The Growing Specter of Deflation

By Nicholas G. Carr

The Federal Reserve is nervous about falling prices. In a statement on May 6, Alan Greenspan and his colleagues warned that over the next few months “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.” Two weeks later, Greenspan went slightly farther, telling Congress that the possibility of deflation, a broad and prolonged drop in prices, “is sufficiently large that it does require very close scrutiny."

A look at recent economic data explains the Fed’s jitters. In April, according to the Labor Department, wholesale prices fell 1.9 percent, the largest monthly decline since 1947, and retail prices dipped 0.3 percent. The core inflation rate for the last 12 months was just 1.5 percent, the smallest rise in nearly 40 years. Investors, anticipating a further erosion in interest rates, have rushed to buy government bonds, sending the yield on 10-year Treasuries down to its lowest point since the 1950s.

It might seem reasonable to conclude that the weakness in prices is a byproduct of the sluggish economy, that companies are cutting prices to induce frugal consumers to buy. But it’s not so simple. The specter of deflation has actually been haunting the economy since the 1990s, a time of robust, even exuberant, economic growth. The prices of many goods and services, from hotel rooms to microchips, from apparel to pork chops, have been falling for years, and the essential cause is not too little demand but too much supply.

The technology-driven investment boom of the last decade, combined with the continued liberalization of world trade, has led to widespread industrial overcapacity and relentless competition. As one market after another has been flooded with products, many companies have simply lost their ability to maintain, never mind increase, their prices. They are suffering the consequences of too much prosperity.

The current situation bears a close, and disturbing, similarity to that of the late nineteenth century. In the 1870s, the world was also emerging from a technology-inspired spending spree - the technology then being long-distance transportation. The rapid spread of rail and shipping lines, along with the closely related development of the steam engine and the telegraph, opened the doors to global free trade and inspired massive commercial investment. The resulting combination of rapidly increasing production, surging productivity, and fierce competition set the stage for nearly three solid decades of deflation.

As Eric Hobsbawm documents in The Age of Empire, his history of the period, prices fell and businesses suffered even as the world economy continued to expand. Farmers, who for the first time faced competition from outside their local regions, were particularly hard hit. The price of wheat plummeted by about 60 percent between 1867 and 1894.

But agriculture was far from the only victim. The cost of goods fell dramatically across the board. In Britain, the dominant economic power of the time, the overall level of prices dropped by a staggering 40 percent. In the United States, prices for most products decreased steadily from 1867 through 1897. Although markets continued to grow, they didn’t grow fast enough to absorb the increases in production.

The deflation was a boon for consumers - for the ones able to hang onto their jobs and their wealth, anyway - but it was devastating for corporate profits. Despite the rapid gains in productivity provided by technological advances, prices dropped faster than businesses were able to reduce their costs. Manufacturers watched the value of their products erode while they were in the very process of making them - a phenomenon that today’s computer manufacturers can certainly relate to.

The consequences for society were often grim. As economic malaise spread, the belief in unbridled commercial opportunity that had taken hold in the middle years of the century died away. Workers lost their jobs, farmers and laborers rebelled, and countries began to rebuild barriers to trade. As the historian D.S. Landes put it, “Optimism about a future of indefinite progress gave way to uncertainty and a sense of agony.”

The world is different today, of course. We understand the dynamics of a global economy better than our nineteenth century forebears did, and we have better mechanisms in place to monitor commerce and trade. It would be dangerous to assume that history will repeat itself. But with companies struggling to boost profits and the world economy flirting with deflation, it would also be dangerous to assume it can’t.

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