By Robert J. Samuelson
Monday, November 10, 2008
Until recently, the idea that deflation -- the decline of most prices -- was possible, let alone a potential economic danger, seemed outlandish. If anything, inflation was the threat. Led by rising oil and food prices, it was increasing in most countries. But in the past two months, deflation has suddenly become conceivable, and, though still a long shot, it's much more menacing than most people realize. The most urgent economic task for Barack Obama and other world leaders is to prevent the long shot from happening.
A mild deflation -- like a mild inflation -- would be barely noticeable, and even pleasurable. Who doesn't like lower prices? But beyond a few percentage points, deflation can create economic havoc by forcing debtors to repay loans in more expensive money and causing consumers to postpone purchases. In the Great Depression, deflation reigned. Consumer prices fell about a quarter from 1929 to 1933. Spending collapsed. Supply swamped demand, driving prices down. By 1933, manufacturing output had dropped 39 percent and joblessness had reached 25 percent.
It's this history that makes deflation terrifying. Obama and his fellow leaders should worry. Since mid-September, economic conditions have deteriorated badly. In October, General Motors' U.S. sales were down 45 percent from a year earlier; Toyota's fell 26 percent. Payroll employment dropped by 240,000, the 10th straight month of decline. Abroad, signs of distress also abounded. In September, manufacturing orders in Germany fell 8 percent from August. Stock markets in developing countries have declined about a third since September.
By all odds, this signals a recession that, though severe, fits within the post-World War II experience. It will suppress inflation, not trigger deflation. Remember: U.S. consumer prices in September were about 5 percent higher than a year earlier; in developing countries, inflation now averages about 9 percent. Remember, too, the economy has changed fundamentally since the 1930s. Then, factories and farms dominated. Gluts quickly depressed prices of wheat, steel and meat. Now, our service economy features health care, entertainment and education. Their prices are less volatile.
Still, this crisis has repeatedly confounded "experts." A few months ago, it was widely believed that many poor countries had largely escaped the financial turmoil of rich countries. Their growth would cushion the downturns in the advanced world. No more. In 2007, China grew 11.9 percent and India 9.3 percent. The latest forecast from the International Monetary Fund cuts their growth in 2009 to 8.5 percent and 6.3 percent. Indeed, the IMF has tossed out forecasts made only a month ago. It now predicts harsher recessions for rich countries and slower growth for poor countries.
So, there's an outside possibility that we're on the doorstep of a more dangerous global downturn. Something significant happened in mid-September, either caused by the bankruptcy of Lehman Brothers or coincident with it. Trust among financial institutions evaporated. Credit spreads -- the gap between commercial interest rates and rates on safe Treasury securities -- exploded. Stock markets plunged. Economies everywhere lurched downward.
Prices for basic commodities, the feedstock of modern economies, attest to a major break. Since early summer, they'd drifted down from historical highs that were usually attributed to strong demand from China and India. Suddenly, prices nose-dived. It wasn't just oil, now about $60 a barrel, down from almost $150. Copper fell from about $8,900 a metric ton in June to $3,800, aluminum from $3,000 a ton to $1,900. "I've never seen markets turn this quickly or violently," says economist John Mothersole of IHS Global Insight.
In theory, lower commodity prices could be a boon. If the propensity to spend among consuming nations is greater than among producing nations, lower prices would promote a global recovery. But in practice, lower commodity prices might herald a broader deflation. We don't know.
But we do know that a severe deflation could abort any recovery. Its harm would operate through two channels, says economist Desmond Lachman of the American Enterprise Institute. First, debt: As prices fell and old debts stayed fixed, companies would have a harder time repaying; bankruptcies and unemployment would increase; banks would suffer more loan losses; the same process would happen to household debts if wages fell. Second, deferred spending: If people believe prices will be lower next month, they may wait to buy; if too many shoppers wait, the economy spirals downward.
The specter of deflation explains much of what many governments are doing. Government central banks -- the Federal Reserve, the European Central Bank, the Bank of England -- are cutting interest rates. But given the reluctance of many banks to lend and many households to borrow, the effect may be muted. A "stimulus package" of more spending increases and tax cuts would provide extra insurance against an economic free-fall. The trick for Obama and other leaders is to ensure that new commitments are temporary -- and don't worsen grim long-term budget outlooks.