Could Deflation Be the Next Boogeyman?

For several years now, some of the biggest bulls on Wall Street have argued that the country’s manic concern about a revival of inflation was misplaced. Inflation ain’t coming back, they’d say--and anyone who thinks so is simply “fighting the last war,” as it were.

Even Federal Reserve Board Chairman Alan Greenspan, speaking to Congress last week, sounded at least capable of imagining that the world has changed enough in the 1990s to keep inflation subdued for an extended period.

Now, some people who are paid a lot to think about these things are toying with another big idea. Maybe the great threat to the world economy (and these wonderful ever-rising stock markets) isn’t resurgent inflation, after all. Maybe it’s the opposite: a deflation cycle, wherein product prices tumble, along with corporate profits, because there suddenly isn’t enough demand to mop up the ocean of goods produced.

Richard Hokenson, a veteran economist at investment firm Donaldson, Lufkin & Jenrette Securities in New York, has been predicting a deflation cycle for some time and believes it will start this year. He calls his scenario the “no-pricing-power recession of 1997.”

Likewise, one of Wall Street’s most-read strategists, Barton Biggs of Morgan Stanley Dean Witter, views the greater risk to the world economy today as “ice” rather than “fire”--in other words, the potential for a cooling of demand, and falling prices, rather than a pickup in demand that would heat up inflation.

The 12% drop in the price of gold this year, to 11-year lows, has served to egg on the deflation campers. Why else, they ask, would the premier inflation hedge be crumbling in value, if not because the opposite of inflation is around the corner?

What’s more, the deflation camp points to the producer price index, showing U.S. inflation at the wholesale level. Through June, the index has fallen for six straight months--a post-World War II record.

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Of course, it’s not terribly difficult to dismiss the concerns of Hokenson and Biggs as the chatterings of grumpy old men who are searching desperately for something to worry about. Instead of enjoying this phenomenal economy, they spend their time thinking about what could go wrong. Get a life already!

And yet, the issues they raise, specifically about the potential for a general deflation wave in the global economy, aren’t so outlandish on closer inspection.

The world economy is in a new era in more ways than one. The good news, we all know: Capitalism’s rise has nurtured a boom in trade and investment among nations, fostering increased competition and thus keeping prices restrained. That, in turn, has kept inflation low, which has brought down world interest rates and sent stocks soaring in most nations--good for businesses and investors.

Thus far in the 1990s, this has been a virtuous circle. More trade fosters more competition, which fosters lower inflation, which drives markets higher, which creates new capital for reinvestment, producing yet more trade.

What could break this circle? Imagine if competition became so extreme that companies (and countries) began to severely undercut one another on price to make sales. At the very least, tensions would rise among governments, as some would face swelling trade deficits. At the same time, price-cutting would erode corporate profit margins, perhaps triggering a dramatic new round of layoffs as companies would seek to slash costs further.

Threaten enough people with layoffs, and consumer spending could shrink--further reducing demand for goods. Suddenly, instead of the virtuous circle, the world finds itself in a ruinous circle.

William Gross, managing director of investment giant Pacific Investment Management Co. in Newport Beach, warned clients about this scenario in his July letter to them. Gross’ concern is about what he calls “virginal capitalism,” which has been a key element of the new economic era.

Virginal capitalism, Gross says, is a term that encompasses “not only neophyte investors throwing their money at the latest sure thing, but neophyte businesses, governments and capitalistic economies operating in a free-wheeling global marketplace for, in some cases, the first time.”

The risk, Gross said in an interview, is that “countries and companies are simply expanding to beat the [competition], without any thought to how much the world can take in terms of demand.”

Sound too far-fetched? Perhaps not to most Southeast Asians today. Thailand, the Philippines, Malaysia, Indonesia and other nations in the region have been caught up in a vicious currency devaluation wave this month, sparked by massive over-building and over-investment (especially in Thailand) that has run up against the cold reality of weaker export growth.

The net result has been growing trade deficits in many of those nations. Now, as they allow their currencies to devalue, Southeast Asian governments hope to gain a competitive edge for their exports (by making them cheaper), in particular against China--where manufacturing capacity for exported goods has, of course, been ballooning in the 1990s.

For Americans, cheaper Southeast Asian exports would seem to be a good thing, putting further downward pressure on our own inflation rate. But cheaper exports naturally would mean tougher competition for many American firms and could worsen our already huge trade deficit. Meanwhile, it’s unlikely that China would sit still and allow its neighbors to steal market share.

A ruinous circle for the global economy? Not so fast, some say.

From the American point of view, at least, there are as yet relatively few signs that a worrisome deflation cycle is dawning.

For one, while U.S. manufacturing capacity is growing at a brisk 4.1% annual pace this year--the same as in 1996, which was the fastest growth in 28 years--there is no indication that the supply of goods is outpacing demand.

As Greenspan noted last week, technology has sharply increased production efficiency and shortened lead times, reducing the risk of dangerous inventory buildups.

Certainly, the generally strong tone of second-quarter corporate earnings reports suggests companies aren’t begging for business.

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What’s more, factory utilization rates have been rising in struggling Germany and Japan for the last 18 months, indicating that global demand for goods has been enough to raise production not only in America but also within the economies of its two major rivals.

Southeast Asia aside, “if there are serious imbalances in the real economy, they’re hard to spot,” argues David Hensley, economist at Salomon Bros. in New York.

But couldn’t Asia’s new cheap-export push trigger such imbalances? Stephen Roach, economist at Morgan Stanley Dean Witter, concedes that the United States, like most nations, is more vulnerable today than in the past to global competitive pressures.

Even so, he estimates that the tradable-goods sector of the U.S. economy accounts for just 19% of gross domestic product. In other words, 81% of our economy, which is largely services-based now, isn’t affected by foreign competition.

In short, we are still primarily dependent on ourselves. Which means that unless U.S. consumers (who now are exceedingly optimistic) stop spending money, and barring a collapse of European and Japanese consumer spending, Hokenson’s fearsome “no-pricing-power recession” seems (thankfully) a fantasy, for now.

Yes, there is ongoing deflation in the world, says Bruce Steinberg, economist at Merrill Lynch & Co. But he argues that it is a good deflation, engendered by productivity gains. “In an economy characterized by deflationary growth, [corporate] earnings gains can be strong as long as costs fall faster than prices, and real wages can rise at the same time,” he says. That has been the trend for the last two years, Steinberg says, and he doesn’t think the game is up.