Move Over Japan – U.S. Edging Towards a Deflationary Trap Too

Increasingly, economists and other analysts are expressing concern that the United States could be edging closer to a different problem — the kind of deflationary trap that cost Japan more than a decade of growth and economic progress – and as Tokyo’s experience suggests, deflation can be at least as tough a problem as the soaring prices of inflation or the financial pain of a traditional recession. Words: 1105

So says Don Lee (http://www.JewishWorldReview.com) in an article* entitled “U.S. may be edging toward period of deflation, some economist fear”. Below Lorimer Wilson, editor of www.munKNEE.com, presents further reformatted and edited [..] excerpts from the article for the sake of clarity and brevity to ensure a fast and easy read. (Please note that this paragraph must be included in any article reposting to avoid copyright infringement.) Lee goes on to say:

When deflation begins, prices fall. At first that seems like a good thing but soon, lower prices cut into business profits, and managers begin to trim payrolls. That in turn undermines consumers’ buying power, leading to more pressure on profits, jobs and wages — as well as cutbacks in expansion and in the purchase of new plants and equipment. In addition, consumers who are financially able to buy often wait for still lower prices, adding to the deflationary trend. All these factors feed on one another, setting off a downward spiral that can be as hard to escape from as a stall in an airplane.

For now, the dominant theme of the nation’s economic policy debate remains centered on the comparative dangers of deficits and inflation. However, economists across the political spectrum — here and abroad — are talking more often about the potential for deflation.

How Likely is Deflation?
The latest U.S. data are sobering: Consumer prices overall have declined in each of the last three months with the inflation index now just 1.1 percent above a year earlier. The core inflation rate — a better gauge of where prices are going because it excludes volatile energy and food items — has dropped to a 44-year low of 0.9 percent and that’s well below the 1.5 percent-to-2 percent year-over-year inflation that the Federal Reserve likes to see.

Private economists and financial experts have expressed much greater concern. John Mauldin, president of Millennium Wave Advisors in Dallas, puts the probability of deflation at more than 50 percent. Among the reasons he cites: a lot of unused labor and production capacity, increased savings and the low speed at which money is changing hands.

“It’s a good bet that by some measures we’ll be seeing deflation by some time next year,” Paul Krugman, the Nobel laureate economics professor, said this month in his New York Times column. He went on to scold the Fed for standing idle while the nation is “visibly sliding toward deflation.”

The Fed’s chief, Ben Bernanke, however, appears to think deflation fears are overblown telling senators recently that he didn’t view deflation as a near-term risk. In the Fed’s latest forecast, core inflation is projected to stay at the current pace this year, then gradually rise toward 1.5 percent in 2012.

Bernanke believes that, should deflation occur, the central bank has the tools to reverse it but many question whether the Fed can do much more, given that it already has pushed interest rates to historical lows and pumped more than $1 trillion into the financial system. Bernanke also stated that America’s economy is more vibrant and productive than Japan’s was and its labor force is not declining compared to Japan’s which has been for much of the last decade and that Japan also was much slower in addressing problems with its banking sector than the U.S.

Japan’s aging population and rigid business and political systems have clearly contributed to the country’s long economic malaise, which began in the 1990s but there are some notable similarities with America’s latest economic slump. In both cases, real estate bubbles burst after years of rapid growth and low unemployment, exposing poor loans and serious problems with financial institutions and regulations. In both countries, the crash also led to a sharp fall in real estate prices and financial markets and to soaring unemployment.

Richard Katz, editor of the Oriental Economist Report, a New York newsletter focusing on Japan and U.S.-Japan relations, believes, however, that the scope and economic fundamentals of the two crises are very different [in that] commercial land prices in Japan’s six largest cities soared 500 percent from 1981 to 1991 and the bust took them [back] down below 1981 levels. [On the otherhand,] the U.S. housing slump has been bad, but nowhere near that severe. Also, whereas bad debts pervaded Japan’s entire economy, the U.S. recession wasn’t the result of structural flaws but rather of excesses in the financial system that came from deregulation and other policy mistakes that he sees as correctable. [Furthermore, Katz makes the point that] the policymaking response in the U.S. is better, in part because of the precedence of Japan, noting that it took Japan’s central bank nearly nine years to do what the Fed in essence did 16 months: bring short-term interest rates to zero.

John Makin, a visiting scholar at the conservative American Enterprise Institute doesn’t take much stock in consumer surveys about inflation expectations because most people have been ingrained to expect inflation in the future, not deflation. Makin also thinks some price declines are indirect and not reflected in government reports. Many online retailers now provide free shipping, and more businesses are offering specials such as “buy two, get the third free” — the functional equivalent of price cuts. In one measure that Makin calls a “flashing red light,” yields on 10-year Treasury bonds, which rise with inflation worries, have slipped to less than 3 percent.

Conclusion
Some analysts suggest that the U.S., like Japan, is heading into a long period of stagnant growth, in large part because of high unemployment and an overhang of debts that will restrain consumer spending which tends to hold down wages, putting more downward pressure on prices and once deflation sets in, consumers may hoard cash or try to pay off their debts faster, fueling the downward spiral of spending and growth.

*http://www.jewishworldreview.com/0710/deflation.php3

Editor’s Note:
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