Deflation and all that  

Some economists argue that worldwide overcapacity threatens to unleash deflation in the world economy. These fears are exaggerated  

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ECONOMICS is not called the dismal science for nothing. Even though America’s economy has been growing strongly in recent years, American economists are becoming intrigued by an increasingly fashionable theory. This is the idea that a global excess of productive capacity together with a slowdown in East Asia will result in worldwide deflation. Some people are already urging America’s Federal Reserve to cut interest rates in order to stave off trouble. The Fed ignored this advice when its Open Market Committee met on November 12th, and left rates unchanged. 

The deflationists’ case is quite straightforward. Around the world, too many factories are making too many cars, too many computer chips and too many chemicals. As a result, they say, supply is outpacing demand. And things could get worse if Asia’s financial problems turn an economic slowdown into a slump. The result will be global deflation—a period of falling prices, shrinking profits and lots of bankruptcies. 

There are, indeed, many examples of excess supply around the globe. A mountain of computer chips, largely the result of overinvestment in Asia, caused the price of memory chips to tumble by 80% in 1996. The world car industry now has enough capacity to churn out 35% more vehicles than are bought each year. Car sales have levelled off in the rich world, and although demand in the developing countries has been rising rapidly, production is growing even faster. 

An article in the November 10th issue of Business Week argues that “production everywhere is running ahead of consumption” and warns that overcapacity will get worse as Asia tries to export its way out of its economic mess. Undeterred by the fact that the very next article in the magazine sounds the alarm about a growing shortage of workers—and hence rising wage costs—in America, the authors conclude that “the global economy may well be heading into a new era—an era of deflation”. Several prominent American economists, such as Ed Yardeni of Deutsche Morgan Grenfell, agree that Asia’s overcapacity poses a deflationary risk to the world economy. 

What is the wider evidence that global supply is outpacing demand? Supporters of the global-glut thesis point to the fact that in all regions of the world, industrial production is currently growing faster than consumer spending. But this is misleading. The bulk of American consumer spending is on services, not goods. And manufacturing (which accounts for a mere 20% of GDP in most rich economies) tends to be more cyclical than services, so it is not surprising that, during an economic expansion, industrial production is outpacing total consumer spending. 

Bold claims about prices falling across the board as a result of excess supply are also misleading. It is true that the prices of many products, such as cars, computers and telephone calls, are falling. But the prices of many other things, including aerospace components, hotel rooms and business-class air tickets are still rising strongly. 
Letting off steam 

In essence, the global-glut thesis is based on two questionable assumptions about why overcapacity can only get worse. 

The first is the claim that global productive capacity is growing at an unprecedented rate. In fact, total investment in rich economies has actually fallen as a share of GDP over the past decade (see chart). It is true that capital spending by American firms, especially on information technology, has surged over the past few years; but that follows a decade of sluggish investment. Moreover, a large chunk of spending on computers and suchlike is intended either to boost productivity or to replace obsolete equipment, not to increase capacity. So the net increase in productive capacity has been much smaller than the gross investment figures suggest. 


Where there has indeed been an investment boom over the past decade is in developing Asia. The region’s investment increased from 23% of GDP in 1980 to 36% last year. Overall, however, world investment has remained broadly unchanged in relation to world output over the past ten years. Moreover, a large chunk of the increased capital spending in Asia went into property, not manufacturing capacity. 

The second, even more dubious claim of the global glutters is that developing countries are adding far more to world supply than to demand. They argue that the millions of new workers in emerging markets do not earn enough to buy as much as they produce. As productivity has risen in developing economies, however, so have wages and hence consumption. Indeed, in recent years developing countries have been big net importers from the rest of the world. Of the 25 emerging economies monitored each week by The Economist, 19 are running current-account deficits (see article). Developing economies as a group are expected to run a combined current-account deficit of more than $100 billion this year. 

Where the doom-mongers do have a point is that this deficit will shrink sharply over the next year, as a slump in domestic demand and big currency devaluations cause Asia to export more to the rich world. Much of Asia’s new investment was intended to serve the regional market, but producers will now be looking for new markets further afield. 

Hence the growing fear that developed economies will be flooded with Asian goods. This could have serious implications for the Japanese economy, which has the closest trade links with the rest of Asia. After all, it comes at a time when Japan’s domestic demand is already sagging and its financial sector is still on crutches (see article). But the impact on America and Europe will probably be modest. 

Many economists reckon that the slowdown in East Asia will shave 0.2-0.4 percentage points off growth in America and the European Union next year, but 0.5-0.7 points off Japan’s growth. If the region’s financial headaches get worse, with a widespread collapse of banks and a deep recession spreading to China and Japan, then the effects on America and Europe would be much more serious. But for the moment, such fears are overdone. 
A safety valve 

Much of the current debate about deflation reflects a misunderstanding about what the phenomenon really is. Deflation is a persistent fall in the general price level. If some prices fall because of cheaper imports from Asia, say, this is not deflation, but simply a change in relative prices. It is monetary policy that determines general inflation or deflation, not structural factors such as global competition. If the prices of imported goods decline, then so long as the money supply continues to grow at the same rate, spending on other goods (and hence their price) should increase. 

If supply did seriously exceed demand, central banks should simply cut interest rates. This is where the Fed went horribly wrong after the stockmarket crash in 1929, when it raised interest rates and allowed the money supply to shrink. Between 1929 and 1933, prices fell by almost 30%. 

But America is not suffering from insufficient demand or tight money. Its broad money supply, M3, is increasing at an annual 8.3%. Unemployment fell to a 24-year low of 4.7% of the labour force in October. And hourly wages rose by 4.2% in the year to October—their biggest rise since 1989. 

Normally, this would be enough to cause the Fed to raise interest rates. However, the central bank is clearly taking account of events in Asia. From this point of view, a drop in American exports to Asia and a rise in its imports from the region may be no bad thing. It will absorb excess demand, and so help prolong America’s expansion while keeping inflation low. 

If Asia’s slowdown helps America’s Fed and other central banks to keep a lid on inflation, it will reduce the need to raise interest rates by as much as would otherwise have been required. But in the long term, rates will still need to rise. Inflation, not deflation, remains the bigger risk. 
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