Deflation or Inflation or Both???

[Richard Wilson]

There has been a belief that deflationary pressures would grip the industrialized world in the coming years, however, the truth is rather the opposite. The United States will more than likely experience a gradual rise in inflation as the overvalued American dollar adjusts and reaches a justifiable value. The other factor which will contribute to inflation in this country is the rise in monetary aggregates caused by the printing of currency and the injection of that paper money that is without any value except the value that the markets assign, into the banking system or into purchasing government treasury bonds to finance the shortfall of the government caused by the most significant arms buildup since the first term of a President Ronald Reagan (Republican) and by ideological "trickle down" tax reductions aimed at the wealthiest 10% of our society.

The position of the US dollar as the universally used currency for measurement on the exchange market - the Forex - granted by the Brentton Woods Agreement of 1944 , (an agreement that arose to rebuild Western Europe, in an attempt to prevent the spread of Communism), has given a favorable position to our dollar and has created artificial demand for dollars that would ordinarily not exist, giving our central bank and treasury, the power to enormous amounts of credit during a slowdown that others can't do. One would expect, unless there was a total change within the Membership of the Federal Reserve, the continuation of current policies aimed at boosting aggregate demand in an attempt to clear the market of excess inventory which accumulated during the late 1990's, especially in the telecommunications, semiconductor, software and computer industries. As the expansion of credit continues (supply) , unless demand abroad continues to create an equilibrium, the US dollar will be under pressures which could drive the valuations downward.

In addition to the threat of growing credit is the current account deficit which is forecast to be over 4.6% of the Gross Domestic Product this year. A current account deficit is a drain on the economy, because it pulls money out of the economy, that means for it to be sustainable, foreign money must flow into the country to make up for the import/export imbalance. During the roaring 90's, foreign investors flooded our equity and bond markets as the Dow Jones & NASDAQ performed well and corporations were sucking up money like vacuum cleaners to cover the cost of rapid expansion. Today, the situation is the opposite. Foreigners own over $7 trillion in American assets, if the tide were to turn and investors were to liquidate their assets, the amount of dollars abroad would soar, sending the dollar down while draining our domestic market of money, sending interest rates higher.

With a weak domestic manufacturing sector, proven by a continous decline in production and a low 75.6% capacity utilization and with the shopping spree continuing so far, courtesy of the lowest interest rates in 40 years, the current account deficit is not set to contract anytime soon. With a government deficit of $306 billion and possibly more if the cost of a war in Iraq are included, the government is absorbing never before seen, sums of money from the private sector, which means the likelyhood of improvements in equity markets, even given that corporate profits were to improve, which is unlikely, aren't set to improve. In fact, most economists and stock market analysts believe that performance this year on stocks is going to be rather anemic and disappointing. With the decline in the US dollar included in the losses for foreigners, the supply of foreign investment flowing in will dwindle or reverse.

There are absolutely, no indicators which suggest that deflation is a threat in the United States, in fact, such a possibility would actually be beneficial, because it would allow for continual monetary easing without consequences. There are more than a handful of similarities between the current state of the United States and the problems faced by the Japanese in the 90's and present period, though, deflation is not one of them. Monetary aggregates, though the Japanese government continued to print paper at remarkable speed, the banks did not lend because banks were left with many bad loans (nearly $750 billion worth). The Japanese government and the banks sort of have a mutual agreement going on, where the Japanese government doesn't make the banks come clean with the full damage and the banks don't collapse. Anyways, without the banks lending the money, monetary aggregates (M2 & M3 combined) remains pretty much unchanged. M2 in Japan in 1993, actually fell by a percentile, peaking at 4% rise in late 1998 to early 1999 and than falling back to 2% change for 2000. That and the fact that the Yen was appreciating against the dollar in both 2001 and 2002, placing the manufacturing sector at competitive disadvantage and it should come as no surprise that deflation is a persistant phenomenon with an improbable improvement in the future.

Compare that to this country, where the banking system is so far out performing those in Europe, Asia and South America. Our banks continue to lend money as if it were water (which it is considering a shift in the minds of key world investors could make it worthless). This does not mean that our banking system won't find itself in the same shape as Japan in the future, in fact, personal and corporate bankruptcies have recently broken the former record . As the markets and economy as a whole continue to restructure production, investment and consumption, former sectors of the economy which were the symbols of prosperity in the 90's (telecoms, airlines, semiconductors, computer markers, the internet) will be purged of excess capacity and competition - driving many straight into the ground, leaving the unfortunate banks which supported the exuberance with worthless loans, undermining the health of our financial system.

There has been some speculation among the liberal groupings in this nation, that inflationary pressues could actually benefit the economy, which is one reason for the continual focus and optimism on deflation. The theory is, inflation would boost corporate profits, revenue leading to business investment and that it would erode the debt burden on the backs of corporate America. The inherent flaw in this petty and most ludicrous of economic arguements, is that (nominal) values mean nothing. So what if the nominal value of goods and services rise, causing nominal corporate profits to be augmented in size? The real value is what matters. Inflation, more than anything else, would actually harm corporations. A rise in prices would have to be caused by either a weakening dollar or by a change in the monetary aggregates - which would affect the valuation of the USD. This would cause foreign direct investment to fall, reducing the supply of capital available for businesses, it would also, as mentioned, erode the value of debt, but by doing so, hurt the banks which are the center of the capitalist economy, (both causing higher interest rates). Inflation would inevitably lead , as it always does , to rampant speculation in an attempt to beat inflation instead of employing capital in the more productive areas, these bubbles would later burst sending shockwaves. The masses, angered and rightfully so, by the rise in prices, would rebel and revolt, demanding higher wages from the employers as well as an upward fixing of benefits to sustain the current standard of living and while nominal profits might rise, real profits (or the amount that the profits can purchase) will be lowered.

The truth is, inflation is already skyrocketing, but the consumers aren't feeling the pinch, because the inflation is being absorbed by wholesales and retailers. Producer Price inflation was 3.8% in 2002 (and a 13.5% increase in the prices of raw materials used in industry), and consumer price inflation was 2.4% which was up from 1.6% in 2001. In 1997 and 1998, the chance of deflation was even more so than now and the economy was prospering than, yet no one even mentioned the possibility of deflation at that time period. In 1997 and 1998 , the CPI rose 1.7% and 1.6% which was as low as was in 2001. With the PPI exceeding the CPI, one can conclude that the additional costs aren't being transfered to the consumer at the present time, but are instead, absorbing profits.

[Richard Wilson]

Even Money Magazine's 2003 Forecast paints the picture: "One current cause for worry is the notion that the United States is in the midst of a deflation. That's false by definition, since one key inflation measure, the GDP deflator, is rising at just over a 1 percent annual rate and consumer prices are climbing faster. Even so, Federal Reserve officials acknowledge that there is a slim chance of a downward price spiral within the next few years. Maybe so. But with money-supply growth topping 7 percent, it seems more likely that inflation will pick up."

We learned, in Marx's Das Kapital that the exchange value of a product differs based on the amount of labour manifested in the commodity, which explains why a hand-made Mercedes Benz costs far more than your typical machine-made Ford Taurus and that a change in productivity ment a lower price, that being when gold was the commodity that all other commodities were compared to. The value of gold was relatively stable, even though it did vary to some degree preventing it from being foolproof and when the value of gold declined, the prices rose even if productivity was high, but not the real value. For example, let's assume a good is $2 this year and the supply of money tripled over the next 4 years and the value of the dollar changed accordingly, all other factors being equal, and after the 4 years, the commodity is priced at $5, does this mean the price is higher? Not really, because for the price to have been higher, it would need be priced at over $6. However, as Monetarists have proven, if productivity continues to grow at a higher rate or an equal rate to the change in money supply and value, than inflationary pressures can be contained or lead to deflation and that is one of the primary reasons why inflation hasn't been higher in recent years as Alan Greenspan even stated in 1999 and why it took so long for him to tighten the monetary policy.

In both 2001 & 2002, the growth of worker productivity has been nothing short of remarkable, even if it was a bit less than during the post war boom lasting from the mid 1940's to the 1970's. The problem with the recent boom in productivity, is that it is not sustainable because instead of being the result of capital investments and the procurement of new machinery, equipement and technology, it is the result of downsizing in corporate America and the sacking of unnecessary workers that were formely not required to perform the tasks at hand, but were still on the payrolls as well as making remaining workers, work longer and harder hours, squeezing more and more out of the employee. It would take on dense individual to assume that the productivity of the past 2 years can continue any further than the 4th quarter of the current year. As the rate of productivity decelerates, the change in prices will accelerate.

The economy as a whole is not going to improve either way though. The airlines still have 15% more seats than are being used, that isn't going to change, the current account deficit isn't going to improve, the end of the Multi-Fibre Agreement in 2004 ends, which will destroy what remains of the American textile industry, advertising isn't improving, in a best case scenario the telecommunication sector won't achieve profitability until 2007, health insurance costs are soaring , the shortfall in pension funds is going to harm companies, runaway deficits threaten to undermine the fiscal health of the country. Unemployment will continue to move upwards toward the skies and consumer spending will most certainly be curtailed by geopolitical conflicts and the burden of interest on previous expenditures made possible by Visa, Discover and Mastercard and your local community bank. Most certainly, profits will fall in real terms as will revenue and the gross domestic product. But on the otherside is the nominal inflation caused by the weakening dollar that will cause speculation in real estate, equities and bonds which will later burst and will threaten our banks. It's the worst of both worlds for corporate America and there just doesn't seem to be an end in site.......