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Web-only Exclusives
November 30, 2000

From Our Correspondent: Hirohito and the War
A conversation with biographer Herbert Bix

From Our Correspondent: A Rough Road Ahead
Bad news for the Philippines - and some others

From Our Correspondent: Making Enemies
Indonesia needs friends. So why is it picking fights?

Asiaweek Time Asia Now Asiaweek story

COVER STORY - SPECIAL REPORT

The Deflation Equation
Inflation's inverse is the stuff of depressions

By Tim Healy and Assif Shameen


THE DISTINCTION BETWEEN DISINFLATION and deflation is roughly the same as cooling down by going for a leisurely swim versus drowning. They both involve water, but the former represents something of a triumph and the latter a serious failure. Similarly, disinflation is normally a good thing -- a steep fall in inflation to a low, relaxing level. China did it by damping inflation that ran at an annual rate of nearly 30% in the last quarter of 1994 to less than 3% for all of 1997. But deflation conjures images of depression: food lines of unemployed workers, shuttered store fronts and negative growth.

The last time the world suffered such an economic drenching was in the 1930s following the collapse of the stock markets in the U.S. and then in other major financial centers. Could it happen again? Today, although many economists insist deflation is unlikely, there is more evidence to suggest it is possible than at any time in the last 60 years.

First, look at prices. Gold, the traditional hedge against inflation, is at its lowest value in two decades: $277 an ounce. Eighteen years ago, gold briefly traded above $1,000 an ounce. In just the last year, benchmark crude oil has fallen 40% to less than $15 a barrel. It continues down even as North America is experiencing its coldest winter in years and Tokyo is snowed under. Additionally, commodities from copper to cotton and from rice to rubber are cheaper in dollar terms than they were a year ago -- in some cases cheaper than five years ago -- and are continuing to fall.

But prices represent only the surface of the deflation story. Dig deeper, and you uncover fundamentally weak demand and excess supply. Asia's currency crisis promotes both. On one hand, the high interest rates pushed by the International Monetary Fund to slow lending and protect currencies also stifle demand. At the same time, they strangle property markets, further encouraging a drop in prices. Both problems tend to make consumers feel poorer and merely contribute to a deflationary spiral.

Don't forget the supply side. Especially in South Korea, easy credit often made it tempting for industrial companies to build production facilities even when they were less than certain there would be enough demand to justify them. Now, the same companies are faced with the imperative to produce and export as much as possible, which means sending products to healthy markets in the U.S. and Europe. More goods chasing fewer customers equals falling prices.

In late December, billionaire hedge-fund manager George Soros raised the possibility of a "deflationary environment." In a speech a week later, U.S. Federal Reserve Board Chairman Alan Greenspan said that although he didn't see deflation as an immediate threat, he did think, because of worldwide overcapacity and currency devaluation in Asia, it was more worrisome than its opposite-evil twin, inflation. When Greenspan talks, world markets listen. The specter of global deflation became the hottest doomsday topic since, well, global warming.

But don't cash in your hard currency for supplies of rice and canned vegetables just yet. "I am not a believer in the deflation theory," says Rajeev Malik, regional economist for Jardine Fleming in Singapore. "I do believe we are in a global disinflation environment. As disinflation in China translates into cheaper products for American consumers, we will see a very benign inflation environment there. Whether this eventually leads to deflation in the U.S. or globally is too early to say."

Manu Bhaskaran, an economist with SocGen-Crosby Securities in Singapore says he thinks falling prices for durable goods are likely to be offset by services inflation. His theory is that American consumers in particular will spend as much on services as they save because of falling prices for cheap Asian durable goods. In other words, the resulting inflation for services will offset falling prices for Asian products.

Still, the debate is hardly over. "It is interesting to note that there are almost an equal number of economists declaring either that Asia is headed for a period of intense deflation or that the region will see significant inflation," says Sanjoy Chowdhury, an economist for Fraser-AMMB Research in Singapore. He says the truth is in the middle. "In the short run, the currency devaluations are likely to encourage a ratcheting up of consumer prices in Asia," he says. But, he predicts, reductions in demand will eventually ease inflationary pressures.

Ease them to the point of deflation, which might trigger a global depression? Chowdhury stresses that, by itself, Southeast Asia is unlikely to have a significant impact on the world. On the other hand, it is impossible to completely discount a worst-case scenario. A year ago, who would have predicted the depth of Asia's collapse? Couldn't defaulted Southeast Asian loans from Japan and Korea cause significant problems for already battered banks in those places, with a ripple effect that could spread around the world? Certainly, it could happen. But perhaps the greatest danger of deflation is, at least initially, regional. High interest rates, a regionwide retrenchment in spending, soft asset values and an overcapacity to produce cheap goods seems a prescription for depressed -- even deflationary -- prices.


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