Gray on global deflation
Source Ian Murray
Date 01/03/26/22:59

Another Wall Street slide could set off worldwide deflation. And Japan shows
where that leads

Special report: Japan
Guardian Unlimited Money

John Gray
Tuesday March 27, 2001
The Guardian

"We need to tame deflation and make it benign. To do so we need not just
different policies but a different economic philosophy." The Japanese banker
who told me this a week ago in Kyoto was not speaking only of Japan. Unlike
most western observers, he understood that the world is returning to a
condition it has not known since the late 19th century, when globalisation
first got under way. Deflation is built into the global economy that has
emerged in the wake of the cold war. The question is whether we can prevent
it from spiralling out of control.
While the stock market continued to defy gravity few people took seriously
the idea that we may be returning to a world of steadily falling prices.
Deflation might be entrenched in Japan, but there was no reason to think
that it could spread. The vast destruction of wealth we have seen in stock
markets over the past few weeks has shattered that complacent consensus. As
in Japan, the risk is that a further collapse in the stock market will
rebound on the real economy and reinforce the deflationary forces that go
with globalisation.

Until only a few months ago, the suggestion that the long boom on Wall
Street would end in a Japanese-style crash was treated with derision. With
few exceptions, western commentators insisted that it rested on sound
economic fundamentals. A surprisingly large number gave credence to the idea
that the US had entered a "new era" of crisis-free growth. This was, of
course, sheer tosh. No doubt it owed something to gains in productivity from
restructuring and new technologies, but America's millennial boom was
essentially a classic speculative bubble, fuelled by loose credit and stoked
up by vast inflows of foreign capital.

As in the bubbles of the past, investors were assured that "This time it is
different". The investment bankers who proclaimed an American economic
miracle were fond of quoting Joseph Schumpeter's description of capitalism
as an economic system driven by creative destruction. But in the euphoria
produced by rocketing stock prices the destructive side of capitalism
identified by the great Austrian economist (the decimation of obsolete
industries and the recurrent booms and busts in financial markets) was
rarely mentioned. Many Americans came to believe that crashes happen only in
history books.

As in the 1920s, the belief that the US had arrived on a plateau of
permanent prosperity became the basis on which they planned their economic
future. Placing their faith in the capital gains they had made in the stock
market, they stopped putting money aside for retirement and borrowed as if
there were no tomorrow. As could have been predicted, the sunlit upland
proved to be a narrow and dangerous crevasse.

Many of the capital gains on which Americans were relying for their security
in retirement have now gone up in smoke. Any figure is bound to be
imprecise, but the worldwide loss of wealth resulting from the decline in
stock markets is estimated to be already five or six times as large as that
suffered in the mini-crash of 1987. The danger to the global economy posed
by this loss of wealth is significant. In order to avoid poverty in old age,
millions of Americans will have to start saving again - and saving hard. If
history is any guide, they cannot rely on being baled out by the markets. In
1949, the Dow Jones Index stood at less than half its top in 1929. In 1982,
when the last great bull market in American stocks began, the index was
still more than 20% lower than its peak in 1966 - 16 years earlier. Contrary
to the claims of brokers and financial advisers, equities are risky even
when they are held long-term. After a meltdown of the sort we are seeing, it
can take decades for investors to recoup their losses. Many will find their
standard of living reduced permanently.

The danger that economic activity will contract throughout the world as
Americans curtail their spending is well understood among bankers and policy
makers. The deflationary impact of globalisation is less widely
comprehended. But the fact is that virtually every aspect of that complex
process works to drive prices down. The internet has brought about a huge
transfer of value from producers to consumers. By comparison with the past,
information is now virtually cost-free. An enormous variety of services can
now be accessed directly, without the need for expensive intermediaries.
With new technologies, production can be sliced into segments and sited in
places all over the world. At the same time, the collapse of communism and
the emerging economies of Asia and Latin America have injected billions of
new workers into world markets.

Taken together, these developments have catapulted us back in time. The
world economy at the start of the 21st century bears a striking resemblance
to the last quarter of the 19th century, when underwater telegraph cables
started to link up markets around the world. Then, as now, new technologies
and global free trade exerted a powerful downwards effect on price levels,
with some parts of the world languishing in prolonged depression.

The risk we face at present is that a further slide on Wall Street will tip
the world economy into outright deflation. We can be sure that Alan
Greenspan will do all he can at the US Federal Reserve Bank to prevent such
a disaster. Interest rates will be cut aggressively in an effort to boost

But the Japanese example is not reassuring. Zero interest rates there have
failed to lift the country out of 1930s-style deflation. The economy is
still contracting, and the stock market has retreated to a level last seen
more than 15 years ago. It can be argued that the bubble economy was more
extreme in Japan than in the United States, and the response of the Japanese
authorities slow and indecisive. But the real lesson to be learnt from Japan
is that once deflation is embedded in the economy it is fiendishly difficult
to control. Japanese policy-makers have found that lowering interest rates
in these circumstances is - as Keynes famously put it - "pushing on a
string". That is why, partly in response to western advice, they are
beginning to accept that the only way out may be to print money.

As the Japanese banker observed, we need a new economic philosophy. But I'm
not holding my breath. Perhaps aggressive American interest rate cuts will
prevent further market slides and consequent recession in the US and
throughout the world. If not, western governments and central banks are
likely to follow the course they are urging on the Japanese. In that case,
we may avoid late 19th-century deflation only to find ourselves back in the
inflation ridden world of the 1970s.

. John Gray is professor of European thought at the LSE.

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