Deflation Is Nothing to Fear
The spread of the Asian contagion to Russia and possibly Latin America is raising the specter of deflation, which to many conjures up images of the bread lines and apple sellers of the 1930s. Back then, U.S. wholesale prices dropped 32% as demand nose-dived in the face of bankruptcies, widespread unemployment and massive pay cuts.</br></br>Today we have financial crises aplenty in Asia, but they are unlikely to spread to the West. In the U.S., the long series of sectoral financial problems -- ranging from the farm-belt collapse in the early 1980s to difficulties related to the defense cutbacks of the early 1990s -- are behind us. Demand will probably not collapse in the West, even though there are some demand-reducing deflationary forces at work in the world. The Cold War is over, and the history of U.S. inflation is the history of wars. Since 1749, prices have risen at double-digit annual rates in wartime, but have fallen by more than 1% a year on average in peacetime. This isn't surprising, since the government is the only economic sector with enough financial credibility to outspend its revenues vastly and create excess demand for any length of time.</br></br>Wars on poverty are similarly inflationary, but the passage of welfare reform suggests that Washington is serious about cutting nondefense spending. Government spending in Europe is hemmed in by the Maastricht requirements for deficits and debts. And despite eight years of a deflationary depression, Japan remains unwilling to enact major tax cuts for fear of the budgetary consequences.</br></br>These are not the only deflationary forces at work. The Federal Reserve and other central banks continue to fight yesterday's war against inflation. Productivity-enhancing and cost-cutting restructuring prevails in this country and is spreading to Europe and Japan. Deregulation is bringing prices down. The continuing strength of the U.S. dollar encourages imports at lower costs, thereby forcing domestic competitors to reduce their selling prices.</br></br>Even more significant are deflationary forces that increase supply. Global sourcing is mushrooming low-cost supplies, and not just of goods. Software engineers in India are working for U.S. firms at 20% of what Americans cost. The shift in both Russia and especially China from the command economy model to unbridled, buccaneer capitalism is also creating huge new sources of supply. The collapsed Asian economies, including Japan, desperately want to increase exports to employ their citizens and earn hard currency to service their huge foreign debts. Include booming high-tech industries, and global supplies of almost everything will surge while prices will necessarily fall.