Contemplating Deflation: A Real Good-Times Party Pooper

With inflation successfully subdued, at least for the time being, it is not surprising that some Americans are now worried about the prospects for deflation. Surely the quick and sharp declines in Asian economies are cogent reminders of the possibility elsewhere of a similar rapid and widespread drop in the prices of goods, services, securities, etc. Moreover, older generations recall the great hardships experienced by many during the prolonged depression of the 1930s.

Nevertheless, most economists find it difficult to conjure up a realistic situation in the United States in the near future where prices in general decline very sharply. Unlike the 1970s, important regions of the world show real economic strength, notably North America and Europe. Also, unlike the earlier period, we have learned a lot about both the structure of our financial institutions and about the operation of economic policy.

For example, few among our fellow citizens now buy large amounts of corporate stock with a very low margin or percent of cash. A sharp decline in stock prices now mainly means a paper loss (or a smaller paper gain than had been anticipated). In 1929, the same drop could mean that your loan was no longer covered by the value of the stock and that you could lose your entire investment. In many other ways, we live in a different type of economy.

Yet, it may be helpful to examine the kind of hypothetical situation that characterizes deflations such as the 1930s experience.

Unlike the present times - when the prices of some items decline but the prices of many more items rise or at least are stable - in our hypothetical scenario, prices of goods, services, and assets (both financial and physical) drop sharply.

The emphasis is on the widespread nature of the price cuts. After all, it is not unusual to see the prices of specific items decline substantially due to technological advance or regulatory reform. Examples range from computers to trucking to long distance telephone calls.

Based on past experience, what can we expect in an economic environment in which most prices decline? In good measure, the results will depend on the causes of the deflation. The relevant prior experience in the US was a deep depression. One point emerges from most such experiences: There will be winners as well as losers. In the best of times, some people lose their shirts. In the worst of times, fortunes are made.

In a period of substantial deflation, we can expect interest rates and wage rates to fall as well as the prices of goods and services. Thus, holders of bonds with fixed and relatively high interest rates will be clear winners - unless the issuer goes broke. Long-term Treasury bonds become an especially desirable asset to hold, while the value of common stocks tends to fall.

While wages in general may drop sharply, workers covered by union contracts experience a substantial increase in real incomes - providing that they are not laid off or that the employer does not go out of business. Holders of government jobs, especially in the civil service, tend to do well as their salaries show more stability than those in the private sector.

Debtors often lose their homes, farms, and businesses when their diminished incomes do not cover the interest payments required. Businesses go bankrupt when their reduced sales fail to cover their fixed costs. With lower incomes on the part of taxpayers, government revenues decline. The federal deficit increases rapidly. State and local governments, many of whom are constitutionally unable to run current account deficits, curtail employment, further dragging down the level of economic authority.

In a downward spiral, government finds it hard to stimulate the economy. There are relatively few creditworthy borrowers, even at the reduced rates of interest characterized by an easy money policy. Fiscal policy - a combination of tax cuts and spending increases - is relied on to raise the level of economic activity and thus to restore price stability. Then again, the alarm clock could ring and we would awaken from this bad dream!

* Murray Weidenbaum is chairman of the Center for the Study of American Business at Washington University in St. Louis.