Deflation Could Trigger Recession

In the past six months, oil prices, interest rates, the dollar and inflation have posted dramatic declines. Many observers and equity investors see them as unmitigated stimuli to the weakening U.S. economy.

Stimuli, yes, but unmitigated, no. The declines are actually indicative of deflationary pressures worldwide: excess supply, slow economic growth and the growing realization that inflation is dead. Moreover, the stimulating effects of the declines themselves may be offset, since they’ll produce as many losers as winners. On balance, a net loss to the economy may even result.

Let’s consider these four declines one by one.

When oil prices shot up in the 1970s, oil consumers were hurt while the Organization of Petroleum Exporting Countries and other oil exporters prospered. Yet, as prices fall, oil producers won’t return to their former status quo with everyone else being net winners.

The world has adapted to high oil prices, and the sharp decline may be at least as wrenching as the increases were. Oil exporters, for example--who used their oil revenue, as well as borrowed funds, to buy goods from oil importers--will now have to curtail their purchases.

Every dollar gained by oil users is a dollar lost by producers--unless lower prices greatly spur demand, which is unlikely. In effect, it’s a zero sum game.

$85 Billion in Savings on Oil

In the United States, which consumed 5.5 billion barrels in 1985, a decline from $30 to $15 per barrel saves oil users more than $85 billion, or about 2% of the GNP. Yet, some 73% of that oil came from domestic sources, so that $60 billion of the savings are matched by U.S. producers’ losses. And these losses are having a ripple effect beyond wholesale layoffs, capital spending cuts and reduced tax revenue in the oil patch: The gloom there may well spread and dampen consumer sentiment nationwide.

Cutting the U.S. oil import bill in half would save about $25 billion. But, since oil producers will slash their imports from the United States by about $25 billion, the trade balance improvement will be annulled. And the situation is even worse for countries such as Germany: since oil is traded in dollars, German exports will suffer both from oil producers’ spending cuts and the dollar’s weakness against the deutsche mark.

Yet, the biggest worry is not that oil exporters will cut back on purchases but that they’ll fail to service their debts. Financial problems are emerging all over the oil patch, and even though the Federal Reserve won’t let major banks fail--dumping money out of airplanes if need be--a number of crises coming all at once may well shake up confidence in the banking system.

True, cheaper oil may pull an oil importer such as Brazil a mile back from the abyss, but if an oil exporter like Mexico is pushed onto the rocks a mile below; the two don’t average out still standing atop the cliff. Oil price declines are transferring incomes from the financially weak oil producers to the financially stable industrialized countries, the reversal of the effects of the price increases in the 1970s.

The dramatic decline in long-term interest rates in the past six months is also not an unmixed blessing and has been limited to only some areas of the economy.

Winners include housing, but gains there will be small. Even if all of the single-family mortgages issued between 1980 and 1985 were refinanced, the saving on monthly payments could amount to $15 billion--enough for any of us to retire at but a mere drop in the $2.5-trillion sea of consumer spending.

Lower mortgage rates also encourage new construction: They should increase single-family starts by 165,000 and add another $12 billion in spending. Thus far, weakness in home sales and starts in the oil patch is unlikely to be made up elsewhere.

Furthermore, short-term interest rates have not yet fallen by as much as mortgage and other long-term interest rates. Most credit card users are still paying 18% on their balances. Furthermore, auto loan rates now are actually higher, on balance, than they were last summer, when many borrowers were enjoying 7.7% subsidized loan rates.

Losers From Lower Interest Rates

Interest rate declines will produce some losers, too. Savers’ incomes have fallen, and the proverbial little old lady in tennis shoes may have cardiac arrest when she goes into her bank to roll over that 12% certificate of deposit and learns how little she can now earn on her money.

Internationally, lower interest rates are a boon for non-oil developing countries with huge debts to finance, but not for OPEC debtors and Mexico. In the case of Mexico, to make up for the $15-per-barrel drop in oil prices, interest rates on its loans would have to be zero!

If the sharply lower dollar brings production back to the United States, our gains will be offset by losses elsewhere as our imports drop and our exports rise. Europe and Japan have been unable to generate internal growth in this recovery and have relied on exports, particularly to the United States, to boost their economies. If these exports are cut, economic growth abroad will probably falter, and world financial problems will be exacerbated.

Yet, due to their dependence on U.S. markets, foreign producers are likely to absorb the effects of their currencies’ strength through cuts in their profit margins. When their currencies were weak in the early 1980s, they built up huge profit margins; now, by cutting them back to normal size, they can effectively wipe out whatever benefits the U.S. economy stands to reap from the lower dollar.

Unfortunately, lack of improvement in the trade balance may further exasperate Congress and fan protectionist fires.

Lower oil prices and lower interest rates have probably reduced inflation by about 2 percentage points in the last six months. This will increase consumers’ purchasing power somewhat, perhaps adding about $30 billion to incomes in 1986. But, in time, much of the gain will be dissipated by smaller cost-of-living escalators and slower wage increases.

On balance, these four dramatic declines in oil prices, interest rates, the dollar and inflation rates will provide a modest stimulus to the economy. Consumers will have more money to spend but not enough to continue to boost consumption--the mainstay of the struggling economy in the past two years--without taking on even more debt.

Last year, due to weak income growth, consumers had to increase their installment debt by one-fifth to sustain growth in spending. If recent rates of growth in income and spending prevail, consumers will need to borrow more than $100 billion this year--far more than the roughly $50 billion combined saving of the four declines.

Consumers probably won’t be able to avoid retrenchment, which they desperately need to work down their debts. In fact, the weakness in consumer spending on autos and many other items in March suggests that consumers have not even spent their oil cost saving, let alone expanded their normal outlays. It may be that people are simply delaying spending these extra funds, but, if not, the economy may soon falter and drift into a full-blown recession.