- The Washington Times - Thursday, January 9, 2003

In the wake of lackluster economic performance during the fourth quarter, both in the United States and around the world, domestic and global deflationary pressures, which have a disturbing propensity to feed upon themselves, have almost certainly intensified. For several years, Japan has been afflicted by deflation, and its evolving economic crisis has become ever more frightful. Meanwhile, the German economy, the anchor of the eurozone, is struggling to avoid another recession, even as it fights its own deflationary forces. In this increasingly fragile worldwide economic climate, U.S. policymakers must prevent deflation from taking root here. To that end, President Bush's bold plan to reinvigorate the economy is the right policy at the right time.
Deflation, which represents a general decline in the price level, could pose extraordinarily serious problems for an economy where private-sector debt levels have soared in recent decades. That's because deflation increases the real burden of debt. In the United States, private-sector debt has skyrocketed from 100 percent of disposable income in 1960 to 120 percent in 1980 to nearly 180 percent today. By offering the expectation that future prices will be lower than current ones, deflation also encourages consumers to postpone spending. With consumption representing 70 percent of U.S. gross domestic product (GDP) for the past two-and-a-half years, such a development would be potentially catastrophic.
Deflation also would make it more difficult for the Federal Reserve to conduct countercyclical monetary policy. Once short-term interest rates fall to zero (the Fed's target overnight rate is now at a 41-year low of 1.25 percent), they cannot fall any more. The Fed would then be compelled to use other, less-effective tools in its policy arsenal. No wonder Federal Reserve Chairman Alan Greenspan uses the word "pernicious" to describe the effects of deflation.
Under the charitable assumption that the annual economic growth rate during the fourth quarter will come in at 1.5 percent, the U.S. economy will have grown by less than 2.5 percent for all of 2002. Growth was an anemic 0.3 percent for 2001. And GDP grew at an annual rate of less than 1 percent during the second half of 2000. This means that the economy has been operating below its potential for the last two-and-a-half years.
Economists have discerned a correlation between an economy's so-called output gap and changes in its general price level. An economy's output gap measures the difference between its actual output and its potential output (the level of output when resources are said to be fully employed). Since the mid-1990s, as more workers entered the labor force and became significantly more productive, potential output has expanded each year by about 3.5 percent.
Here's how economists explain the relationship between the level of output and the price level. When actual output exceeds potential output for example, the unemployment rate can fall below its full-employment level and the capacity-utilization rate can exceed normal cyclical highs the economy will experience inflationary pressures. As a result, the price level will increase at an accelerating rate. As the unemployment rate fell from nearly 5.5 percent in early 1997 to less than 4 percent in 2000, for example, the annual increase in the consumer price index accelerated from 1.7 percent in 1997 to 3.4 percent in 2000. Conversely, when actual output falls below potential, the economy experiences disinflationary pressure as the rate of inflation declines. Consumer-price inflation fell from 3.4 percent in 2000 to 1.6 percent in 2001, for example, as actual output fell below potential output.
Last year, potential output once again exceeded actual output, which probably grew by less than 2.5 percent. Cumulatively, the output gap is getting wider. As the U.S. labor supply continues to increase inexorably, so too does potential output. Meanwhile, productivity (output per hour of labor) continues to soar, causing potential output to rise even more. Over the past four quarters for which data are available, output per person in the nonfarm business sector has risen an astounding 5.6 percent, the highest rate in more than 50 years.
Unfortunately, actual output has not kept pace with the increases in potential output for the past two-and-a-half years. As a result, unemployment, which reached a cyclical low of 3.9 percent during 2000, has increased to 6 percent today. And unused production capacity is nearly 25 percent. As the output gap has widened, there's no mystery why deflationary pressures are intensifying.
Two important price indexes confirm that deflationary pressures have made themselves felt throughout the economy. The economy-wide GDP implicit price deflator has increased by less than 1 percent for the four quarters through the third quarter of last year. The annual GDP deflator has not been less than 1 percent since 1949. Even more disturbingly, a Commerce Department price index that measures the prices received by non-financial businesses has actually declined for four quarters in a row. That hasn't happened in more than 50 years.
When an economy operates for an extended period below its potential output rate, disinflationary pressures (the tendency for inflation to fall) can evolve into outright deflation, when the price level actually declines. This is especially so as the output gap widens. The United States may be approaching that tipping point now.
Based on an average forecast of 2.6 percent for U.S. economic growth in 2003, as compiled by the Economist magazine, the output gap would widen yet again in 2003, producing even more intensifying deflationary pressures.
While there is still time, policymakers need to take action to thwart that outcome. As Mr. Greenspan has frequently noted in the past, and as Japanese experience has confirmed, once deflation takes root, it is even more difficult to fight. In this context, Mr. Bush's economic-stimulus and growth-enhancement package, which he unveiled Tuesday, is as timely as it is necessary.


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