What's behind the fears of deflation?
May 30, 2003 | Page 6
THE U.S. government's top financial officials sent shock waves through Wall Street in May when they admitted that the U.S. economy was at risk of deflation--the very thing that tore the bottom out of the economic system during the Great Depression of the 1930s.
What is deflation? How would it make the economic slump worse? Who will suffer the consequences? Can anything be done to stop it? ALAN MAASS and JOEL GEIER look at these questions--and show how the fears of deflation represent a new stage in the ongoing economic crisis in the U.S.
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Deflation's vicious circle
"The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation." With this confusingly technical language in the report from their meeting in early May, the governors of the Federal Reserve Board--the government-run U.S. central bank--sent up a red flag about the seriousness of the U.S. economic crisis.
A "substantial fall in inflation" means deflation--an extended period of falling prices and wages throughout the economy. Falling prices might sound good, and mild forms of deflation are not uncommon. But it is what can happen next that frightens the Fed.
Corporations that see their profits squeezed when prices drop over the long term inevitably respond by trying to cut costs, which means pushing down wages, slashing jobs and closing factories and offices. But that further reduces demand for goods and services across an entire economy, because growing numbers of people put off big purchases and have to scrimp and save on the necessities. This pushes prices further downward in a vicious circle.
Deflation is especially harmful when an economy has a lot of debt, because companies that owe money still have the same debt burden, even after deflation drives down the value of whatever they borrowed money to buy. Thus, the companies are under even greater pressure to repay debts, which contributes to the drive to cut costs, which puts further pressure on prices, and so on. Once the downward spiral of deflation begins, the economy is more likely to suffer further losses than to climb out--which is why the Great Depression of the 1930s was so destructive.
From boom to slump
For the Federal Reserve Board (known as the Fed) to raise the possibility of a deflationary cycle is an admission of the seriousness of the U.S. economic slump of the past several years. During the boom of the 1990s, economic commentators began talking about how the system had been transformed--and that the periodic recessions caused by the ups and downs of the business cycle would never happen again.
When the economy started slowing down anyway at the turn of the decade, the same pundits were certain that Fed Chair Alan Greenspan would bring the economy in for a barely noticeable "soft landing." And with every report since then confirming that the "landing" has been anything but soft, the same commentators claimed that renewed economic growth was around the corner--just a few months down the line.
The Fed's statement is an admission that the U.S. economy could well be facing a long-term crisis--whether that comes in the form of a dip back into recession or worse, or years of drawn-out stagnation and deteriorating living standards. The threat of deflation comes from the same factors that made a "soft landing" impossible, and that have made it difficult for the economy to rebound again.
The heart of the problem is what economists call "overcapacity." "U.S. factory usage is at its lowest in more than 20 years; hundreds of jetliners are mothballed and the rest fly more than a quarter empty; rising apartment vacancies are forcing landlords to cut rents; and unemployment is at an eight-year high," the Wall Street Journal reported last week. "In short, too much supply is chasing too little demand."
Now, in a world where millions of children die of malnutrition every year and where homelessness is increasing in the heart of the most advanced countries, this analysis might not seem to make sense. Obviously, if people are homeless on the streets of New York City, then there can't be "too much supply" of apartments and "too little demand" to fill vacancies.
But because the capitalist economic system is organized around profits, the priorities of the system are topsy-turvy. From the standpoint of Corporate America, it is possible for there to be "too much supply," even when people are going without--because there is "too much supply" to sell their products for a decent rate of profit.
The existence of "overcapacity" today--or what Karl Marx described as a "crisis of overproduction"--is the inevitable outcome of the 1990s "miracle economy." With commentators predicting that slumps were a thing of the past, U.S. corporations dueled with one another in an investment binge in the hopes of capturing a bigger piece of a pie that seemed like it would never stop growing.
The economy did grow dramatically during the 1990s, and Corporate America rang up mega-profits. But the headlong expansion laid the basis for the slump to come by creating too much capacity--giving the capitalists the capability to produce more products than they could sell at a price that would bring them a decent profit rate.
For example, the worldwide auto industry has the capacity to manufacture 80 million vehicles a year, according to an analyst at Ford Motor Co. But global demand for new cars and trucks is only 60 million a year.
What is the response of automakers to this? For one thing, they try to get rid of "excess capacity"--by laying off workers and closing down factories. They also face pressure to cut prices--in the hopes of winning new customers at the expense of their competitors.
The same factors are at work when overcapacity spreads from one industry to others, and finally to the economy as a whole.
Layoffs and shutdowns at one auto company put pressure on that company's suppliers, which then cancel orders from their suppliers--and so on down the chain of the whole economy. Likewise, the pressure to reduce prices and wages spreads to other sectors--and if it lasts long enough, can set off a deflationary spiral. This is what the Fed is worried about today.
Manufacturing employment has dropped for 33 straight months without a letup. And the so-called "core inflation rate" in the U.S. fell to a 37-year low in April and is approaching less than 1 percent. Fed officials say that a deflationary crisis is still unlikely. But this is the first time that they have gone so far as to talk about such a threat in 63 years.
Whatever the chances of deflation, the crisis of overproduction--of too much capacity to produce for a decent profit--remains severe throughout the economy. This is the central reason why--despite the supposed economic "recovery"--employers have not begun hiring again or building new factories and offices. They don't see any profit in it--and no amount of tax cut giveaways to the rich or lowered interest rates will change that.
Bursting the bubbles
The main reason for today's slumping economy is at the heart of the system--overcapacity in the production of goods and services. But other factors make the situation that much more unstable.
Another consequence of the 1990s boom was the creation of financial "bubbles," as speculators bid up the price of, for example, shares on the stock market. At the height of the Wall Street boom, the prices of stocks shot up far out of proportion to the actual earnings of the companies they represented.
All told, the Wall Street bubble added $8 trillion in paper wealth to the economy. Some of that ended up in the personal portfolios of Corporate America's super-rich, or in the bank accounts of the upper and middle classes. But it also contributed to the 1990s investment binge, particularly in high-tech industries such as computers and telecommunications.
When the bubble burst with the onset of the recession, the stock market plunged in value--though not as far as some analysts believe it could yet go. Business investment fueled by the financial boom took a hit, and corporations--including the most respected names in American business--were saddled with high levels of debt.
Now, a second financial bubble is starting to leak--the housing bubble. Since 1995, the rise in home prices has outpaced the overall rate of inflation by more than 30 percentage points--a faster increase than at any point in the post-Second World War era.
Estimates of the size of this bubble are $3 trillion in new housing wealth. While the stock market fell after the onset of recession, the housing bubble continued--fueled by the Federal Reserve's interest rate cuts that made mortgages cheaper and led to a wave of buying and refinancing.
One result of all this is that a much higher proportion of mortgage borrowers are at the beginning of their loans, where the amount that they owe on their homes is higher than what they have paid off. These borrowers are especially vulnerable if the bubble in housing prices deflates. They could easily find themselves owing more than their homes are worth.
Thus, families could find themselves with a $200,000 mortgage on a home that was worth $250,000 when they took out the loan--but is now worth only $150,000. Under those circumstances, the incentive is for homeowners to walk away from a losing battle--and let the bank foreclose. If this were to happen on any kind of scale, it could be the final straw for many banks and financial institutions already struggling under high levels of bad loans, from both personal and corporate bankruptcies.
The economy sputters along
What are the chances that the economy will sink back into recession--or, even worse, a depression caused by a deflationary spiral? For mainstream economists to even admit the possibility of another Great Depression is telling.
For decades, the standard thinking among economists was that the government had all the tools it needed to prevent recessions from spiraling into depressions. First of all, there's the government's "monetary policy"--most importantly, the ability of the Federal Reserve, as the U.S. government's central bank, to cut interest rates on loans to private banks, which follow suit by lowering their own interest rates.
Lower interest rates are supposed to spur investment by business, creating jobs and setting the stage for renewed expansion. When interest rate cuts alone aren't enough, there's the government's "fiscal policy"--the use of tax cuts or increased spending to stimulate the economy.
However, what stands out about the current U.S. slump is how ineffective both policies have been. The Fed has cut interest rates a dozen times since January 2001--its short-term rate is now at 1.25 percent, as low as it has been in four decades. But the rate cuts have mainly spurred the restructuring of existing debt--through mortgage refinancing, corporate debt consolidation and so on.
New corporate investments, while rebounding slightly from the depths of the recession, remain low--certainly too low to turn the tide on the overall loss of jobs in the economy. Likewise, the promised economic stimulus of the Bush administration's tax cut legislation has yet to show up in renewed growth.
When the giveaways haven't simply disappeared into the bank accounts of the very richest Americans, they have functioned as a subsidy to prop up corporate profits. But they haven't spurred new investment. The result has been an economy that sputters along, staying out of recession--at least so far and according to official statistics that could still be revised downward--but not producing the kind of new economic growth that would turn around the net loss in jobs and the decline in ordinary people's living standards.
Why aren't the government's traditional tools to fight recession working? The answer lies in the character of the slump. If the root of the problem is overcapacity, then lowering interest rates, even to zero, or handing out tax breaks isn't going to produce new investments. No U.S. automaker, for example, is about to build a new factory, or even hire back laid-off autoworkers at existing facilities, if they already have too much capacity.
The failure of government action to do more than keep the economy limping along has parallels in the now decade-old slump in Japan. During the 1980s, the Japanese economy was in a prolonged boom, gaining ground relative to other competitors among the advanced countries--especially the U.S., where big business considered Japan both a model to follow and a profound threat.
But Japan never recovered from the recession that hit worldwide in the early 1990s. The government continued to cut interest rates until they reached zero in 1996--but this never produced sustained growth. And massive state spending programs on infrastructure and construction have succeeded only in staving off a sharper collapse.
Looking at the situation in the U.S. today, economist and New York Times columnist Paul Krugman concluded that "Japan's economic woes may not be unique. In fact, they seemed to show that we might not be as well defended against depression-style problems as we imagined." Japan has suffered through a long period of stagnation for many of the same reasons that the U.S. economy is slumping today--most importantly, large amounts of unused capacity created in an investment boom that continues to weight down the system.
Ultimately, the only solution to a capitalist crisis of overproduction is to destroy that excess capacity. It seems an absurd idea--that economic recovery could depend on shutting down, for example, steel mills, in a world where hundreds of millions of people desperately need the most basic steel products to live a better life.
Yet in the upside-down logic of capitalism, this is exactly what's needed. The cost is paid by working people--who lose their jobs and see their hard-won living standards dragged down by a system gone mad.
Behind the "dollar crisis"
In the past month, it has become clear that the Bush administration is pinning some of its hopes for economic recovery on another strategy--letting the value of the dollar fall against other currencies. This means exactly what it sounds like. It costs more dollars to buy, say, British pounds or Japanese yen--and by extension, to buy British or Japanese products--then it did before.
The value of a country's currency goes up and down compared to others because of a combination of factors, including international investment flows, trade surpluses or deficits, government policies and so on. But the impact is felt by ordinary people whenever you buy a product that's imported--which now costs more because of the cheaper dollar.
The mainstream media have mostly reported on all this as if it was an unexpected calamity. But administration officials seem to hope that the falling dollar will be a boon to the economy. Why? Because a lower value for the dollar against other currencies makes U.S. products exported to other countries cheaper--and makes products imported into the U.S. more expensive.
That works to the advantage of U.S. manufacturers--provided these companies can find consumers to buy their products, even at the lower relative prices. In the past year and a half, the value of the dollar has fallen by 9 percent against the currencies of America's main trading partners--and more than 25 percent against the European Union's euro alone This isn't purely a matter of manipulation.
The U.S. boom of the 1990s took place despite a massive trade deficit, with Americans spending far more on imports than people of other countries spent on U.S. exports. This should have led to a declining value for the dollar, because of the net outflow of U.S. currency to pay off the trade deficit. Yet the dollar's value remained strong--in large part because the Wall Street boom continued to draw in money from around the world.
Over the 1990s, the amount of money invested in the U.S. stock market from outside the U.S. nearly doubled. When the stock market bubble burst, it was natural that international capital would start flowing the other way, leading to a decline in the dollar's value. But governments have tools to maintain the value of their currency--if they want to.
Over the last month, it became clear that the Bush administration wasn't using the tools at its command to stop the dollar from losing value. This is a calculated gamble. The administration is hoping to enjoy the beneficial effects of a cheaper dollar, while avoiding the problems.
Above all, the policy is designed to spark some life in U.S. manufacturing, the hardest-hit sector of the slumping economy. One economist estimates that a 30 percent decline in the value of the dollar would add 1.5 percentage points to overall U.S. economic growth--enough to lift the sputtering economy out of the doldrums over the next year (crucially for the Bush administration, just in time for the 2004 election). But there are risks.
A decline in a country's currency is usually associated with inflation, because any imported good automatically costs more. With the Federal Reserve advertising its fears of deflation, the administration probably believes a little inflation will be beneficial. But if the value of the dollar begins sliding fast, all bets are off.
Plus, if international capital pulls rapidly out of the U.S. stock market--not to mention all the other complicated forms of gambling, known as derivatives, available from U.S. banks and brokerage houses--Wall Street could plunge into another nosedive, causing a shock to a U.S. financial system that is already showing real weaknesses.
In global terms, though, the administration's cheap-dollar policy has to be seen as an attempt to export U.S. economic problems to other countries. The crisis of overproduction is an international phenomenon. If the U.S. gains market share because of a cheaper dollar, both at home and abroad, it will be at the expense of other countries--pushing them deeper into crisis.
The U.S. may gain a short-term benefit from a cheaper dollar. But in the long run, the policy could contribute to a deeper worldwide slump that would choke off the very export markets where U.S. manufacturers hope to make more money. As economist Robert Samuelson wrote in the Washington Post, "If a cheaper dollar rescues the American economy while plunging the rest of the world into recession, the triumph could be short-lived."
Making workers pay
The Bush administration may have high hopes for its weak dollar strategy. But in the end, it has higher hopes for the most important weapon that capitalists have in any economic crisis--passing the cost on to workers.
Corporate America is carrying out a vast attack on working-class living standards. Real wages (after inflation is accounted for) had finally begun rising at the end of the 1990s boom. Now the trend is running backward again.
And that's not even taking into account attacks on health care benefits and pensions, the sharpest edge of the attack on living standards. Plus, employers are laying off workers and cutting back on hours in a bid to get fewer people to do more work.
The Bush administration's tax cut mania has to be viewed in this light. The latest legislation will have an impact as an economic stimulus by adding more dollars to the economy--though less than it could because such a large proportion of the benefits will go to the already rich, who have the least incentive to spend the windfall.
But the tax breaks have another purpose--to place a financial straitjacket on the U.S. government for decades to come. With falling tax revenues causing a rapidly growing government deficit, politicians will claim that they have little choice but to carry out cuts and more cuts in any program that primarily benefits the working-class and the poor.
Driving government programs like Medicaid or Head Start or Social Security into a crisis is every bit a part of the program of America's rulers as demands for wage concessions or a cheap dollar or low interest rates. The goal is to redistribute wealth upward--ultimately to restore the profitability of Corporate America.
The problem remains, of course, that all the austerity in the world won't spark an economic expansion as long as new investment remains stagnant. Still, though, U.S. rulers can get out of any crisis if they can make workers pay a high enough price. And they won't stop their offensive until they face opposition.
The attacks on working people are stoking bitterness throughout U.S. society. That bitterness can be turned into resistance--by building on all the fightbacks that take place throughout society to organize an alternative to a system that produces poverty and suffering.