THURSDAY JANUARY 15 1998, Financial Times

                  Policymakers should forget inflation and focus on the danger of falling prices
                  and demand

                  Economic policymakers have been fighting the last war so long, they can't see
                  they're about to enter a very different battle on the opposite front.

                  The old war was against inflation. It shaped the fears of those who watched it
                  run out of control in the 1970s. Yet the inflation war is largely over. The
                  enemy may re-emerge in the future, and it is important to keep a vigilant eye.
                  But for now, inflation is vanquished. The new enemy approaches from the
                  opposite direction. While our policy artillery is still aimed at the spectre of
                  spiralling inflation, the real danger is spiralling deflation.

                  The generation that witnessed the worldwide depression of the 1930s recalls
                  the power of this enemy, but memories are distant. The seeds of depression
                  were sown in the late 1920s, when demand began to fall. By 1927, sales of
                  houses, cars and consumer durables were in decline, commodity prices had
                  turned downwards and industrial production began to fall. We are entering a
                  similar era. But we have become so accustomed to the danger of excessive
                  demand that we no longer appreciate the danger of its opposite - inadequate
                  demand. Nor do we feel the urgency of taking pre-emptive action.

                  A deflationary spiral can be as dangerous as an inflationary one. Falling prices
                  squeeze profits, causing companies to reduce wages and cut employment. As
                  a result, workers have less money for goods and services, causing prices and
                  profits to drop further. The value of property bought on credit declines until it
                  is worth less than the debt owed, resulting in defaults. Lenders are unable to
                  make further loans. The crisis deepens.

                  A vicious deflationary cycle can also let loose a vicious social cycle, worsening
                  the economic one. In contrast with periods of strong demand, characterised
                  by low unemployment and rising wages, periods of weak or receding demand
                  lead to higher unemployment and falling wages. Deeper indebtedness,
                  combined with higher unemployment, may give rise to strikes, changes in
                  democratically elected governments, or violent forms of unrest. Such instability
                  further slows the economy.

                  Even before the Asian currency crisis, world prices were falling for basic
                  goods, such as food, energy, steel and other commodities. On January 8, the
                  US Labor Department announced wholesale prices had dropped 1.2 per cent
                  in 1997. The core rate of price inflation (which excludes energy and food)
                  showed the smallest annual gain since the department began gathering the data
                  in 1974. If, as many economists assume, official data overstate inflation by
                  around 1 percentage point, deflation has commenced.

                  A large, unco-ordinated global contraction is under way. We are experiencing
                  only the beginnings.

                  Demand is contracting in south-east Asia, and the consequences are rippling
                  outwards. Many Japanese banks are technically insolvent and are no longer
                  making loans to small and medium-sized local companies. Japanese
                  companies that had relied on south-east Asia as a growing market have lost a
                  large portion of their customers. US companies that had expected east Asian
                  growth to continue are frantically revising their plans. For example, nearly one
                  third of the backlog of orders for Boeing aircraft is from Asian airlines.

                  Demand is also shrinking in much of Latin America. In an effort to maintain
                  investor confidence, Fernando Henrique Cardoso, Brazil's president, last year
                  sharply raised central bank lending rates. The result has been to flatten
                  consumer demand in Latin America's largest market of 160m people.

                  Brazil's contraction is rippling through much of the rest of Latin America,
                  where economic austerity is also in vogue. Real wages are falling throughout
                  much of the continent and inequality is widening. The maintenance of adequate
                  demand requires a large and growing middle class, which Latin America may
                  be in danger of losing.

                  Demand is also listless in western Europe. Budget deficits are being slashed in
                  order to qualify for a common currency one year from now. At the same time,
                  European interest rates remain relatively high.

                  Until recently, a rising share of German exports had gone to developing
                  countries, including Asia. But orders for exports have been tumbling for
                  months. The value of ordered export goods has dropped by more than their
                  volume - further proof of price declines. German unemployment shows no
                  signs of improving.

                  Lionel Jospin, France's prime minister, has continued to cut his budget even
                  though 3.1m French citizens are without jobs. France's unemployment rate has
                  remained above 12 per cent for more than two and a half years. This is how
                  long unemployment benefits last. Those over the limit began occupying
                  employment offices last month.

                  The US is doing much of the job of keeping the global economy moving
                  forward. Its economy is supremely healthy. Unemployment is lower than it has
                  been in almost a quarter century. The economy grew by nearly 4 per cent in
                  1997, largely due to consumer spending and to large outlays by business for
                  new equipment in anticipation of even greater demand. Spending pushed
                  corporate profits to their highest levels in 30 years.

                  US wages, however, have barely risen. The real median wage is still below its
                  1989 level. The sluggishness of wages is significant. It means the economy is
                  being propelled largely by household debt. Household debt - including credit
                  cards, personal loans and mortgages - is at record levels. Accordingly,
                  personal bankruptcies have also risen to a record level, as have defaults on
                  credit cards.

                  We are rapidly reaching the limit. Recent evidence suggests the rate of growth
                  in US household debt is starting to slow, as households cut back their
                  borrowing. As they do so, the most important source of demand in the US will
                  shrink.

                  Consider the big picture: an east Asia of toppling currencies and bank
                  insolvency; rising unemployment in Latin America's largest economy and falling
                  real wages throughout the region; stagnation and unemployment in Europe; a
                  rapidly approaching limit to the capacity of US consumers to take on more
                  debt. As the global economy slows, social unrest threatens.

                  This unco-ordinated global contraction could lead to a deflationary cycle.
                  Central bankers, financial ministers and International Monetary Fund officials,
                  acting rationally in their own spheres of responsibility, may be failing to see the
                  larger picture. They should be discussing what steps they could take to have a
                  significant effect in the opposite direction. At the very least, they should draw
                  up contingency plans. A wider view would consider whether it is time for
                  central bankers in advanced economies to loosen the reins on the money
                  supply.

                  The strict budget requirements for eligibility in Europe's single currency need
                  to be reconsidered in the light of a possible deflationary cycle. Similarly, it may
                  be wise for pending US budget surpluses to be used for tax cuts and
                  additional spending. Japan must em-bark on a package of measures to
                  stimulate domestic demand. And the IMF, while continuing to make Asian
                  loans conditional on financial restructuring, must balance its demands for sharp
                  cuts in public budgets and higher interest rates against the strong
                  contractionary forces under way.

                  Policymakers who for years have sought to pre-empt spiralling inflation must
                  now be active in fighting spiralling deflation.

                  The author is professor of social and economic policy at Brandeis
                  University. He was secretary of labor in the first Clinton
                  administration