Fight against global deflation must involve Asia
24 September 2002
Morgan Stanley's Stephen Roach has been pessimistic about the US economy for quite some time. Even as the US appeared to be recovering from recession at the beginning of the year, he was already warning of a double dip. As recent economic indicators show the US recovery beginning to weaken -- the latest being a 0.2 percent decline in the index of leading economic indicators for August -- Roach's views appear to be gaining credibility among more and more economists. He now argues that the world needs to take greater steps in combating the shift in the global economy from disinflation to deflation.
On 23 September, Roach wrote in the Global Economic Forum: "There were two key complications along the way that I believe shifted the balance from disinflation toward deflation: the IT revolution and globalization." I would add a third complication: China. As Roach's Morgan Stanley colleague, Andy Xie, wrote on 17 August 2001 in the Global Economic Forum, "China is following a deflation-led growth model. Because China has such a huge surplus labor force in comparison to the global economy, it is difficult for wages to rise. Domestic consumption is therefore based on bringing prices down in line with Chinese labor costs. China is redefining the prices for tradable goods."
However, for all the impact of these factors, has deflation actually arrived in the US? The inflation data so far actually show few signs of deflation. As Caroline Baum pointed out in her Bloomberg column on 18 September, "the core consumer price index, which excludes food and energy, has averaged a 2.6 percent annual increase for the last two years… In August, the CPI rose 1.8 percent from a year earlier." Baum also pointed out that core services, or services less energy services, rose 3.7 percent in the last 12 months, little changed from a year ago. So while the global trend towards deflation is certainly there -- many parts of Asia are already in deflation -- the US has largely escaped it so far. If anything, the US Federal Reserve's premature efforts at fighting deflation in the late 1990s -- partly, as suggested by Roach, to counter the shift to fiscal austerity in the 1990s -- probably contributed to the stock market bubble in the US that is still in the process of deflating. But the stock market's decline, which is now entering its third year, has yet to spill over to prices in general.
"I have argued recently that a sharp correction in the US dollar could be one of the key avenues of hope for an ever-precarious global economy," wrote Roach. "It would help arrest the strain of 'imported deflation' that is currently afflicting the US -- one of the legacies of an overvalued dollar." The idea that the overvalued dollar is contributing to imported deflation in the US is somewhat ironical. To me, it is just as valid to suggest that the foreign capital flows into the US which gave rise to the US dollar's strength also led to asset inflation in particular and probably consumer price inflation as well by increasing money supply in the US. In so far as foreign goods prices declined, it can be attributed as much to the impact of China's increasing productive capacity at low prices -- and to the consequent competitive devaluation among the currencies of other Asian economies -- as to the strength of the US dollar.
So one has to be careful in concluding that the strength of the US dollar has deflationary ramifications on the US, and that its weakening would necessarily arrest deflation. Roach himself quoted a recent paper by Martin Baily, former chairman of the Council of Economic Advisors in the Clinton administration, which indicated that a 20 percent drop in the value of the US dollar "would reduce the level of real GDP by 1.2% by 2007 -- with personal consumption down more than 5% and capital spending down nearly 12% over the same period". That suggests deflation, although the paper suggested that the CPI-based inflation rate would be raised by one full percentage point over the next five years. That seems to me like getting the worst of both worlds.
The bottom line is that the US economy, with its massive debt levels, has shot its bolt. There is little it can do on its own to avoid deflation. Instead, it needs to be careful not to exacerbate the risk to its economy by boosting its debt levels even more by pursuing loose monetary and fiscal policies.
Rather, the key in avoiding global deflation is to get other economies to increase demand, particularly those economies which are already in deflation. Japan, in particular, needs to resuscitate its economy, but most other export-oriented Asian economies can also do their part by stimulating domestic demand. At the moment, most Asian economies generally have ample productive capacity but relatively little domestic demand, resulting in large current account surpluses which cannot be recycled domestically. Consequently, they are major sources of capital to the US and thus also major contributors to the US dollar's strength and, back in the late 1990s, the stock market bubble as well. In contrast, Europe still has substantial inflation that the European Central Bank is committed to containing, so it can probably contribute less to global demand, although structural reforms to its rigid labour market can help over the longer term.
Ultimately Asia, with its excess productive capacity, excess funds and inadequate demand, has been a major contributor to the deflation threat that is now hanging over the US and the rest of the world. Asia, especially Japan, must now do its part to deflect that threat.
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