Greater Opportunity Through Innovative Change


One valid criticism of economists is that we rely too heavily on econometric models while discounting anecdotal information from human sources. The Arkansas Policy Foundation has heard from many truck drivers, auto workers, farmers and entrepreneurs who talk about "falling prices."

The period (1997-2001) was the third rolling deflation (see 'Definition of Terms' at the end of this research memo) in producer prices (seasonally adjusted) in the post-war era. The Producer Price Index (PPI)-Finished Goods was negative in 1997, 1998 and 2001. The PPI-Industrial Commodities, Crude Materials for Further Processing, and Intermediate Materials components, of interest to Arkansas manufacturers, were all negative for the cumulative five-year period (1997-2001). The PPI-Crude Foodstuffs and Feedstuffs, and PPI-Intermediate Foods & Feeds components, of interest to Arkansas farmers and agricultural interests, were also negative for the five-year period.

Rolling deflation has been a factor related to the U.S. dollar's strength versus other currencies and the bull market in cash this recession.

Postwar, the PPI was negative at least three years in two other periods (1948-1954 and 1959-1963):

1948 -

1949 -

1950 +

1951 -

1952 -

1953 +

1954 -

1959 -

1960 +

1961 -

1962 +

1963 -

The widely followed Consumer Price Index (CPI), on a non-seasonally adjusted basis, was not negative in any of these three periods. The CPI, on a seasonally adjusted basis, was last negative in 1954 (St. Louis Federal Reserve) or 1955 (Minneapolis Fed). Negative CPI is rare in the postwar era. Negative wholesale or producer prices are more common, and have occurred 12 times in the 57-year postwar era.5 The PPI has been negative in recession (1948, 1949, 2001); in expansion (1951, 1952, 1959, 1961, 1963, 1986, 1997, 1998); and in years where recovery followed recession (1954, 1991).

There are two differences between the period (1997-2001) and the earlier periods: wholesale price components (PPI-Intermediate Materials, All Commodities, Fuel Related Products and Power, and Industrial Commodities) were all negative (1997-2001) versus positive (1948-1954) and flat or positive (1959-1963) in the other two periods.

Second, asset-price deflation has occurred. Federal Reserve Chairman Alan Greenspan termed it “widespread equity asset price deflation” and the “severe deflation of equity asset values” in a Jan. 11, 2002 speech in California. These are references to the NASDAQ stock market index. Fed officials have publicly advanced the theory that consumer spending increases as asset prices rise. Consumers feel wealthier and spend more. But these consumer wealth effects are reversed when asset prices fall and consumers spend less. A significant decline in spending would affect the real economy.

Stock market indexes increased in the earlier periods. The Dow Jones Industrial Average increased from 181.16 (Dec. 31, 1947) to 404.39 (Dec. 31, 1954), and from 583.65 (Dec. 31, 1958) to 762.95 (Dec. 31, 1963). The Dow also increased in the current period (1997-2001) from 6,448 to 10,021. But the NASDAQ has declined by two-thirds since March 2000 from a peak of 5,132, and stands lower than when the Fed began its current round of interest rate cuts.

Implications for Consumers

Free market economists see good and bad deflation. Consumers benefit from falling prices for products, and receive more purchasing power in a good deflation. Consider one of the major purchases made by consumers: automobiles and other motor vehicles. New vehicle prices remain near their 1994-95 levels (Bureau of Labor Statistics) and have fallen year after year. "There is deflation in automobiles, Toyota U.S. President Jim Press said in an interview at the Detroit International Auto Show in January. Automakers, to attract consumers, have offered zero-percent financing and rebates in today’s deflationary price environment. Product differentiation among automakers has become more of a factor as desperate producers compete aggressively for consumers.

A weaker Japanese yen has also made motor vehicle imports cheaper. Japan’s economy is an example of bad deflation yet its automakers have been increasing exports and market share in the U.S. as the yen depreciates versus the dollar. Many domestic manufacturers have lost pricing power. General Motors and commodity-based giants like U.S. Steel could still raise prices in the 1948-1954 period. Pricing power disappears today on a rolling basis.

Implications for Arkansas Business

A striking feature of the current recession has been the lack of pricing power in sectors of Arkansas’ economy. The lack of pricing power is apparent in manufacturing and farming, and has led to forced consolidation or capital flight due to high state tax rates.

Understanding deflation’s redistributive aspects will be important to manufacturers and farmers if PPI components continue to fall. Deflation redistributes income by altering the relationship between debtors and creditors. Creditors tend to gain while debtors suffer. Businesses who hold heavy debt burdens are more likely to be forced into a restructuring or bankruptcy as their real assets decline in value while the principal and interest payments to creditors are greater in real terms. In a worst case scenario these bad debts enter the credit structure (financial system) and become insolvent.

There are examples of Arkansas businesses that understand this unique environment. They have emphasized product differentiation, increased volume sales, and grown profits while outstate competitors who did not understand have failed.

Credit Structure Issues

Interest rates will remain lower than consensus estimates until credit structure issues are resolved. There are unresolved structural imbalances in the economy. The collapse of two large credit entities--the Long-Term Capital Management hedge fund (1998) and Enron (2001)- are warning signs. Both used counterparties-money center banks-in credit arrangements that might have contributed to systemic risk in a larger crisis. Today’s rolling deflation has occurred against the backdrop of recurring financial crises in Asia (1997), Russia (1998) and Argentina (2001). To ignore these warning signs is to risk a greater crisis in the future.

Fortunately, there is time to craft a policy solution. Free markets rely on information to function efficiently. Transparency measures could include stating GAAP and pro-forma earnings simultaneously, and reporting more off-balance sheet derivative transactions by notional dollar amount. This requirement should extend to government units and retirement systems with potential exposure.

APPENDIX: Definition Of Terms

Good Deflation: Consumers benefit from falling prices for products. Businesses are able to increase profits through productivity gains, volume and product differentiation.

Bad Deflation: Financial institutions and other credit structure enterprises use or hold excessive debt or leverage whose losses increase as prices fall. Examples include Japan today and the U.S. in the 1930s.

Asset-price deflation: Assets such as equities or real estate decline in price.

Negative price index: The value of a price index declines year-to-year. Price indexes are comprised of component parts. The two most important are the Consumer Price Index (CPI) and Producer Price Index (PPI).

Constant Deflation: Prices of products and assets decline month-after-month, or year-after-year for an extended period of time.

Rolling Deflation: Deflation appears, disappears and reappears in the CPI or PPI in economic expansion and recession.

-- Greg Kaza