The Economic Undertow Known as Deflation

THE BALTIMORE SUN

Richmond.--President Bush and his advisers brag that their economic policies have defeated inflation. The death of inflation is said to justify the so-called supply-side policies of the 1992 GOP platform. Well, it was Mr. Bush who originally used the term "voodoo" to describe his present economic policies, and we all know that reformed sinners tend to be the most obsessive in proclaiming their new righteousness.

But hyperbole aside, if we listen to Washington policy makers discussing today's financial statistics, it is clear that they know something is happening but they do not know just what it is.

Focusing on the wrong problem makes it impossible to develop the right solution. The immediate economic requirement is to increase demand, not supply. Yes, the inflationary spiral has been checked. But the need now is for policies to prevent a deflationary sinkhole.

In a country raised on inflationary expectations, only a Final Jeopardy contestant would be likely to know the precise year of our last acknowledged deflation. But today, for the first time since the Great Depression, America faces huge government deficits combined with a massive liquidity crisis. Hundreds of billions of dollars have been lifted from bank reserves by the savings-and-loan scandal. Cash is draining from our nation as the dollar continues to fall. Suddenly, we are discovering how much poorer as a nation we have become.

Bank failures and mortgage foreclosures are higher than at any time in modern memory. The price of a one-family home in many areas has fallen significantly. After the riots in South Central Los Angeles, we had to struggle to find reconstruction money. In order to rebuild hurricane-damaged Florida and Hawaii, we have to push the federal budget deeper into the red. More bad news about our banking, insurance and other financial institutions will be forthcoming after the election.

Price decline and reduced purchasing power are not news to those on the retailing front lines of American business. Increasingly, retailers have one price tag on a product, but there is a lower price they will quickly accept if the customer is only bold enough to ask. The real value of the average paycheck is not growing. Cash flow is contracting and will continue to contract for many individual and corporate consumers.

These are conditions that normally signify the presence of long-term deflationary forces here at home (even though they may signal different forces abroad).

Federal bureaucrats argue that these worrisome conditions do not indicate a deflation, but only that inflation is close to zero. It is true that some goods, linked to prices abroad, have been increasing in price. But most goods and services linked to the real wages of American workers have been in a long-term price decline simply because Americans no longer can afford to buy the goods and services they produce. Is it possible the government's consumer-price index is missing the true dimensions of today's deflationary conditions? Do our early-warning mechanisms work as they should, given all the changes that have occurred in the financial markets here and abroad during the 1980s?

Let's suppose we are in a deflation. Is there cause to worry? On the surface, reduced prices would appear to be a shopper's dream. If deflation merely meant less inflation, that might be so. But today's deflation means less of everything for most Americans, especially the middle-class homeowner and business owner. The reason: A real deflation squeezes anyone with sizable debt payments, such as a mortgage, accumulated student loans or pressing commercial obligations.

The great American middle class and those struggling up the ladder of success are debtors, not lenders. Several decades of inflation persuaded Americans that debts incurred today can be repaid tomorrow with inflation-cheapened dollars.

In an inflationary world, borrowing can often be very good business. Unexpected and persistent inflation hurts everyone, but especially lenders with long-term commitments. Thus lenders include as a part of their interest rate a calculation of what it will take to offset the inflation loss in the time value of money. The lender wants to transfer the inflation risk to the debtor. Trillions of dollars of debt now exist that assume a steady long-term growth in the domestic inflation rate.

Ideally, the ups and downs of deflation and inflation would be avoided by sustained growth with price stability. But the real world is never so kind. The political blunders of the 1980s may have replaced double-digit inflation with something our political system has not faced in recent times: deflation, which is deadly for borrowers. In a deflationary world, debtors lose their gamble: They have to pay back debts with dollars of higher-than-expected value and less-than-expected availability.

More important, these Americans must repay not only their own debts, but they also have to pay for the huge debt service on the record government borrowings. The national debt has more than trebled since 1980 and is increasing by more than $1 billion a day. The fastest-growing part of the federal budget, consuming an increasing share of the income taxes paid by American families, is the interest on this debt. Instead of borrowing to improve tomorrow's quality of life, we are paying for yesterday's high living.

During times of deflation, the value of personal and business assets decreases. That makes it harder to borrow. Without the ability to borrow, businesses of all sizes cannot grow. It becomes increasingly difficult to service existing debts. Deflation creates a vicious, downward spiral, pulling profits, jobs and the American dream with it.

What should be done? We must immediately focus on the demand side of the economic equation. There is actually one way for the government to reverse the deflationary forces it has helped to create. That is to pursue government policies that enhance the value of human capital and responsibly reflate the economy. The comparatively easy part is to get these forces in motion; the risky problem, not to be underestimated, is how to get the economy moving again without trading the poison of deflation for the hemlock of hyperinflation.

A net increase in taxes will likely prove counterproductive in a deflationary environment. This money is better used to support the production and sale of goods and services. In a deflationary environment, government wants to encourage people to spend their after-tax income; not reduce it by higher taxes.

The Bush solution -- cutting the capital-gains tax -- also makes little sense. The deflation has already reduced the effective cost of capital. There are better and more effective ways to encourage investments.

Those tempted to say a dose of high inflation would be good -- because it will effectively reduce the real size and burden of the debt -- will encounter the realities of international finance. Too much inflation will further drive down the value of the dollar and perhaps dry up those sources of capital presently buying U.S. government notes and bonds. Under such conditions, there may be few willing lenders; or the interest rates required to attract buyers may drive the cost of servicing the national debt to unbearable heights.

The president must be careful to avoid a large decline in the value of the dollar. A lower dollar makes our products more competitive in world markets, but at the same time, it makes American assets, and our companies, a lot less expensive to buy for those from countries with stronger currencies. No country in history has ever grown more powerful by purposely debasing its own currency. That's why the prospect that James Baker -- the architect of the 1980s destruction of the value of the dollar -- might become the domestic czar in a second Bush term is disturbing.

If we are right and the immediate economic need is to fight the forces of deflation, then America needs a new economic mindset in Washington. Inflation means there is too much money chasing too few goods. In a deflation, the reverse is true. Our problem is not a lack of goods-producing capacity, but a lack of consumer demand.

Right now, we need to create demand for American products; that means getting more consumers for the goods we presently produce. The laws of economics cannot be suspended, even for world's only superpower. America needs policies that will prevent a deflationary undertow from keeping our economy under water.

Paul Goldman is chairman of the Virginia Democratic Party. Arthur Mitzburg teaches at Touro College.

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