Deflation Is the Real Threat to Economy

President Bush knows what the real economic problem is today. Last weekend, he lectured finance ministers and central bank governors of Japan, Germany, France, Britain, Italy and Canada on the need for lower interest rates to spur the global economy.

Bush fears that if U.S. trading partners keep the brakes on their economies, through high interest rates, they will buy fewer U.S. exports and throttle one of the strongest opportunities for U.S. economic recovery.

But the other nations--members along with the United States in the Group of Seven industrial nations that try to coordinate economic policies--turned Bush down on interest rates. Led by Germany and Japan, the other countries said inflation was the big worry in the world and therefore interest rates had to remain relatively high--close to 9% for Germany, 7% for Japan.

The world is suffering a capital shortage, the foreigners argued--with demands for financing coming from the Middle East, Eastern Europe and elsewhere. Unless interest rates were kept high to discourage such demand, the result would be inflationary growth.

And if U.S. interest rates are low at present--the Federal Reserve lowered its main interest rate to 5.5% on Tuesday--it is only because the U.S. economy is in recession, the other nations said. In their view, inflation will rise and U.S. interest rates will have to move back up as the economy recovers. “Inflation will average 5% this year and 4% in 1992, and in other countries, too, inflation will be a worry,” declared the Economist magazine, reflecting the conventional wisdom.

Trouble is, such fears paint a picture of business straining at the leash, when in fact the opposite is true. U.S. inflation in the first three months of 1991 ran at a 2.4% annual rate, and wages rose at only 1.2%. U.S. demand for credit is low and banks aren’t eager to lend in any event.

Meanwhile, high interest rates have so chilled business confidence “that both Europe and Japan could be facing recession before the end of the year,” according to studies by the Conference Board, a research organization supported by leading U.S. companies.

The fact is, Bush is right and all the others are wrong. The economic threat of these times is not inflation, but deflation--the falling of prices and wages and values of real estate and businesses.

The recession we’re in is an aftermath of inflation, of a wild expansion of borrowing in the 1980s that pushed up prices. Now the whole game has changed and prices are falling. A good example is the department stores acquired by Campeau Corp. in debt-financed deals that were the hallmark of the 1980s. Campeau, which went into Chapter 11 bankruptcy in January, 1990, paid a total of $7 billion for the Federated and Allied department store chains. On Monday, the trustees proposed a settlement with creditors that valued the assets at roughly $5 billion. That’s a 30% decline in value.

Prices are falling in commercial and residential real estate in many parts of the country. The falling values in turn are threatening the solvency of banks and insurance companies that hold real estate as collateral.

Deflation is the pattern in Japan and Germany too. Japan had a tremendous credit boom in the 1980s as Tokyo real estate prices reached for the stratosphere. But now that boom is over. Tokyo real estate prices are falling--down 20% so far--and bankruptcies are increasing.

Germany is afraid its financing of unity with East Germany will be inflationary. But the real effect is deflationary, because West Germany took over East German factories and buildings at politically calculated prices. Now those prices are coming down toward low or nonexistent resale values--just like the busted savings and loan properties acquired by Resolution Trust Corp. in the United States.

All that asset deflation reminds economists of Dust Bowl farms and repossessed real estate in the 1930s, which is why many are beginning to suggest that the 1990s could see another Depression.

That’s scary talk, but fortunately it’s inaccurate. There is one big difference between the 1930s and today: The ‘30s suffered from a lack of investment capital, but there is a lot of money around today and it’s willing to invest.

“There’s no capital shortage,” says Charles Clough, chief investment strategist for Merrill Lynch. “Solvent borrowers are the commodity in short supply. East European countries may want loans but won’t get them because they can’t pay back. But there is ample capital around for investment.”

Look no further than the public and corporate pension funds that put hundreds of billions of dollars into stocks and bonds and also invest a percentage of their funds in venture capital. In recent weeks, the funds have been active. The public employee pension funds of Wisconsin, Michigan, Oregon and other states have backed Kohlberg Kravis Roberts & Co. in its financing of the Bank of New England and of the purchase of a magazine group from media baron Rupert Murdoch.

The eagerness of Federated Department Stores and many other companies to seek fresh financing in the public market is a signal that money is available.

This makes it all the more important for interest rates to fall here and abroad, to encourage investors and lenders to keep economies moving. With U.S. unemployment at 6.8%, jobs depend on low interest rates. Bush knows that; maybe the rest of the world will wise up.