THE THREAT OF DEFLATION

With markets rebounding from the Oct. 27 Asian shock, it's only natural to wonder what all the fuss was about. Was it, after all, simply a wild overreaction?

Don't bet on it. Even if the markets remain calm, the crisis in Asia that spurred the sell-off signals a deep change in how the global economy works. Thanks to a building binge throughout Asia, continuing economic expansion in the U.S., and recovering economies in Europe, production everywhere is running ahead of consumption. That's even true in the U.S., where consumer demand remains strong (chart, page 58). Today, for the first time in years, there is worldwide overcapacity in industries, from semiconductors to autos. And the excess supply will get even worse as Asia tries to export its way out of trouble.

The result: The global economy may well be heading into a new era--an era of deflation. Prices for goods are falling or stagnant around the world. In the U.S., industries with stable or falling wholesale prices account for two-thirds of manufacturing production. And in many parts of the world, such as Japan, overall goods prices have been falling (chart, page 59). ''Fundamentally, something has changed in the economy,'' says John F. Smith Jr., chairman and CEO of General Motors Corp. ''In today's age, you cannot get price increases.''

For investors, corporations, and workers, deflation is a mixed blessing--and a potential danger. Productivity growth lets companies boost profits even as prices fall. Living standards can rise even when wages don't grow much, since the same paycheck can buy more clothing, more TVs, a better car. And low inflation in the U.S. has been an economic windfall. With inflation at bay, the Federal Reserve has held off raising interest rates, extending a cycle of expansion longer than most economists thought possible.

What's more, both stock and bond markets can thrive with mild deflation. From 1865 to the 1890s, prices dropped 1% to 2% annually and ''the real return in the stock market was remarkably the same as in other periods,'' says Jeremy J. Siegel, a Wharton School professor who wrote the best-selling Stocks for the Long Run. Adds James W. Paulson, chief investment officer of Norwest Investment Management Inc.: ''A mild deflation or stable deflation, slightly below zero, but not a collapse, is bullish for long-term financial assets.''

Mild and stable--not rapid. Rapid deflation can do enormous damage very quickly. The danger is that falling prices and wages make it much more difficult for leveraged companies and households to pay back their debts. In the worst case, a wave of business and personal bankruptcies sets off a chain of failures throughout the entire financial system. Investment and growth collapse. ''In the new era, the risk is deflation, not inflation,'' says Edward E. Yardeni, chief economist for Deutsche Morgan Grenfell.

BIG RISK. The Great Depression of the 1930s was exactly this sort of deflationary spiral. From 1929 to 1933, prices fell by 10% annually. Even moderately leveraged companies went under, the banking system was devastated, unemployment soared, and the economy and the stock market went into a deep swoon that was only ended by World War II.

The biggest danger for the global economy today may be the prospect of a sustained deflationary downturn in East Asia. In recent months, countries such as Thailand and Malaysia were forced to depreciate their currencies in order to keep the prices of their goods competitive on world markets. But the cuts exacted a huge cost: Higher import prices, falling domestic demand, and lower wages for workers, which further smother domestic demand. In Thailand, for example, employers are cutting wages by up to 15%, and many will not pay bonuses in December.

What's worrisome for the rest of the global economy is how deflationary pressure can spread. The country immediately at risk is Japan, which has been flirting with serious deflation throughout the 1990s as huge real estate and stock market losses crippled its financial system. Now, it is in danger of being sucked into a deflationary maelstrom, as it tries to compete in Southeast Asia where it does 40% of its business.

At the moment, the U.S. doesn't face the same risk. The difference between mild price declines and runaway deflation is largely determined by the state of an economy's financial system. ''Deflation only creates a problem if balance sheets of financial and nonfinancial firms are already in a weakened state,'' says Frederick S. Mishkin, a former New York Fed economist who teaches at Columbia Business School.

The U.S., in other words, is well-placed to weather, and even benefit from, a deflationary trend. Most corporations have strong balance sheets and have refinanced borrowing at low interest rates. And while consumers have added debt, they should have no trouble paying it off as long as the job market stays strong (page 60).

In fact, deflation in East Asia may help extend the U.S. expansion. Economists estimate the depreciation of Asian currencies will reduce inflation by as much as 0.4 percentage points over the next couple of years, lessening the need for the Fed to raise rates. Of course, some economists are still worrying about inflation rather than deflation. Growth remains robust, and unemployment hovers around 5%. And, with U.S. factories running at 83% of capacity, well above their long-run level, there apparently is little evidence of overcapacity in the U.S.

But in an era of global oversupply, even high capacity utilization in the U.S. does not necessarily lead to higher prices. All of the industries with domestic capacity utilization above 90%--steel and other metals, petroleum refining, paper products, and industrial machinery--face heavy competition from imports. As a result, it is very difficult for these producers to raise prices.

DIGGING OUT. Moreover, manufacturing capacity in the U.S. is rising at a 4.3% annual rate, the fastest in 25 years and well ahead of the 2.5% growth rate of consumption. In the third quarter, business investment spending is expected to rise at double the rate of consumer spending, making it less likely that there will be production bottlenecks.

This U.S. investment boom, however, pales next to what's happening in Asia's developing countries. In 1996, the region's total capital investment was $914 billion, just slightly less than that of the much larger U.S. economy. ''The region has had some of the highest investment rates the world has ever seen,'' says Uri Dadush, director of the World Bank's Development Prospects Group. ''A lot of capacity has been built up on the expectation of continued rapid growth, so you have a lot of stuff that is just coming on stream.''

Efforts by nations such as Thailand and Indonesia to dig out from their currency devaluations will exacerbate worldwide oversupply and deflation. In recent years, the Asian developing countries have actually been net consumers, making them the only part of the world, besides the U.S., to run trade deficits. But that's likely to change, as they try to export themselves out of trouble. Consider Mexico. After the devaluation of the peso in 1995, prices of Mexican goods became so competitive that exports jumped 30% in many industries, turning a trade deficit into a trade surplus.

The tightly linked global economy means that the effect of overcapacity in any region ripples out and drives down prices everywhere. Look at how prices in East Asia's developing nations, where the U.S. buys only about one-quarter of its imports, affect prices of goods from other nations. The U.S. gets another quarter of its imports from Japan and Mexico, two countries that directly compete with East Asia for the U.S. market. Last year, Mexico supplanted China as the single most important exporter of garments to the U.S., in part because the North American Free Trade Agreement helped lower trade barriers to Mexican goods. But to retain that business, Mexican manufacturers now have to keep pace with the prices offered by China and other Asian nations.

One place where the link between global overcapacity and downward price pressure is clear is in the auto industry. In North America, production capacity for cars and trucks exceeds demand by at least a half-million vehicles. ''Capacity in North America is growing,'' says G. Richard Wagoner Jr., president of North American operations for GM. ''The Japanese are adding transplant capacity at a fairly significant rate.'' Meanwhile, Mexico's car output is projected to grow at 10% annually over the next three years, with almost two-thirds of it to be sold through exports--mostly to the U.S.

The glut has produced a new kind of sticker shock: In the U.S., prices on passenger cars have dropped by 2.1% over the last year, according to the Bureau of Labor Statistics. Toyota Motor Sales U.S.A. Inc. trimmed the base price of its Corolla by $1,090, or 8%, to stay competitive in the tough small-car market.

A BOOM. That's still better than Europe, where carmakers have the ability to produce 3 million to 4 million more vehicles than the market can absorb. The average price of a car in Europe dropped $500 to $1,000 over the past year, figures David J. Herman, CEO of Adam Opel.

And a car-building boom in Asia is hitting just as its economies slow and car-buying tanks. In South Korea, Daewoo Corp. and Hyundai Corp. both are building capacity for global exports. The Samsung Group is investing $10 billion to enter the business.

Overcapacity problems have been building in memory chips and other types of semiconductors and are expected to worsen. Prices of DRAMs dropped sharply last year, as Asia's output skyrocketed. Now, Taiwan plans to double its semiconductor capacity in the next six months, much of it in DRAMs. ''We're concerned about the relentless desire of the Taiwanese to spend,'' says Hong Kong-based Daniel A. Heyler, a semiconductor analyst at Dataquest Asia Pacific Ltd. Adds Robert Hsieh, vice-president of Vanguard International Semiconductor Corp., a Taiwan-based memory-chip maker: ''We expected a price rebound in the fourth quarter, but in fact it's down. Overcapacity will continue until at least mid-1998.''

In the chemical industry, Asian producers' capacity to make ethylene, a plastics building block, will rise 70% by 2002, estimates L. Wayne Feller, an executive vice-president at consultants Chemical Market Associates Inc. in Houston. And current market woes won't derail these projects because it takes so long to build such plants. ''There may be a couple that haven't gotten funding yet [and could be delayed]. Most are going forward.''

Overcapacity is cropping up in all sorts of unexpected markets. China and India, for example, have become major producers of penicillin G, the raw material for the antibiotic, driving the price down to about $11 per billion units from $21 in mid-1996. Chinese antibiotic makers are moving up the industry ladder, learning how to produce more sophisticated antibiotics formerly made only in Europe and the U.S.

BIG CUT. Asian businesses, pressed to make use of their new capacity, will put downward pressure on markets around the world. Many of the new factories were built to meet Asian demand that has evaporated. The Asian Development Bank, which predicted Southeast Asian economies would grow by 7.3% in 1997 and 7.5% in 1998, has slashed those forecasts to as low as 4.9% this year and as low as 4% next year. Credit Suisse First Boston estimates that slower growth rates will cut Asian consumption by up to $400 billion.

Japan would be a logical market for the excess goods. It's the second-largest economy in the world, and it's nearby. But the Japanese government shows no sign of backing off from its policy of fiscal austerity. Nor has it implemented meaningful deregulation, which could cut consumer prices. As a result, domestic demand is expected to rise at less than a 2% rate over the next year. Meanwhile China, which should be Asia's other engine of growth, isn't helping either. In part because of high protectionist barriers, Chinese imports rose just 2.5% during the first nine months of the year, while exports soared by 24%.

Demand in key European markets is also likely to be constrained. Although some smaller economies are recovering, France and Germany, the Continent's two biggest markets, have been mainly exporting their way to decent growth this year. And the move to a unified European currency will mean that interest rates in Europe will have to converge. As a result, short-term interest rates in Germany and France, now 3.3%, will have to rise towards the much higher interest rates in Italy and Spain, further cutting into already weak domestic buying confidence. ''I don't see consumer demand picking up,'' says Bernd A. Stecher, chief economist at German industrial giant Siemens.

To be sure, as global demand slows, some of the investment in the pipeline will be delayed or eliminated, easing the oversupply problem. For example, there's mounting pressure for Indonesian President Suharto to cancel huge, money-wasting investments, including a national car project. But because many local tycoons wield enormous political clout, it is very hard for politicians and banks to force them to consolidate or let them go bankrupt. What's more, while manufacturers in Malaysia and Thailand have suspended plans to build new steel and chemical plants, they are still insisting the lull is only temporary. And some of Asia's biggest players are even upping the ante in order to drive out competitors. Despite a serious oversupply in shipping capacity, for example, Taiwanese shipping giant Evergreen Marine Corp. in mid-October announced it will buy another 25 container ships over the next seven years.

HIGH HOPES. So what happens next? Some countries are at least making noises about stimulating domestic demand. For example, concerned that consumer demand is starting to tank, Beijing recently announced plans to stimulate spending among China's 900 million rural citizens, who have been largely left behind in the boom--and to convince urban residents to spend more on consumer goods.

But most countries are hoping that depreciating their currency, whether forced or voluntary, will do the trick. Since 1995, almost every major currency, including the yen and the German mark, has depreciated by at least 15% against the dollar. After the latest round of devaluations, every region except for the U.S. will be a net exporter.

This makes the global economy dangerously dependent on the U.S. as the consumer of last resort. That's fine as long as the U.S. keeps growing. But if the U.S. stumbles, the world could end up with all sellers and no buyers--and on a path that leads to a devastating deflation.