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World: Recent Trends Show Deflation Can Be As Bad As Inflation

The Japanese economy is suffering from the rare and still poorly understood problem of deflation. Consumer prices are falling, and there appears to be no end in sight. For countries and populations ravaged by runaway inflation and even hyperinflation, deflation doesn't appear to be much of a problem. But economists say deflation may actually be worse than inflation and, in any event, is harder to deal with.

Prague, 6 March 2002 (RFE/RL) -- U.S. President George W. Bush inadvertently highlighted Japan's vexing problem of deflation when he made an embarrassing gaffe in Tokyo last month.

Speaking to reporters after meeting with Japanese Prime Minister Junichiro Koizumi, Bush mistakenly said the two leaders had discussed the issue of "devaluation." What he meant to say was "deflation." The comment sparked a minor currency crisis as traders, thinking Bush meant a devaluation of the Japanese yen was imminent, sold off the currency.

The gaffe, however, did help to underscore how poorly understood the problem of deflation -- in other words, falling consumer prices -- really is. Bush's error was understandable. Few people outside of Japan have ever even heard of deflation.

Economists define deflation as a "persistent decrease in the level of consumer prices." It's the textbook opposite of inflation -- which is a sustained rise in prices.

But while many countries have battled inflation and some have coped with hyperinflation, Japan is the only industrialized economy in modern times that has had to combat deflation. Prices have now been falling for more than two years.

At first glance, deflation does not appear to be much of a problem. As prices fall -- and wages remain steady -- real incomes rise. But economists say deflation is just as serious as hyperinflation and may even be more pernicious.

Colin Asher is an economist at the Japanese investment bank Nomura Securities, based in London. He tells RFE/RL that deflation is dangerous because it creates a downward momentum: "In deflation, [there's] a declining spiral. Businesses make less profits so they cut back [on] employment. People feel less like spending money. Businesses then don't make any profits and everything works itself into a declining spiral."

The causes of deflation are two-fold. One is cyclical and occurs normally when an economy enters a weak phase. Companies are forced to eliminate jobs and, in turn, the demand for goods and services falls. Consumer prices then fall because of the lower demand.

Pockets of this kind of deflation are to be found in all developed economies, but there are usually sufficient inflationary pressures -- such as rising commodity prices -- so that the problem does not last.

Asher says in Japan, deflation has become more serious because of what he calls "structural problems." For years, he says, prices in Japan have been too high -- among the highest in the world. But as Japanese companies have increasingly farmed out labor to low-wage Asian countries, production prices -- and the prices of finished goods -- have dropped.

The lower prices are initially good for consumers, but ultimately the reduced prices translate into lower corporate profit margins, and the downward spiral begins.

Prolonged deflation squeezes consumers by lowering the value of homes, real estate, and investments, while leaving interest payments on debt and obligations unchanged. It hurts companies by depressing the value of factories and investments.

Deflation -- as with inflation -- becomes rooted in peoples' psychologies and becomes self-perpetuating. Consumers are discouraged from buying expensive items like automobiles or homes because they know those things will be cheaper in the future.

Economists say the main problem with deflation is that there are not many remedies available to fight it. By comparison, tools for combating inflation are relatively numerous and effective in practice.

When prices are rising, central banks typically raise interest rates to reduce the supply of money in an economy. Higher interest rates slow borrowing -- and thus spending -- by businesses and consumers. Prices fall as the demand for goods falls.

Asher says the obvious remedy for deflation -- reducing interest rates -- is not nearly as effective. The Bank of Japan, the country's central bank, for example, has already cut interest rates to zero to stimulate demand, but without much effect.

"Well, [the obvious remedy] would be to cut interest rates, but unfortunately Japan's interest rates are already at zero. So there's no scope for looser monetary policy in these circumstances. Japan finds itself in a liquidity trap. There's no demand for credit so it doesn't matter what the Bank of Japan does."

The other obvious solution would be for the Japanese government to increase spending to inject more cash into the economy. It could do this by printing money or borrowing it.

Asher says the government is not interested in printing more money and has so much debt that it cannot afford to borrow much more. In any event, he says, borrowing money may be counter-productive.

Any borrowing now would have to be paid back later through higher taxes. Asher says consumers will see this and begin saving -- meaning the stimulus effect would then be lost.

"The government [could] spend large amounts of money to prop up employment and spending within the economy. But again, here in Japan, the problem is that the government already has extremely large debt. And to get back to the problem of the debt trap that we mentioned earlier, obviously the problem of the debt is that it has to be paid back sooner or later. If consumers see the government raising the levels of debt, the government will have to raise taxes later. [Consumers] will start saving for that eventuality at some stage."

Economists say there are signs that consumer prices are falling in some Western European countries, sparking some concern that the deflation contagion could spread.

Britain's "Financial Times" daily recently noted that prices for goods like women's clothing, televisions, electronic products, and gasoline have all dropped on the order of 10 percent in recent months.

While the paper notes there are few signs of genuine deflation in Britain, the drop in the prices of some goods nevertheless is likely to have implications for the central bank, the Bank of England, as well as for other central banks. The paper argues they may have trouble raising rates now after cutting them recently to stimulate the economy.

Asher says that -- luckily for Britain, at least -- there's enough inflationary pressure in the economy to prevent deflation from firmly taking root.

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    Mark Baker

    Mark Baker is a freelance journalist and travel writer based in Prague. He has written guidebooks and articles for Lonely Planet, Frommer’s, and Fodor’s, and his articles have also appeared in National Geographic Traveler and The Wall Street Journal, among other publications.