The Economic Undertow Known as Deflation



RICHMOND — 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.

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