasis on the word `general.' "

Like inflation, deflation affects the nominal prices of all goods and services the numbers on every price tag. Deflation is independent of underlying relative values like how many bananas equal a shirt or how many freelance articles equal a new laptop computer.

In essence, inflation and deflation describe changes in the value of money compared with everything else.

When the price of toys falls because Chinese suppliers make them cheaply, or the price of computer chips falls because of new designs or the price of manicures falls because there is a nail salon on every corner, that is not deflation. These are changes in relative prices, not the overall price level.

These relative price changes mean consumers have more income to use elsewhere, bidding up the price of college tuition or fancy coffee, new houses or prescription drugs. (Conversely, the increasing price of education or health care, relative to other categories, is not inflation.)

People often confuse lower prices in some industries with economywide deflation.

"Pricing power is receding right across the board," David Rosenberg, Merrill Lynch's chief economist, told Bloomberg News in response to the Labor Department's latest consumer price index report. In the context of deflation, this statement is a non sequitur. Even if there were tough competition in every industry, that would just mean low profit margins, not falling prices throughout the economy.

Analysts who respond to questions about inflation and deflation with talk about the "pricing power" of businesses are confusing real and nominal prices. Not being able to charge more because the value of your products isn't rising relative to other goods is different from not being able to charge more because the value of each dollar, regardless of how it is spent, is rising. Only the latter is deflation.

Tough price competition may keep managers and investors up at night, but those industry-specific problems are different from the problems posed by deflation (or, for that matter, by inflation).

Falling prices in a single industry may push resources, including jobs, out of that business into other sectors. That change can certainly disrupt the lives and fortunes of people who have invested their careers or money in that industry. But those falling prices don't depress the economy as a whole. To the contrary, they raise the overall standard of living.

Unexpected changes in the overall price level, by contrast, effectively rewrite all sorts of contracts. Dollar amounts specified today have a different value tomorrow. In the case of deflation, the promised sum buys more than expected.

That sounds great if you are a worker whose salary is fixed or a lender who is collecting on long-term debts. But what happens when the employer or borrower has to come up with the money?

If widgets are selling for fewer dollars than expected, the widget maker has a hard time meeting its payroll and debt service. If the company can't just cut everyone's salary to correct for deflation, it will lay off workers. And if it can't renegotiate its loans, it may default.

The same thing can happen in an industry facing tough competition, of course. But when the cause is deflation, it happens not just in one sector but throughout the economy. Resources don't move to more productive uses. They simply disappear.

As a result, unexpected deflation can lead to a downward spiral, where each round of cutbacks brings others. (If the deflation is expected, people will write contracts to take account of the changes, just as today's mortgage rates include a premium for expected inflation.) The problem is intensified if, as in Japan, financial institutions and labor markets are rigid and slow to adapt.

Fortunately, that prospect isn't likely in the United States. If anything, trends are moving in the opposite direction. The falling dollar raises the cost of goods, while the growing federal deficit creates inflationary pressures.

"I've never known an economy I doubt that there is one that has a falling exchange rate and a large and rising deficit and that has deflation," said Allan Meltzer, an economist at Carnegie-Mellon University, in an interview.

That may not reassure businesses that can't raise their prices because of competition. But it's good news for the rest of us.


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