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|  | MAY 14, 2004
By Christopher Farrell The Roots of Deflation In his new book, BusinessWeek's Chris Farrell looks at the history of falling prices and the implications for today's economy An inflation panic is sweeping the markets. The signposts are easy to spot. Wall Street fears a powerful sustained upward trend in prices is gathering momentum with the economy healthy and hiring picking up. Oil prices are at nosebleed levels, gasoline at the pump keeps ticking up to new records, and prices for lumber, steel, coffee, and other commodities are through the roof. Management at companies such as Procter & Gamble (PG ), Kimberly-Clark (KMB ), Morton's, Motorola (MOT ), and Disney (DIS ) are whipping out the mark-up pen for the first time in years for some product lines. The Consumer Price Index surged higher during the first three months of the year. So much for the deflation alarm that rattled Federal Reserve Board chairman Alan Greenspan and investors for much of the past year. Right? Hardly. In his new book, Deflation: What Happens When Prices Fall (HarperCollins, May, 2004), BusinessWeek Contributing Economics Editor and regular BussinessWeek Online commentator Christopher Farrell argues that the emergence of deflation in America wasn't a temporary fallout from the recession -- and the recovery that, until recently, felt much like a recession. No, the downturn amplified the powerful forces behind deflation, but the underlying trend toward stable to falling prices for most goods and services will resume even as the expansion matures and the unemployment rate drops into the low single digits. An excerpt from the book follows: "The world is shifting from an era of structural inflation to one of deflation, in which prices for most manufactured goods and tradable services fall rather than rise," observed Eisuke Sakakibara, Japan's former vice-finance minister. Chief Executive Jack Welch got it right several years ago when he ran General Electric: "Inflation has yielded to deflation as the shaping economic force." Of course in the current environment you can almost hear the sound of Wall Street veterans scoffing. They are fond of quoting the legendary investor John Templeton, "The four most expensive words in the English language are 'this time is different.'" They've been burned by too many new eras, new economies, and revolutionary transformations. Inflation is the economic condition we know. Many baby boomers and Wall Street traders remember when inflation reached double-digit levels in the 1970s, peaking at over 14% in 1980. Inflation was eventually contained through a combination of factors, including a tough anti-inflation battle waged by the Fed under the leadership of Paul Volcker and his successor Alan Greenspan. The consumer price index averaged 7% in the '70s, 5.5% in the '80s, 3% in the '90s, and 2.5% in the early 2000s. The odds of another bout of double-digit 1970s-style inflation are remote. Still, now that the economy is picking up steam and the job market is getting better, the widespread expectation is for resurgence in inflation. Rising prices are such an embedded part of our society that we all assume inflation is the economy's natural state. Yet every once in a great while the established economic order is overthrown. Within a span of decades, technological changes, organizational upheavals, and new ways of thinking transform economies. From the 1760s to 1830s, steam engines, textile mills, and the Enlightenment produced the Industrial Revolution. The years 1880 to 1930 were shaped by the spread of electric power, mass production, and mass democracy. This time is different. Or maybe I should say, it's back to the future. From 1776 to 1965, America's overall price level was essentially flat. Inflationary flare-ups were mostly associated with major wars until the post World War II era. These inflationary conflagrations were quickly extinguished in the aftermath of war. The rest of the time stable to falling prices dominated, especially in the latter part of the 19th century, the last time there was a tightly integrated global economy. It's sometimes obvious when a historic divide is crossed. The 1929 stock market crash. The 1973 oil shock. Far more often, "change creeps upon us incrementally, punctuated by upheavals that, often as not, are rationalized as part of business as usual," said the late, legendary financier Leon Levy. "Only later do we realize that the world has been turned on its head." Levy called these events "a tap on the shoulder." Deflation may have taken a lot of people by surprise in 2003, but the price trend didn't emerge overnight. It had been building for years, a secular undertow to all the cyclical twists and turns in the economy. There were many deflation taps on the shoulder. Among the most important were the chairmanship of two inflation hawks at the Federal Board: Volcker and Greenspan; the rise of retailing giant Wal-Mart and its low everyday price strategy; the commercial embrace of the Internet, an inherently deflationary technology; a falling price level in Japan in the late 1990s; the vicious global price cutting wars that erupted following the financial collapse of Asia's emerging markets; China transforming itself into the developing world's leading economic juggernaut; and Corporate America's outsourcing high-pay, high-skill white-collar and skilled jobs to low-pay, well-educated workers in developing nations like India, China, and Malaysia. The emergence of deflation as the dominant price trend will dramatically impact businesses, workers, investors, the government, and the economy over the next several decades. "Of all the recording devices that can reveal to an historian the fundamental movements of an economy, monetary phenomena are without doubt the most sensitive," wrote the French historian Marc Bloch. "But to recognize their importance as symptoms would do them less than full justice. They have been and are, in their turn, causes. They are something like a seismograph, which not only measures the movements of the earth but sometimes provokes them." Deflation, like inflation before it, is taking on a momentum of its own. The promise of a fast growing deflationary economy is enormous. But so are the pit falls for everyone from the worker on the factory floor to the CEO of a major multinational corporation to the head of the Federal Reserve Board. SUPPLY SIDE ECONOMICS Deflation in America reflects fundamental changes on the economy's supply side. At the same time, a new international monetary system has evolved that contains a bias toward lower prices. Deflation is built on three fundamental changes dating back to the late 1970s and early 1980s: (1) the embrace of market capitalism at home and abroad; (2) the spread of information technologies; and, most importantly for understanding the economy of the next half-century, (3) the triumph of the financier. None of these factors is new, but what is surprising is how powerfully each change has informed and reinforced the other. First is globalization -- that abstruse, abstract word frequently invoked by everyone from politicians to business executives to trade protesters. Globalization is really the spread of market capitalism. Communism's collapse in Eastern Europe and the former Soviet Union, the embrace of freer market's by China's profit loving mandarins, and the turn toward market capitalism by many authoritarian governments in the developing world led to enormous increases in global commerce, international investment, and immigration flows. For instance, in 1980, only 25% of developing countries were manufacturers. By 1998 that figure had swelled to 80%. Trade as a percent of America's GDP -- the sum of exports and imports of goods and services -- was 13% in 1970. It is now around a third. The U.S. has absorbed more than 1 million immigrants a year for the past two decades. More than 12% of the American workforce was born overseas, and almost one in five residents speak a language other than English at home. Taken altogether, competition for markets, profits, and jobs is white-hot, keeping managers and employees on their toes, encouraging creativity and pursuing efficiencies. Capitalist competition and innovation are a force for low everyday prices. Global excess capacity for all manners of goods and services, old and new, is pulling prices down. "That excess capacity is a function of decades of development strategy by successful emerging economies, whereby they sought to create enough capacity to satisfy fully their own domestic needs plus a margin left over to serve export markets," says James Griffin, consulting economist at ING Investment Management. "This goes beyond a low-frequency cycle; it is more like an era." It is this ratcheting up of capitalist competition that accounts for the rise of the second major factor behind deflation: the Internet and other advanced information technologies. The integrated circuit was invented in the late 1950s, IBM revolutionized computerized data processing with the development of the 360 series in the mid-1960s, and Time Magazine named 1982 the "Year of the Computer" as personal computers gained widespread acceptance. Yet it wasn't until the 1990s, after a long gestation period and the commercial development of the Internet, that business finally started figuring out how to harness the power of high-tech gear by reorganizing the workplace. The Information Age came into being because intense price competition forced management to invest in high-tech gear to boost efficiency and shore up profits. Innovation doesn't have a straight-line impact on growth. Picture this: a chart with an S-shaped curve. Whenever a major new technology is introduced into an economy or workplace, workers and managers struggle to master unfamiliar skills. Learning how to exploit a frontier technology takes years of experimentation and organizational reshuffling. Over time, though, both management and labor move up the "experience curve." Gains in output per worker showed up in lower prices and higher quality that, in turn, put additional downward pressure on prices. The beauty of the economic impact of the high-tech sector is that it actually lowers inflation as prices drop. The third factor is a new international monetary system that washed out inflation. The new system is based on a shared commitment among central bankers that their job is to prevent inflation and keep prices stable. And the commitment needs to be firm and credible since the link between currencies and a commodity like gold and silver was severed in the 1970s. Nations adopted a "fiat" system where the value of a dollar, mark, franc, yen, or other currency was backed by the full faith and credit of government. Central bankers made a number of devastating mistakes in the early years of fiat money. But eventually central bankers in Washington and London, traders in New York and Shanghai, and investment bankers in Frankfurt and Chile, came to share a common ideology or worldview: Inflation is always bad. In America, Paul Volcker and his successor Alan Greenspan gradually contained inflation through a long, cumulative process called disinflation, or lower inflation rates. The CPI for the major industrial nations peaked at more than 13% in 1980; by 2003, CPI inflation had declined to an average of less than 2%. The comparable figures for the U.S. were 14% and 1.5%. Business and consumer expectations of higher prices moderated over the years. The commitment to price stability goes far beyond the abilities and desires of any central bank. Alan Greenspan and his peers have no choice but to contain inflation since the global capital markets are even more important than monetary policy in dampening inflationary pressures. Investors abhor inflation since it degrades the value of their investments. So, in today's tightly integrated capital markets, linked satellite and fiber-optic communications networks that span the globe, financiers will flee any currency that shows signs of inflation. The global stock and bond markets are a "giant voting machine" that limits the ability of governments or central bankers to tolerate inflation. Investors force central bankers to stick with anti-inflation strategies. Put it this way: Does anyone really believe the Fed will tolerate a sustained rise in the overall price level? To be sure, there's a debate among economists whether the Fed should have tightened a month or so ago or whether it should still wait few more months. The Fed is still a credible inflation fighting institution.
BW MALL
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