Cheap Labor Ripples Through Global Economy

Contrary to prevalent theory, deflation, not inflation, may be the cause for concern

One hundred million unemployed Chinese crowd their cities, looking for work at less than a dollar a day.

And, in an updated version of the domino effect, that eventually means US homebuyers pay lower rates when they secure a mortgage; businesses in Germany can find cheap money when they expand; and US computermakers can keep prices low.

In a global economy, cheap labor in one part of the world helps explain why wealthy countries of the West no longer struggle with inflation. Low inflation is now so widespread around the world, in fact, that some economists are raising concerns about its opposite - deflation.

Inflation occurs when prices rise too fast; deflation - a rare event - describes an economy where prices actually fall.

That's already happening in some parts of the world, notably Japan and Switzerland, and last week the US Labor Department reported a drop in wholesale prices for the seventh consecutive month, down 0.1 percent in July.

That's the first time wholesale prices have fallen for that long in 66 years. During the Great Depression, they dropped for nine months.

Few, if any, mainstream economists are suggesting such a calamity. The benign hallmark of the prosperous 1990s remains declining inflation - "disinflation" not deflation.

But the trend of wholesale-prices in the US and Japan leads some analysts to wonder whether the downward spiral has more momentum than policymakers realize.

"There are gluts and overproduction everywhere," says Merrill Lynch strategist Charles Clough. "Inflation is not the threat. Deflation is."

In the US, economists are baffled by the combination of low unemployment, low wages, and stable consumer prices.

Federal Reserve Chairman Alan Greenspan tells Congress he is "puzzled." Fed Vice Chairman Alice Rivlin calls it a "mystery."

According to popular economic theory, inflation should pick up when unemployment falls below 5 or 6 percent.

But the jobless rate seems stuck near 4.8 percent, and inflation is still stable - a modest 0.2 percent in July and 2.2 percent in the last 12 months.

Part of the mystery can be explained by China. US companies can build products cheaply in China - and Thailand and Mexico - and keep the brakes on wages paid US workers.

Economist Philip Braverman says a Chinese trade official recently told him that when 100 million unemployed Chinese in the cities find work, 100 million in the countryside will take their place.

The entire American labor force, by contrast, is not much more than 100 million, Mr. Braverman notes.

When wages and prices remain stable, the Fed feels comfortable keeping rates low.

Peace also helps explain low inflation, he says. Wars generally bring inflation, with their high demand for workers and goods. When war ends, prices should decline.

That, he says, happened after the American Revolutionary War, the War of 1812, the Civil War, and World War I. It didn't happen after World War II because of the cold war, the Korean War, the Vietnam War, and the Gulf War.

Now, peace has returned and deflationary forces are in control, reinforced by growing world trade and investment.

Economist Mickey Levy of NationsBanc Capital Markets in New York says the US economy is able to grow at a 3 percent real rate - a bit higher than many economists believe possible. With the Fed keeping growth in current dollars to 5 percent, there is only room left for 2 percent inflation (5 percent nominal growth minus 3 percent real growth).

Under these conditions, business has little capacity to boost prices and must hold back wage costs, Mr. Levy argues. Levy expects inflation to remain modest, even when the economic pace picks up in the second half of this year. This combination of low inflation and a solid economy should be a "healthy foundation" for stock prices," he says.

Who Wins and Loses When Inflation Falls

Periods of disinflation - when inflation rates decline dramatically - have the following winners and losers, according to A. Gary Shilling, an economic consultant in Springfield, N.J.

Winners

* Savers.

* Pensioners and others on fixed incomes.

* High-quality stocks and bonds.

* Low-cost producers.

* The US dollar (if disinflation is very strong in America). Favors importers and tourists abroad.

Losers

* Heavily indebted individuals and companies.

* Owners of real estate, art, and collectibles.

* Commodity producers.

* Unionized labor in once-regulated industries.

* Indebted federal and city governments.

* Oil exporters.

COULD INFLATION DROP TOO LOW?

* If there's no inflation, there's a problem, argues George Perry of the Brookings Institution in Washington. Business needs a little inflation to smooth wage adjustments. Some industries and companies are thriving and must hike wages to attract new workers. Other businesses are in trouble or shrinking, and must trim wage costs to stay sound.

But it is extremely difficult to cut wages in current dollars. American workers usually revolt. It is possible, though, to let inflation trim real wages, Mr. Perry says. Management gives workers no wage hike or a small one that is eaten by inflation.

If there is zero inflation, unemployment will rise, not fall, Perry says. Since companies won't be able to lower wage costs through inflation, they will cut staff instead. Unemployment would rise quickly.

So the Federal Reserve should not aim for zero inflation, he holds.