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Deflation

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At the risk of sounding like Chicken Little, I am going to describe the economic situation in plain English. The United States is flirting with a low-grade depression, one that may last for years unless the government takes decisive action to overcome it. This would most likely be depression with a small d, not the financial collapse and "grapes of wrath" devastation Americans experienced during the Great Depression of the 1930s. But the potential consequences, especially for the less affluent and the young, would be severe enough--a long interlude of sputtering stagnation, years of tepid growth and stubbornly high unemployment, punctuated occasionally with a renewed recession. Depression means an economy that is stuck in a ditch and cannot get out, unable to regain its normal energies for expansion. Japan, second-largest economy in the world, has been in this condition for roughly twelve years, following the collapse of its own financial bubble. If the same fate has befallen the United States, the globalized economy is imperiled, too, since America's market for imports and its huge trade deficits keep the global trading system afloat.

About the Author

William Greider
William Greider
William Greider, a prominent political journalist and author, has been a reporter for more than 35 years for newspapers...

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Most authorities, I should add, do not regard any of this as likely. The great difficulty for policy-makers is that this doesn't much feel like a crisis--not yet anyway, for most Americans. So where's the urgency to undertake radical remedies? Some of Wall Street's best forecasters, for instance, are predicting 4 percent US growth in the second half of 2003. But Japan experienced false recoveries, too. Nobody knows what will unfold if nothing is done, but the consequences of waiting to find out could be horrendous for the broad ranks of Americans. When the US economy corrects for its excesses, it is always the innocents who are led to the slaughter first. Even if the odds are only one in four that the worst will happen (as the Dallas Federal Reserve Bank president recently estimated), it seems reckless to gamble. Taking strong measures now would be messy and disruptive to regular order (maybe wasteful if they aren't needed), but in the present circumstances that would seem more prudent than a false optimism that lamely repeats that the "good times" are right around the corner.

A depression can be read as a "market signal" of a dysfunctional economy that requires fundamental restructuring. Japan learned this the hard way. In this case, such a signal may be flashing the need for deep changes both in the American economic system and the world's. Surely it is not too soon for Americans to ask themselves what might be out of whack and how to correct things--starting with their own much-celebrated economy.

I asked a financial economist at a major US hedge fund where the United States appears to be at this point. "We are in the second or third year of what Japan has gone through," he surmised. How much longer might this go on? "Another ten years," he said, "if you think about Japan, another ten years."

The good news, so to speak, is that the Federal Reserve is on the case. At least Fed Chairman Alan Greenspan and colleagues now acknowledge that the gravest danger lurking in this situation is a general deflation of prices, and they promise to make sure that doesn't happen. For many months, Greenspan and other governors dismissed the growing anxieties expressed in financial circles by describing the chances of deflation as "extremely small" and "quite unlikely." After the indexes for wholesale and consumer prices both fell in April, the Fed dropped those reassuring phrases. The chairman instead announced that pre-emptive actions may be needed to head off the threat. Declining prices, if they persist generally, create a vicious spiral of negatives--falling profits, more closed factories, shrinking employment and incomes, accompanied by waves of failing debtors, both corporations and families. In short, a far larger calamity than stagnation.

Though Greenspan doesn't say so in plain English, Fed governors recognize the corrective action that may be required of monetary policy: Pump up the money supply and deliberately induce rising prices--that is, foster a renewal of inflation, their old scourge. Rising prices provide an essential lubricant for any sustained recovery because a dose of inflation helps businesses get well and takes some of the depressive pressures off wages and debtors of every kind. The central bankers, however, are facing a very awkward moment. After twenty years of relentlessly reducing the inflation rate to near zero and winning great praise for their triumph, the governors are naturally reluctant to announce that the "disease" they conquered has become the "cure."

But at least the Fed is thinking about doing something. Washington's elected politicians, by contrast, continue to act as if this is just a temporary downturn in the normal business cycle, an opportunity to score political points with measures that show folks they care. Neither Republicans nor Democrats seem to grasp the enormity of what the economy is facing. Their ignorance matters. Without a full and contentious public airing of the cause-and-effect implications, there is no way to develop the political foundation for undertaking large and controversial measures. If Washington responds tentatively with cautious half-measures, as Japan's government did for many years, then the results for us may look a lot like Japan.

Basically, what's under way is a brutal unwinding of the delusional optimism that reigned during the 1990s--excesses like the hyperinflation in financial assets and the swollen ambitions that led investors and companies to wildly overvalue their prospects for future returns. The stock-market bubble was the most obvious expression of excess, but not the most serious dimension. In an era of Internet fantasies and collective self-delusion, business sectors (and their financiers) overinvested on a grand scale and generally used borrowed money to do so. That is, they built too many factories, shopping centers and office buildings--creating more productive capacity than the marketplace could possibly absorb. Consumers indulged in their own version of wishful thinking, borrowing heavily to keep on buying, hoping the "good times" would last long enough to bail them out.

This legacy of accumulated excesses lies across the American economy like a heavy wet blanket--overcapacity in production, overpriced financial investments, mountainous debt burdens for corporations and households, and thus a deepening reluctance to invest or to consume. Personal debt is now at an extraordinary 130 percent of disposable income, up by nearly one-third since the mid-1990s. Manufacturing is operating at only 72.5 percent of its productive capacity, greater idleness than during the 1990-91 recession and approaching the severity of the 1982 recession. For producers of semiconductors and related electronic components, capacity utilization has fallen to 65 percent. In telecom equipment, it is at 50 percent. That's why there is so little new investment. What company is foolish enough to build new plants when so many existing ones are shuttered? And who would lend them the capital? If consumers run out of capacity to borrow more or can no longer refinance home mortgages, the collapse of aggregate demand will become far worse.

The US economy is unlikely to recover its full vigor until this dead weight from the past is substantially reduced. In the meantime, the struggle of companies (and other countries) to dump their excess production by selling cheap, while also shrinking jobs and workweeks, threatens to make things still worse, eventually tipping into a general deflation of prices. The broader meaning of deflation, however, is that assets of almost every kind, from financial investments and real estate to manufactured goods and commodities, are being revalued downward--slowly, steadily correcting for the falsely optimistic asset valuations achieved during the boom years. The overvaluations, though most dramatic in Japan and the United States, were transmitted worldwide through trade and the hyped-up energies of global investing. In this sense, deflation is already under way and started five or six years ago with the violent financial collapses that swept across developing nations in Asia and that continue to stalk weakening economies on other continents. China, given its burgeoning low-wage output, is now the world's main deflationary engine. Its exports are underpricing Japan's and taking market share away from other poor countries, thus forcing rival producers to lower prices still further (China now has the largest trade surplus with the United States, surpassing Japan). When too many goods are chasing too few buyers, the main game is to make sure someone else gets stuck with the unsold surpluses.

In another era, there would be clamoring voices not only from the political sphere but also from business and finance demanding bold action by Washington. In this era of conservative orthodoxy, there is general complacency and silence, as if everyone agrees that the ugly possibilities will go away if nobody talks about them. Aside from subdued kibitzing of the Fed by selected financial experts, there is no debate on these momentous matters. Governing elites are deeply enthralled by "market fundamentalism" and dare not speak of the alternatives (or perhaps don't even know about them). The principal remedies sound to them like liberal heresies. And they are. This political passivity may give way once the presidential campaign heats up. Howard Dean was evidently the first Democratic candidate to invoke the "d word" when he recently warned Iowans: "If we re-elect this President, we'll be in a depression."

In broad strokes, the government has the power to intervene on three fundamental fronts to remove the depressing overhang from the past. First, the Federal Reserve can deliberately induce price inflation to counter the deflationary forces and excite what Keynes called the "animal spirits" of business leaders. Rising prices will also automatically ease the debt burdens of borrowers by diluting money's real value (that's why creditors always adamantly oppose inflation). Second, Congress and the White House can simultaneously launch a major stimulus program composed of public spending and quick-acting tax cuts, thus running up far larger budget deficits than the Bush Administration has engineered. Whether the money builds schools and highways or hires more schoolteachers, it creates new jobs, incomes and business activity. Finally, if these steps are insufficient, the government may have to intervene more directly and manage a substantial liquidation of debt burdens--either arrange ways to write off failed loans (as it did in the savings-and-loan crisis of the 1980s) or create more lenient terms for the indebted companies and households, much like a banker's "workout" for a financially troubled business.

If this negative cycle worsens to extremes, only the federal government can interrupt it and push the economy in a positive direction. The basic task, as John Maynard Keynes explained in the thirties, is to get the money moving again. The government does this by borrowing idle wealth from the private sector and spending it or distributing it to taxpayers who will--thus putting the money to economic uses and stimulating business activity. Federal deficits, in other words, are an essential element in the solution--very large deficits if you intend to jump-start a $10.7 trillion economy. Yes, borrow-and-spend therapy increases the national debt, but the renewal of economic growth will handle that. (The alternative--doing nothing--means allowing events to take their own course toward destruction and multiplying failures. "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," Andrew Mellon advised Herbert Hoover after the 1929 crash. "It will purge the rottenness out of the system.")

The political choice is, Act now or wait and see. In terms of this three-pronged crisis prevention, only the Federal Reserve has shown any awareness of what may be required of it (revive the economy by reviving inflation), perhaps because the Fed's historic disgrace was its failure to act after 1929. Last fall, Fed governor Ben Bernanke reassured the worriers in a boldly stated speech: "The US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost.... A determined government can always generate higher spending and hence positive inflation."

To underscore the commitment, Bernanke said the Fed is prepared to use unorthodox tools to expand the money supply if short-term interest rates (already close to zero) can be cut no further. Instead of buying only short-term Treasury notes to inject new money into the economy, the central bank may purchase long-term US bonds or foreign bonds. It may accept corporate debt, private bank loans and mortgage securities as collateral for the Fed's direct lending to banks--a way of pushing bankers to lend more generously to business. In fact, the Fed has far broader powers inherited from the Great Depression--the ability to make emergency loans to private businesses or state and local governments in extreme circumstances. But will the Fed act? Some financial insiders are not persuaded by the official statements. One told me that only three or four of the key decision makers on the nineteen-member Federal Open Market Committee take the deflation potential seriously--those who closely followed the slow-motion unwinding of Japan.

By comparison, the more visible fiscal debate in Congress is utterly out of sync with present reality, since both parties are dodging the "d word" and its implications. The White House, I am told, is deeply worried in private, but won't say so for fear of adding to the public's anxieties. The GOP's misdirected tax cutting does help modestly, putting money in motion by enlarging the federal deficits, but Bush is pursuing "trickledown" Keynes--help the wealthiest households get back their zest as consumers, and the rabble will surely follow. Democrats, on the other hand, are still playing the loser's role of Herbert Hoover and worrying obsessively about the rising deficits--wrong economics and bad politics too. Instead of fighting the last war, a clearheaded opposition would be leaning hard on the Fed and the White House for immediate preventive actions, advocating easy money, credit reform and aggressive public spending to restart the economic engine.

If things deteriorate further, who knows, the government's deficits may have to grow twice as large to become effective therapy. While the political climate is not yet ripe, forward-looking progressives should already be drawing up a grand list of spending projects--repairing the tattered infrastructure and launching innovative public investments that speak to the future. If the money builds real improvements for society, it will not be wasted, even if the Chicken Littles are wrong.

The third avenue for dealing with the potential crisis--reducing the mountainous debt burdens on families and businesses--is a far more controversial challenge and fraught with the potential for insider favoritism. Rescuing the big boys while allowing others to drown has been the conventional approach in recent decades, including the banking bailouts engineered by the Fed. But a lively political debate might inspire broader remedies that are both more equitable and more effective. Just as the S&L bailout fifteen years ago aided major financial players, government could create a "resolution trust corporation" for people--an agency that supervises debt workouts for households, gives them more time to catch up with mortgage and credit card payments, and imposes these relaxed terms on the financial industry, with government guarantees against failure. That would represent stimulus with a democratic bottom line. More likely, we will see one industrial sector after another line up for emergency bailouts, and the government, including the Fed, will pick winners and losers, defending politically influential elements of the status quo in the name of protecting the soundness of the system.

If fundamental restructuring is also in store for America, the US economy has advantages that Japan's lacks. The American system is more flexible and able to adapt--more willing to throw the losers over the side--while Japan's dense webs of business-financial relationships promote mutual loyalties that are very difficult to dismantle. On the other hand, Americans may discover in the next few years that the United States is not the economic powerhouse described in popular lore. Technological strengths notwithstanding, many US sectors have steadily lost market share, both at home and abroad, to foreign competitors (think of Boeing being surpassed by Airbus as the leading producer of commercial airliners).

"Painful adjustment" means facing up to some long-suppressed truths. Washington's single-minded championing of globalization, for instance, has been good for US multinationals but not for the balance sheet of the American economy, which is underwater and has been for years. That is the meaning of the huge trade deficits, the accumulating indebtedness that inevitably will produce a painful reckoning in standards of living (as a nation, we manage to consume more than we produce by borrowing every year from abroad).

But the even larger reality is that America's weakening position signals the need for a deep restructuring of globalization as well. The globalized system the United States launched and protected throughout the cold war decades approaches its own reckoning with the dilemma of too many factories and not enough buyers. Escaping this condition will require fiendishly difficult diplomacy (made more so by the Bush Administration's cockeyed imperialism), but the risks are historic in dimension (the global trading system disintegrated after 1929 as worldwide depression led nations to protect their own producers and markets from foreign competitors). First, leading nations must join to launch worldwide stimulative policies and persuade rising nations like China not to bring down the system by overwhelming rival producers. The fundamental solution, however, involves the kind of moderating reforms advocated by antiglobalization activists worldwide--rules to rebalance the system and genuinely promote wages as well as output, financial terms that give developing countries more time and space to seek their own distinctive economic plans, plus new institutions of governance that are truly equitable and democratic, instead of corporatized lawmaking. That's a very tall order for statesmanship in a world presently governed by small-minded men.

Meanwhile, the economic dysfunction in the American system involves many other contentious questions, including the overbearing scale of certain dominant enterprises. The spectacular costs of allowing ever-growing bigness in corporations are reflected every day in the news (think of the doomed AOL Time Warner merger that has lost more than $200 billion for investors, or the scandalous behavior of financial mega-firms like Citigroup, or the conglomerate homogenization of broadcasting). The gathering evidence also suggests that the mass-consumption economy that has flourished since World War II may at last be running out of gas. Too many indebted consumers are tapped out or will be in hard times. Who's going to buy all this stuff? Is this weakened condition related to the gross and growing wage inequalities of the past two decades?

The "market signal" of small-d depression might be saying: Don't invest more in the old stuff since we've already got too many shopping centers. Start investing in "problems" the country has long neglected--see these really as economic opportunities. Invest in the energy technologies and industrial transformations required for the posthydrocarbons age of ecologically sustainable prosperity. Invest in healthcare and transportation and production systems to deliver safe, healthy food. Invest in the smaller, more nimble firms ready to do things differently. Invest in people--the human development that begins with children at a very early age. These and other investment opportunities are where the future jobs and higher returns are most likely to be found. The status quo interests will naturally resist such shifts in purpose and deploy their political muscle to block any promising departures. But a fundamental restructuring at least would open the way to think anew, to strive for a different kind of politics. If the Chicken Littles turn out to be right, a pivotal moment is approaching, one that may be both dreadful and promising.

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