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Deflation launched great depression Original Source Link: (May no longer be active)
http://www.examiner.com/business/default.jsp?story=n.smilgis.1115whttp://www.examiner.com/business/default.jsp?story=n.smilgis.1115w
Publication date: 11/15/2002
Worst-case scenario: deflation
BY MARTHA SMILGIS
Special To The Examiner
LAST WEEK, Alan Greenspan shocked Wall Street by slashing the federal funds rate to 1.25 percent from 1.75 percent. On first inspection, this is a positive move. The U.S. economy has again teetered toward recession during the past two months. Economic growth has sputtered to 1 percent from 2.5 percent while consumer spending has stalled. Theoretically, lower interest rates will stimulate growth by boosting the availability of cheap money for businesses.
Unfortunately, many economists view the rate cut as drastic. They think the Federal Reserve is running scared, in panic mode, hoping a larger rate cut will reinvigorate the economy before it is too late.
Speaking before Congress this week, Greenspan attributed the renewed slowdown to geopolitical risk. Translation: war with Iraq. He assumes that when the geopolitical risk passes, the "soft" economy will improve. He calls the rate cut insurance against "permanent decline."
Permanent decline?! Guess what, folks, that means long-term deflation, the hydra-headed monster that last appeared from 1929 to 1933 and launched the Great Depression. To be accurate, Greenspan insisted the risk of deflation is "remote." (Inflation is an equal possibility, but it is easier to correct by simply hiking rates.) And yet, he revealed that the Federal Reserve has prepared a battle plan if deflation, though unlikely, should come to pass. (The Fed would reissue long-term paper, or 30-year bonds, much like those issued during World War II.)
Optimists, such as Larry Kudlow on CNBC, swiftly dismiss any possibility of deflation. They assume we will win the war with Iraq and happy days will be here again. Why? Short-term victory will not win the hearts and minds of a billion Muslims. If anything, it might solidify their hatred toward the United States. We are using their oil (our companies will increase Iraq's production to 5 million barrels a day) and stealing their land (the West Bank of Palestine, most obviously).
A war with Iraq and its aftermath will add an estimated $200 billion to the mushrooming deficit. Meanwhile, our trade imbalance continues. Imports keep rising while exports remain weak. Until the dollar started its downward spiral against foreign currencies, this was OK. Although Americans bought more foreign goods, the money that foreigners reaped from those goods often was invested in the U.S. through the stock and bond markets. Unfortunately, this is no longer the case.
There are some chilling comparisons between 1929 and today. The Nasdaq's bubble and subsequent drop of 80 percent from its high perfectly corresponds to the stock crash of 1929. At that time, prices went down 24 percent. Unemployment was at 25 percent. Today, unemployment is under 6 percent. But for how long? In a recent survey, 60 percent of CEOs said they expected to cut staff next year. Given our low interest rates, a rise in unemployment to just 8 percent could tip us into deflation.
Exactly what happens in deflation? Prices for goods fall. Wages follow falling prices, and in time, corporations (and individuals) can't pay their debts. Foreclosures and bankruptcies seal the whole ugly package. But we are not in a deflationary cycle just yet. Inflation is around 1.4 percent. Still, prices for many consumer goods are eroding. Just look at computers and clothes. Check prices for telecom services and stocks.
Corporations count on consumer buying to pay down their debt. Right now, corporate debt is so high that 89 percent of corporate revenue goes to service that debt. Some auto companies only make $400 of actual profit on the cars they sell. They must sell new cars (zero financing, zero down) or go bankrupt.
Of course, real estate is the shining star. But many economists think that market is about ready to blow apart. (Keep in mind that in Japan, deflation started when the real estate bubble burst.) Fortunately, the U.S. is a more variegated economy, with levers and pulleys that pick up the slack when one industry trips. A Japan-style deflation is unlikely. Still, increased unemployment, declining prices and wages, a growing deficit and an anemic stock market spell trouble. During the Great Depression, more than 40 percent of mortgages went into default. Home values dropped 50 percent.
If a mild deflationary scenario comes to pass, cash is king. There will be eye-popping bargains in stocks and real estate if you are among the lucky who kept their powder dry.
E-mail: msmilgis@examiner.com
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