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Going Down

Why deflation is such a threat to our economy.

A stroll through any large shopping mall will reveal that America is undergoing the sale of the century. Luxury men’s stores are offering three-for-one suit sales; airlines are dishing out record-low fares; there was even an auto dealer in Idaho who dreamed up a buy one new truck, get a new car free special.

But what might seem like great news for bargain hunters is actually evidence of a worrisome phenomenon--deflation--that threatens to wreck the American economy for years. If policymakers don’t act swiftly, a startling number of retailers will fail, unemployment levels will rise, and we’ll be staring down the worst period of price instability since the late 1970s and early 80s.

Here’s what’s happening: After an historic run-up in the middle part of this decade, consumer prices have fallen rapidly over the last two months--0.7 percent in December and 1.7 percent in November, which was the most severe price drop in 60 years. Everything from a gallon of gas to airlines tickets and clothing is much cheaper today than it was even just a few months ago. And the signs of deflation are not just in store windows. Inflation-indexed U.S. Treasury bonds, called TIPS, are signaling significant future deflation. The same is true for Japanese bonds that are indexed to inflation.

And just as prices spiking too quickly can create problems--as we saw with the bubble in the housing market--rapidly falling prices can create significant problems, too. They suggest to consumers that it’s all right to hold off purchases and wait for a better deal later. Indeed, despite the historic price declines recently, that’s precisely what American consumers are doing: hoarding their money and increasing their savings to ride out the economic turmoil brought on by the financial crisis.

This type of behavior poses a dangerous and long-term risk to stability. During a deflation, homeowners, businesses, and other debtors suffer extreme economic pain as the value of their assets fall while they are, by the terms of their mortgage contract, obligated to make payments based on previously elevated values.

Even foreign producers of goods--who are also American creditors--are at increased risk, as borrower defaults rise and the loss of a customer base leads to deflation at home. While creditors might not like to see the value of the dollars they own (in the form of Treasury debt) fall, they would likely become more uncomfortable holding Treasury obligations of a country whose workers could no longer afford to purchase or finance goods at the same stores at which they work.

Amid all the bad news, policymakers today are fortunate in one respect: There are recent historical episodes from which they can draw lessons. Japan suffered a decade of serious deflation exacerbated by the U.S. recession of the late 1980s. As our consumers began to increase their savings, demand for Japanese products plummeted, and the Japanese--who had used the increasing profits of earlier years to bid up their own domestic assets through speculative purchases of real estate and excessive and risky lending--began to feel the effects of a deflationary cycle.

The Japanese, however, appear to have learned from their mistakes. Starting last September, Japanese inflation indexed bonds again began to signal deflationary expectations. But instead of weak measures in response, Japan has initiated a series of strong actions, like suspending auctions of inflation-indexed Japanese bonds while having the Bank of Japan buy them back. The Japanese seem to be clearly demonstrating they will not again be complacent in the face of deflationary pressures.

This is a striking contrast to the current U.S. policy. The U.S. Treasury is reluctant to signal a willingness to do everything necessary to prevent further deflation. But the longer deflationary expectations are allowed to fester, the more deeply entrenched they become in consumer habits, and the harder they become to disgorge. Perhaps the Treasury is afraid of repercussion from foreign investors, because if it reduced the value of the dollars they are paid back with, these foreign holders of our bonds would see their returns diminished. But Washington must not fail to consider that without a healthy U.S. consumer--or an economy of equal size and consumption capability to replace us, which simply doesn’t exist now--our creditors too will face further economic distress.

Fortunately, President Obama’s economic advisors Lawrence Summers and Christina Romer are well versed in Japanese economic history and might be more likely to suggest policies--like buying TIPS as a way to signal that inflation will emerge again--to ward off deflation. If decisive action isn't taken soon, Americans could suffer the same fate that the Japanese endured for far too long.

Joshua Rosner is managing director of Graham Fisher & Co., Inc.

By Joshua Rosner