Alternative Insight

Taming Deflation
War mobilization as an economic solution
The Deflationary Trend

In October, 2001, The Bureau of Labor Relative Statistics in Industrial Production and Payroll Employment (plus Manufacturing Sales and Personal Income) verified the United States recession. The apparent recession contained seeds of disinflation, in which prices rise at a continually decreasing rate that quickly approaches zero. After price rises become nil, an economy can enter a deflationary trend and generate problems.

Economists were alarmed but not desperately troubled with the declining economic situation. The American economy suffers periodic recessions and the economists expected the tremendous expansion of the last ten years would lead to a temporary decline. The economy has always quickly emerged from a recession and renewed its expansion, except for the depression of 1929, when a severe deflationary spiral accompanied the declines in other economic indicators. Could this be happening now?

Back in October 2001, a deflationary trend started to appear--consumer prices fell 0.3 percent and the Producer Price Index, a gauge of inflation in wholesale prices, dropped 1.6 percent, the biggest decline since records started in 1947. Prices of industrial commodities, such as steel and cotton, rubber and tin, fell to their lowest levels in 15 years. Economists and government officials disagreed on the extent of the deflationary trend.

"Some sectors of the U.S. economy may experience a deflation in prices during the current period of softness, but there is little risk of broad-based deflation," Michael Moskow, the head of the Federal Reserve Bank of Chicago, said at that time.

So, what's the problem?

One fear of deflation is that, unlike inflation, debtors are repaying creditors with more valuable dollars, which transfers wealth from debtors to creditors. As prices fall and deflation is enhanced, the real interest rate (the difference between the interest rate and the inflation rate) increases. Deflation's high real interest rate depresses investment, lowers demand and increases unemployment.

The world economies have become highly competitive, and overproduction has forced reductions in prices. The abundant production stimulates deflation. The competition in global expansion demands cheaper sources of well equipped labor. As one example, the labor intensive apparel manufacture has graduated to worldwide cottage industries and manufacturing centers that continually pursue cheaper labor and use refined merchandising methods to facilitate market entry. Huge capital investments have brought a glut of production facilities in automobiles, steel, semiconductors, electronics, etc. Technologies that simplify the production of goods and their market entry aggravate the glut. Electronics, especially computers, consumer appliances, communications hardware, etc. can be easily designed and assembled from a combination of non-proprietary microchips. In many industrial sectors, a budding electronics manufacturer can begin production after raising capital, which was readily available during the 1990's.

Industrialized Western nations that exhibit stagnant population growths (except for the U.S.) cannot absorb the increased production. As worldwide inventories build, markets decline and competition forces drastic price cuts. Since markets remain saturated, the only means to stop the competitive trend and the fall in prices are by a reduction in the number of companies and their production facilities--bankruptcy. That has happened.

Internet companies, which competed by selling to one another, have been the first casualties. The competitive electronic, computer, communication, fiber optics, wireless and steel industries has had many failures. Even after the industry shakeouts, the problem might remain. Unless an industry has a monopoly or some legal or secretive means to regulate prices, manufacurers will produce in accord with classical economic theory, until the marginal profit is zero. Without profits, the capitalist system folds.

Profits-The Real Problem
Marginal profits lead to marginal companies, many of whom fail. Sliding companies lead to sliding employment and sliding demands for consumer and capital goods. The uncoordinated approaches to the potentially crippling problem can prove more crippling. The government realizes the perilous situation and intervenes. Taxes are refunded, some troubled industries receive government loans, long term bonds are no longer issued and short term interest rates are lowered to almost zero.

These policies have not always been effective. If the Japanese economy is a guide, then the policies don't work. Japan has used similar policies for a faltering economy that entered deflation. The policies have not corrected the economy or prevented the deflation. Deflation is becoming a global phenomena and threat. In order to contain the deflationary threat, Washington is steadily moving towards a non-conventional policy--perpetually mobilizing for war.

Mobilization for War -- an economic solution

The inflation rate in the United States shows that Inflation increases dramatically during mobilization for war. In World War I and World War II, inflation reached high rates. During the Cold War, a slow simmering inflation ignited into hyperinflation at the end of the 70's decade, and then subsided to lower levels. The ending of the Cold War unleashed the "peace dividend." Government budgets, labor, newly developed technologies, and capital became optimized for economic growth rather than for development and production of military products that didn't assist in capital formation. The less hostile atmosphere convinced investors that foreign nations were sufficiently stable and not prone to "Cold War" influences. World economies "boomed" until becoming constrained by competition, overproduction and falling prices. Similar constraints occurred before the Great Depression.

The United States and its "New Deal" of the 1930's did not fully emerge from the Great Depression until it entered World War II. The totalitarian and militaristic countries, Germany, Italy and Japan, all of whom had been mobilized for war, exhibited rapid recoveries before WWII.

The United States mobilization for war against international terrorism and the almost total mobilization for a "war" environment might prove fortuitous for the U.S. economic environment. "Mobilization for war" creates employment, which allows increased demand that is not accompanied by increased supply. In that situation, prices tend to rise. Budget deficits contribute to higher interest rates and a slowly increasing inflation. Government demand for goods, its controls and industry protections ensure prices cannot fall--which leads to two questions:

Are U.S. government planners considering that "mobilization for war" might halt deflation? Or vice-versa: Have government planners decided that deflation requires a "mobilization for war?"

alternativeinsight
December 1, 2001
updated: January 26, 2003

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