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Thursday, May 22, 2003

Deflation: Stephen Roach is Barking Up the Right Tree

Well Stephen Roach says it loud and clear, and he is right: deflation is not a monetary phenomenon. My difference with Stephen: I would put a fourth leg to the stool, ageing. Ageing and declining labour forces attack both the demand and the supply side. The supply side since there are less entrants for the labour force, and even as you struggle to maintain participation rates the quality inevitably goes down. On the demand side (actually the demand and the supply side are at bottom the same, but, well, oh never mind......) with less young people and lower growth expectations there is less borrowing (unless of course the government does it, hence all the fiscal deficit arguments) and hence it is more difficult for growth to hit those critical take-off levels. But apart from this (perhaps important quibble) chapeau. For once I am agreeing with someone: deflation is not a monetary phenomenon.

Don’t listen to the monetarists. They would lead you to believe that both inflation and its diabolical mutation — deflation — are simply monetary phenomena. As long as central banks have control over the printing press, goes the logic, rest assured — they will never abdicate control over the aggregate price level. I would argue, instead, that the current perils of deflation have little or nothing to do with your favorite monetary aggregate. Today’s strain of deflation risk is first and foremost a story of the cyclical imbalances and structural flaws in real economies — problems that are far from amenable to the so-called monetary fix. That’s especially the case in the United States, where the deflation debate now rages.

As most of the world has finally caught on to the risk of deflation, it’s worth reviewing why. It’s not just that America’s price statistics are now flashing ominous warning signs. It’s that the analytical underpinnings to the case for deflation suggest there could well be more to come. As I see it, there are three powerful forces at work — the first being the business cycle. Recessions, by definition, are deflationary events. So, too, are subpar recoveries. A cyclical downturn opens up a gap between aggregate supply and demand that alleviates pressure in labor and product markets. In a subpar recovery — defined as growth in aggregate demand that falls short of the potential gains on the supply side of the equation — that gap remains wide. Basic economics tells us that a cyclical overhang of aggregate supply reduces pricing leverage.

That’s precisely the case today. America’s most recent recession has been followed by an anemic recovery. As a result, unemployment has continued to drift up, and capacity utilization rates have continued to fall. But there’s an important twist: The recession of 2001 commenced at an exceedingly low inflation rate — 2.3% inflation as measured by the GDP price index in late 2000. That means the US economy entered a period of cyclical distress very close to the hallowed ground of price stability. In that context, the implications of a recession and its subsequent subpar recovery entail a far closer brush with deflation than would have been the case had the US been running a higher pre-recession inflation rate.

The bubble — and the post-bubble shakeout that has ensued — is the second key macro underpinning to the case for deflation. The bubble led to bloat on the supply side of the equation — fostering excessive hiring and capital formation. Tantalized by the allure of skyrocketing Nasdaq multiples, US businesses went for scale and scope — just what the apostles of the New Economy were urging. The bubble popped and yet the legacy of excess supply lingers — precisely the point underscored by an unusually low capacity utilization rate. At the same time, there has been a post-bubble compression of aggregate demand growth, as the wealth effect now works in reverse. In the three years since the bubble popped in early 2000, growth in personal consumption has averaged 2.7% — 40% slower than the 4.4% pace recorded over the 1996–99 period. The legacy of the bubble — subpar growth in aggregate demand in the context of lingering excess supply — reinforces the cyclical pressures on pricing leverage.

Globalization is the third leg of the stool. Not only has trade liberalization expanded aggregate supply in tradable goods markets, but there has been a comparable development in the once-non-tradable services sector. The globalization of services — the newest and potentially the most powerful piece in this equation — reflects three developments: global deregulation, which transforms administered pricing into market-determined prices; surging cross-border M&A activity that has led to the creation of huge multinational service providers; and the Internet, which has facilitated the growth of IT-enabled service exports (i.e., software programming, consulting, design, engineering, etc.) from places like India. In the long run, the supply-led impetus of globalization generates incremental income that supports increased aggregate demand. But today’s world is far from that long run. Instead, it is coping with the impacts of the first-round effects of globalization on the supply side, which further exacerbate the global imbalance between supply and demand.
Source: Morgan Stanley Global Economic Forum

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