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November 5, 1998


U.S. Deflation Is Frightening but Toothless


Deflation is scary. The last time prices nose-dived throughout the economy was during the Great Depression. Then government stood by helplessly as wages and prices plummeted and over a quarter of the labor force stood desperately in unemployment lines.

No wonder, then, that investors cringe at the word "deflation." Alan Greenspan, chairman of the Federal Reserve Board, recently warned that "deflation from the Far East is heading our way." Many analysts now echo the deflation theme. Charles McMillion, chief economist of MBG Information Services, wrote last week in The New Republic that deflation "could happen again soon."

But predictions of deflation amount to little more than blather. The experts who dwell on deflation can point to no data that show prices are generally falling. Nor can they point to evidence that across-the-board price cutting is likely to break out in the future. Most important, deflation has not reached the all-important sinews of labor markets.

Predictions of deflation miss the key difference between today and the 1930s: a Federal Reserve no longer asleep at the monetary switch.

First, the data. This year, as in most other years, prices in some individual industries are falling. Energy prices have dropped almost 10 percent in the last year. Commodity prices have dropped by about 20 percent in the last year. The prices of raw materials, clothes and other imported goods have also declined, partly in response to the economic collapse of Southeast Asia.

But other prices are more than making up for the slack. Producer prices, excluding energy and food, are rising about 1 percent a year. Consumer prices are rising by about 2 percent a year. These rates are small. But they are nowhere near negative.

Look to the labor market, which drives the formation of prices. Over the last year, wages and salaries have been rising about 4 percent a year. Nothing in economic logic or history suggests that wages will suddenly reverse course. Indeed, even if recession strikes, wages will almost certainly continue to rise, as they have in every recent downturn.

And if wages do not fall, prices will almost certainly not fall either. Labor costs typically account for two-thirds of the cost of producing goods and services. In general, wages and prices move up and down together.

They can move in opposite directions, however, in times of rapid gains in productivity. If, say, workers are given the tools to churn out 5 percent more each hour, then the extra output would yield enough new revenue to allow the company to pay workers 5 percent more even without raising prices. The company could even cut prices a few percent and still have enough extra revenue to pass along to workers as higher wages.

But productivity is now rising by less than 2 percent a year. That provides no room for prices to fall if wages continue to rise anywhere near their current 4 percent clip. As Martin Feldstein of Harvard points out, "Only in the extreme case of the economy falling into a deep depression like that of the 1930s would the level of prices actually begin a sustained decline."

Nor are prices falling in any other industrialized economy except Japan. Throughout Europe, prices are rising very slowly. In developing countries, inflation rules nearly everywhere outside China. Even in the decimated economies of Indonesia, South Korea and Thailand, prices are rising rapidly.

So why the frenzy over deflation? Robert Solow, Nobel laureate at the Massachusetts Institute of Technology, attributes some of the chatter about deflation to analytical confusion.

In virtually every industrialized country, the official task of the central bank is to achieve price stability, or roughly zero inflation. At least since the reign of Paul Volcker in the 1980s, Fed chairmen have been measured by their ability to get inflation down. With prices rising by only 2 percent a year, Greenspan has come close to victory.

But Solow observes, "if average prices are not changing, then, to a rough approximation, half the prices must be falling, while the other half must be rising" in order to keep the price index relatively level. To invoke the specter of specific price cuts for oil, apparel and computers as harbingers of deflation is, by this argument, to confuse economics with algebra.

The United States has not experienced deflation since the 1930s. But though economic historians continue to debate the underlying cause of the Great Depression, they do not dispute the simple proposition that deflation was then, and will almost certainly be in the future, a monetary event. Translation: Prices can only continue to fall if people are given fewer and fewer dollars to spend on good and services.

This is the flip side of the commonplace proposition that inflation can rage only if people are given more and more dollars to spend by the Fed. In the 1930s, the Fed committed the fatal mistake of sitting back while banks closed and the supply of money shriveled.

It is inconceivable that the Fed would make the same mistake today. If, as Greenspan fears, deflation forces drift ashore from Asia, the Fed has an ironclad remedy. It needs only to step on the monetary pedal, as it has already begun to do cautiously by lowering interest rates.

There are lots of economic forces to fear. Recession. Inequality. Productivity slowdown. In each case, living standards are at risk and government cannot perfectly anticipate what to do and when to act. But deflation isn't worth fretting about unless you believe that the United States will suffer a once-in-a-century catastrophe and the Fed will play dumb.

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