Are We Headed Towards Global Deflation?
by Nouriel Roubini
October 1998

After decades in which inflation has been the main concern of policymakers and central banks, there has been recently a lot of talk about the possibility of a global deflation, i.e. a situation in which the price level continuously falls rather go up. The reasons behind all the recent talk about deflation are several:

1. In the 1990s inflation has been low and falling at lower levels (arouns 2%) in most industrial countries (Europe, U.S. and Japan).

2. The economic stagnation in Japan has led flat prices with inflation being close to zero.

3. In the U.S., CPI inflation is close to 2% but producer prices have been flat or falling for several months in 1997. Also, following the Boskin Commission report, there is now a wide belief that official CPI inflation may overestimate actual inflation by 1-2% per year.

4. The economic crisis in Asia is in part characterized by excess capacity and overproduction that will lead, in the view of some, to a glut of products being dumped in world markets and causing wide price declines.

5. Technological changes, especially in the high tech sector, lead to a continuous fall of the relative price of computers and other information technology products.

The possibility of deflation has become a more serious matter of policy debate as even U.S. Federal Reserve  Chairman Alan Greenspan has started to talk about the risks of generalized deflation. In a speech on January 3, 1998 Greenspan warned of dangers if the U.S. economy should enter a period of falling prices, reinforcing beliefs he is not inclined to raise interest  rates. In his most detailed talk yet on the potential for deflation, Greenspan said  that a debate on the  issue was hampered by faulty price measures and  lacked clarity.  "Some observers have begun to question whether  deflation is now a possibility," the central bank chief  told the annual meeting of the American Economic  Association (AEA).  "Even if deflation is not considered a significant  near-term risk for the economy, the increasing discussion of it could be clearer in defining the circumstance," he added.  Deflation has not occurred in the United States on a broad scale since the Great Depression of the 1930s.  Greenspan declined to say whether there was an   imminent risk of a deflationary cycle, but said it could be at least as bad for the economy as inflation.  "Both rapid or variable inflation and deflation can  lead to a state of fear and uncertainty that is associated with significant increases in risk premiums  and corresponding shortfalls in economic activity," he  said.  Discussing deflation, Greenspan drew a distinction  between declines in the prices of assets, such as  stocks and houses, and those of goods and services. He said a gradual fall in asset prices had contributed to the recent troubles in Asia but that in most cases this type of deflation could be absorbed by  the economy.  "But historically, it has been very rapid asset price declines -- in equity and real estate, especially -- that have held the potential to be a virulently negative force  in the economy," he added. The Fed is charged with seeking an environment of stable prices, in which neither inflation nor deflation is  a threat, while maintaining the maximum level of employment. Greenspan said the "remarkable progress" that had been made in bringing down inflation had brought the issue of price measurement into especially sharp focus. He said there were "uncertainties surrounding the accuracy of our measured price indexes," adding his weight to criticism of the main U.S. inflation gauge, the consumer price index. Inflation had declined to the point where even an upward bias of a few tenths of a point mattered, he said. "Inflation has become so low that policymakers need to consider at what point effective price stability has been reached," he noted.

    Economists listening to Greenspan's speech were struck by the attention on deflation after decades in  which the Fed has made the fight against rising prices  its overriding mission. "Today, he devoted a full 15 minutes to discussing the negative consequences of deflation," said Peter Kretzmer, an economist at NationsBank.  "It indicates that Greenspan will take a lot of care before he decides to tighten monetary policy and there  is even a possibility of an easing."
    Inflation, running at 1.7 percent in 1997, is at its lowest level in a generation and Fed research suggests even that figure may be double the actual rate of price  increases.  Asia's financial crisis has put a spotlight on deflation as producers in the battered region are expected to unload a glut of cheapened goods, bringing down global prices.
    Before the Asian troubles mounted, Fed policymakers were leaning in favor of higher interest rates because of worries that the nation's tight labor   market would generate wage pressures that could  feed inflation.  Allen Sinai, chief economist at Boston-based Primark Decision Inc., said Greenspan's remarks on  Saturday clearly showed that deflation was at least on   the Fed's radar screen.  "It's a tip-off they will not raise interest rates," he  said. "The Fed will be on guard in either direction."   Fed policymakers next meet on Feb 3-4 to consider interest rates. The key overnight federal funds rate currently stands at 5.5 percent and has remained  unchanged since March 1997. Moreover, on January 8, Federal Reserve Governor Laurence Meyer remarked that the Fed's next move could be an easing because of the strong effect of the Asian market jitters.

To understand the debate on deflation, one can start with several readings.

An Economist Article on Deflation

"Global Good Times, Meet the Global Glut" by Louis Uchitelle (New York Times)

Krugman's Fortune article on why deflation is unlikely to occur

Krugman's article on why we should not worry about a global glut in Foreign Affairs, Sep/Oct 1997

An Article by Jude Wanniski following Greenspan's speech (WSJ)

A WSJ Editorial following Greenspan's speech

An Op-Ed Piece by Holman Jenkins on theWSJ

Why Deflation is Bullish by David Ranson (WSJ)

The Fear of Deflation Is Latest Jitter on Street"  by Greg Ip (WSJ)

Krugman's critique of Greider's Book "One World, Ready or Not: The Manic Logic of Global Capitalism"

A more favorable review of Greider's book in Slate

For another skeptical view on the productivity boom hypothesis and the risks of deflation, see the arguments by Stephen Roach, chief economist at Morgan Stanley in three different pieces on Nov 19, 1997, Aug 1, 1997, and Aug 5, 1997 and a recent long essay he wrote on The Boom for Whom: Revisiting America's Technology Paradox (this latter piece is in PDF format).

Author: Nouriel Roubini, Stern School of Business, New York University, 1998.