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The Case for Deflation
By Chris Farrell
March 18, 1998

This story is part of a larger feature about deflation:
The World Turned Upside Down: An End to Inflation?

In 1965, an AM/FM clock radio with a plastic cabinet and analog clock would have cost you about $40. In 1998, a simple AM/FM digital clock radio at Target runs about $10 - and it sounds a lot better.

In a sense, the US economy these days is becoming a lot like our radio: lower prices and higher quality.

New car prices are flat and used car prices are down sharply over the past year. A burger and fries costs less. So does a soda or a beer. Computers and other high-tech goods are cheaper by the month. After adjusting for inflation, a gallon of gas in a sport utility vehicle costs less today than when your Dad's car had fins.

These numbers tell a story - the Age of Inflation may be over. That's right: The Age of Inflation may be over.

True, some prices are going up, such as airline tickets, a hospital stay, and cable television. Yet when the government's statisticians calculate the change in overall prices, the consumer price index is up less than 2% over the past year - compared to 5% in 1990 and 14% in 1980. With low-cost imports heading our way from the troubled economies of Asia, the US is closing in on a zero-nflation economy.

Imagine.... For some four decades, the specter of inflation has haunted America; the energy crisis, soaring food bills, mortgage rates in the high teens. How about Gerald Ford and his "Whip-Inflation-Now" buttons? Ronald Reagan at his 1981 inauguration address echoed the fears of a nation traumatized by inflation:

Reagan: These United States are confronted with an economic affliction of great proportions. We suffer from the longest and one of the worst sustained inflations in our national history. It's distorting our economic decisions, penalizing thrift, and crushing the struggling young and the fixed income elderly alike. It threatens to shatter the lives of millions of our people.

How was inflation tamed? From the 1980s on, an arsenal of domestic and global forces were unleashed against inflation, from the tight-money policies of an inflation-phobic Federal Reserve to brutal domestic and international competition.

Inflation is now at its lowest level in three decades. Michael Shannon is chairman of Ecolab, the leading supplier of cleaning and sanitizing systems to industrial and institutional markets.

Shannon: Now what it means is that we have very little pricing flexibility. Just as we're not accepting increases from our suppliers, our customers are not accepting increases from us.

Still, with unemployment at 4.6 % and worker wages rising smartly, many Wall Street prognosticators are fearful that inflation will break out.

Yet a growing number of economists worry that the shock waves from Asia's economic earthquake could trigger a phenomenon we haven't seen in the US for seventy years: deflation. The prospect of a broad-based decline in prices is real, says William Wolman, chief economist at Business Week.

Wolman: It's hard to forecast anything like this with precision. But the fact of the matter is, that for most of my life, economists had been underestimating the rate of inflation. In the current period what strikes me is that economists are underestimating the amount of deflationary forces that are in the world economy.

Here's the basic dynamic. A global investment boom was triggered by communism's collapse, the embrace of freer markets by much of the developing world, and the long US economic expansion. Even before Asia stumbled, factories everywhere were supplying consumers with more computers, cars, and other manufactured goods than they wanted. Now, domestic demand in Asia has shriveled, and these troubled nations are pushing hard for more exports through lower prices.

"Well, you've got to ask where is the demand going to come from?" says Robert Reich, the former Labor Secretary and now a professor at Brandeis University. Reich worries that Asia's economic collapse may set in motion a global deflationary spiral - something we haven't seen since the Great Depression.

Reich: If there isn't sufficient demand in the United States or elsewhere for all the goods and services being produced by companies, then companies start finding that their profits begin to erode and they have to lay people off both in the US and elsewhere. Well, if workers don't have enough money in their pockets because they are laid off, they can't buy anything. And, obviously, if they can't buy, that means companies can't sell, and then there are fewer and fewer options open to companies in terms of markets. A lot of businesses can't repay their loans, their profits are so low. And banks start suffering. They are overextended. They begin to become somewhat illiquid or bankrupt. And you can see as we go on how this vicious cycle plays itself out. Again, I don't want to be Chicken Little. I don't want to predict that any of this is going to happen. But we have to be vigilant against the possibility of accelerating deflation just as we are vigilant against accelerating inflation.

Should we worry? Despite the largest international financial bailout ever engineered, Asia's crisis could spread in dangerous ways. Japan, the world's second largest industrial power, has struggled with falling prices for seven years. Inflation rates among the major industrial nations hover between a measly 1% and 2%. The stock market could crash.

Not everyone is worried about deflation - far from it. Arthur Rolnick, director of research at the Federal Reserve Bank of Minneapolis, can't help but wonder what the fuss is all about.

Rolnick: If prices are falling because, say, commodities are cheaper to buy, foreign goods are cheaper to buy, that should be a boost to our economy.

Call it the Walmart economy - a world of everyday low prices. Interest rates are down sharply. Cheaper commodities are slashing the costs of production. The stock market has surged to record highs and the economy is in sight of the longest expansion in the post World War II era. The nation's leading edge businesses, such as computers, software, telecommunications gear, and the Internet, are all thriving in a deflationary world of falling prices and rising sales..

Deflation may be a chilling word to some, with visions of bank failures, farm foreclosures, and long lines of unemployed workers in the 1930s. But Bill Wolman of Business Week cautions that deflation is not synonymous with depression.

Wolman: The fact of the matter is, if you look at the United States in the late 19th century economic growth was relatively strong even though prices were falling. The price level was stable to falling for a long period of time.

So far, falling prices are acting more like a tax cut. People have more money in their pocket. The lower inflation runs the more workers can buy with their earnings. Jim Paulson is chief investment strategist at Norwest Investment Management.

Paulson: A couple of years ago, the level of inflation was about the same as wages, and today, the level of inflation is about 1.5 and wages are still at 4, and the result is that the real purchasing power of wages have been exploding. And the reason they have is because of deflation. Falling product prices imply that your wage goes farther.

The Mall of America in suburban Minneapolis is a citadel to consumerism. It's the nation's largest shopping mall. Shoppers there all had a clear idea of what is happening to prices, and that there are plenty of ways to get your money's worth.

A male shopper: I wouldn't say prices of goods are coming down, you just get more sales. They just give you more money because they can't get rid of the product. So you end up buying stuff on sale instead of buying stuff at the regular price. There's always going to be leftover product that nobody wants, so they'll put it on sale and you can get it for half price. You can see that in the car industry right now. There are three-year-old cars that are brand new, just sitting in the lot. That happens everywhere. Outboard motors are the same way... you can buy outboard motors, three, four-year-old outboard motors. Everything. There's a surplus of everything. It's just a matter of shopping around, waiting. Everyone waits for the sale... if you do your shopping right, you'll get a good deal. That's what counts.

Three women shoppers: I think most of us are really shopping - shopping, looking for the best deal. If it doesn't say sale or clearance, I don't even go into that area, because I want the most for my money. I want that deal.

Intense pricing pressure means companies are having to rethink virtually every aspect of how they do business. It's a treacherous, tough business environment that punishes inefficiency and bureaucratic bloat and rewards speed and imagination. Take Supervalu, one of the country's largest wholesale and retail food companies. The company did well in the 1980s with prices rising at a 4% to 5% rate. The real price shock in their industry came in the 1990s. Prices have been rising at a mere 1% pace and, in 1994, Supervalu lived through a year of deflation in food prices. Michael Wright, the company's chief executive, says 12 years ago, there were eight national food wholesalers. Today, there are three.

Wright: When you have a high inflationary environment - or even not all that high, but 3% to 6% inflation - about anybody can make money and seem to get along and nobody goes away. In these tougher times, when you get deflation or no inflation and you don't have a business like Microsoft with everybody buying stuff and new computers and things, a growing business, you get overall stagnant sales level. It puts pressure on the poor operators. And that's the way the system is designed to work: you get rid of the weak and the strong survive.

Welcome to the Age of Productivity. Over the past two decades, companies have downsized, restructured, reengineered, and invested heavily in high-tech gear - all with an eye toward cutting costs and boosting productivity. Business is learning how to harness the power of high technology, and gains in output per worker are showing up in lower prices and higher quality. The only way companies can charge a higher price is by innovating.

The classic example is agriculture. Robbin Johnson, vice president for public affairs at Cargill, the giant commodity trading company, says grain prices have been declining in inflation adjusted terms since the beginning of the 20th century.

Like farmers before them, managers are struggling to wring more efficiencies from their businesses. The sense of urgency at the St. Paul Companies, the giant insurer, is typical. Patrick Thiele, head of St. Paul's worldwide insurance operations, says the company has a goal of boosting productivity by 5% per year - more than enough to offset its 3% to 4% salary increases.

Thiele: We've been able to attain that over the last five years, albeit a little chunkily, but we've had that. I think what really occurs for us, much like other service businesses we are continually replacing human capital with information technology capital. In fact, we have less employees today than we had five years ago, but our IS spending, our information system spending is approximately double. And as we look forward into the next five years, I expect our information technology will continue to increase at 10% to 15% a year, and basically all of our other expenses, of which 70% are people related, will be flat to down.

Growth, more than ever before, relies on what Joseph Schumpeter called "creative destruction" - the tumultuous process by which new technologies, new markets, and new organizations supplant the old. The two most powerful forces of our age, globalization and technology, are combining in ways we can't quite yet fathom to create wealth, low prices, and low unemployment - but massive layoffs and job insecurity for workers.

Assuming prices don't collapse, a world of low everyday prices is good. It is also very unfamiliar. It took years for Americans to adjust to inflation. But inflation became the devil we knew and understood. Now, we may have to revamp our expectations if the prices we pay for goods and services sometimes rise at a moderate pace and occasionally fall at a mild rate. We also need to recognize that the stable prices is not just inflation, but the risk of virulent deflation.