_____Correction_____ In yesterday's column by Robert J. Samuelson there was a typographical error in a sentence that should have begun: "From 1929 to 1933, consumer prices fell almost 25 percent . . . " _____What's Your Opinion?_____ • Share Your Views About Editorials and Opinion Pieces on Our Message Boards • About Message Boards E-Mail This Article Printer-Friendly Version Subscribe to The Post

By Robert J. Samuelson
Wednesday, November 21, 2001; Page A23

What do computer chips, coffee, oil and airline fares all have in common? Their prices are falling. It is a mark of the changed economic outlook that deflation -- a general decline in prices -- has quietly replaced inflation as a threat. Last week, the Labor Department reported that consumer prices fell 0.3 percent in October. A week earlier, the October Producer Price Index (reflecting raw-material and wholesale prices) dropped 1.6 percent from September, the biggest monthly decline in the index's history since 1947.

Economists worry about deflation because it can be enormously destructive -- at least in theory. Jack Lavery, the former chief economist for Merrill Lynch, points out that deflation poses multiple dangers. If consumers think prices tomorrow will be lower than today, they may postpone buying. That would depress production, threatening even lower prices and a deflationary spiral.

Likewise, deflation harms borrowers, because they have to repay their debts in costlier dollars. Suppose you're a widget maker with a $1 million loan. With widgets selling for $6 each, you easily make your loan payments. If widgets drop to $4, you struggle. Perhaps you fire workers or cut wages. Maybe you default or simply shut down. Now your bank (or another lender) has suffered a loss. It has less money to lend to others. So deflation can trigger a chain reaction of layoffs, defaults, bankruptcies and tight credit.

Against this grim backdrop, what do we know about deflation? Herewith a brief primer.

Do we have it?

Not yet -- and many economists doubt we ever will. Despite last month's drop, the Consumer Price Index (CPI) has risen 2.1 percent in the past year. The CPI's recent decline stemmed mainly from lower gasoline and home oil prices, down 12.6 percent and 11.7 percent from a year earlier. Still, some other prices also fell: hotel rooms (-3.4 percent over the year) and clothing (-2.5 percent). As for the Producer Price Index (PPI), its tiny year-over-year deflation (-0.4 percent) won't automatically lower consumer prices. The PPI dropped in 1991 (-0.1 percent) and 1997 (-1.2 percent) without dragging down the CPI.

One reason is that the PPI excludes most services -- health care, college tuition, cable TV. "I think the likelihood of a full-blown deflation in the United States is about nil," says Mark Zandi of Economy.com, a forecasting service. "Half the things we buy are services . . . that are based on labor costs. Compensation costs [wages, salaries, fringes] are slowing but not falling."

What does history teach?

Just this: Deflation's dangers seem greater in theory than practice. "We've had a couple of recent recessions with deflation: one in 1937-38 and another in 1948-49. We recovered from those quite nicely," says economist Allan Meltzer of Carnegie Mellon University. In both cases, says Meltzer, the Federal Reserve prevented a deflationary spiral by easing money and credit. Even before the Fed's creation in 1913, deflation wasn't fatal if it was mild. Prices drifted down slowly in the late 19th century (about 2.5 percent annually from 1865 to 1880) without crippling industrialization. Railroads, steel companies and meatpackers all expanded rapidly. However, falling crop prices hurt farmers, who were often big debtors.

The scary counterexample is the Great Depression. From 1929 to 1933, consumer prices fell almost 205 percent, unemployment rose from 3 percent to 25 percent and 10,797 banks failed. This was a classic deflationary spiral. Meltzer blames the Federal Reserve for not stopping it with easier credit.

Do other countries have deflation?

Yes. In Japan, consumer prices have been falling slowly since late 1998. Hong Kong and Argentina also have modest deflation, says economist Nariman Behravesh of DRI-WEFA, a forecasting service. In the past year, consumer prices have dropped 1.2 percent in Hong Kong and 1.7 percent in Argentina.

But these deflations seem more a consequence than a cause of economic distress. In Japan, bad bank loans and scarce investment opportunities have enfeebled economic growth. Weak demand and surplus industrial capacity push down prices. As for Argentina and Hong Kong, their currencies are tied to the strong dollar. That has made their exports expensive and their imports cheap. Domestic policies (interest rates, budget) have been kept tight to prevent huge trade deficits, resulting in falling prices and rising joblessness.

Up to a point, all this is reassuring. Indeed, a brief deflation might speed up economic recovery by strengthening Americans' purchasing power. But there's one huge unknown: the possibility of a devastating global deflation that might overwhelm central banks like the Federal Reserve.

Three-quarters of world trade now consists of manufactures -- steel, clothes, toys, electronics, tractors, cars, shoes -- that compete directly with domestic goods. Because many of these products are similar, they follow the laws of supply and demand. Surplus supplies push down prices -- and, clearly, there's worldwide surplus production capacity. In the United States, industrial production has declined for 13 consecutive months. Japan is in recession; Europe is close (its unemployment is headed back toward 10 percent, say economists at J. P. Morgan). Here are the ingredients of a powerful global deflation.

Lower prices would cripple export earnings (in dollars, euros and yen) of developing countries, which would have trouble paying for imports. Trade would suffer. Debtor countries would also strain to repay international bank loans and bonds. Argentina has already effectively defaulted. There may be other losses that hurt creditors -- banks, insurance companies and pension funds -- in developed countries. Worse, manufacturers in the United States, Europe and Japan would experience a growing squeeze as prices, profits and capital investment fell. With unemployment rising, the damage might then afflict services industries. They aren't totally immune to supply and demand. After Sept. 11, airline fares and hotel rates dropped; these are services.

The Fed isn't eager to explore this logic. Its frantic interest-rate cuts aim to restart the U.S. economy so that deflation's theoretical dangers remain just that. Stay tuned.