Deflation and Depression

The capitalist forecasters have got renewed optimism about the global economy and the value of their investments on the stock market. After huge falls in stock prices during September, the last two weeks have seen a significant rally in world financial market prices - up 15%. But world's stock markets are still down 15-20% on the year, which if maintained, would make it the third year in a row that they have fallen. That would not have happened since the Great Depression of the 1930s. Michael Roberts looks at the prospects for the world economy as it slides further into decline.

The capitalist forecasters have got renewed optimism about the global economy and the value of their investments on the stock market. After huge falls in stock prices during September, the last two weeks have seen a significant rally in world financial market prices - up 15%. Of course, the world's stock markets are still down 15-20% on the year, which if maintained, would make it the third year in a row that they have fallen. That would not have happened since the Great Depression of the 1930s.

But optimism reigns, because in the third quarter of this year, US and European corporations announced better profits than they achieved in the third quarter of 2001 and better than the expert forecasters had predicted. After so much bad news over the last year, capitalist investors breathed a sigh of relief and launched a buying spree. But is their renewed optimism justified?

Well, even on the evidence of the profit figures of the big US companies, it is not. First, the increase in profits overall is just 6% more than last year, which was a period of very low profitability for American companies. Second, profit growth in the current fourth quarter could be even less. That means US (and European) companies have made little recovery from the depths they descended to last year. And that's despite cutting nearly 2.2m jobs in the private sector in the US in the last 18 months.

That's how even this small improvement in profits has been achieved - by sacking workers and by stopping new investment in plant and technology. The costs of production have been lowered. But there has been hardly any rise in sales and no prospect of much improvement ahead. Unless there is a dramatic rise in sales for most companies, another round of job cuts and plant closures will ensue over the next year.

And the company pension problem is now becoming a crisis. Merrill Lynch, the US investment bank, reported that 98% of the 346 companies in the S&P 500 that offer defined benefit pension plans will find their plans are underfunded by the end of this year. The pension-funding gap for US auto employers alone will rise to more than $30 billion at the year's end, from $13.9 billion at the start of the year, with no immediate remedy in sight. It will take them many years of lower earnings to make up that $30 billion.

Of course, the capitalist forecasters remain confident that growth will start to accelerate worldwide over the next year and their political masters in the G7 governments echo that optimism. Of 51 'expert' forecasters who gave their opinions on likely economic growth in the US next year, the average forecast was 3.5%, with some as high as 4%.

But this is wild optimism based on little evidence. As stock markets rose during October, the economic news that came in continued to worsen. US industrial output fell for the second month in a row. Capacity utilisation in manufacturing is down to 75.9%. Experts normally say that when capacity utilisation is below 80% companies are unable to increase prices or profits. Honeywell, Sun, Motorola and scores of tech companies announced lay-offs, as they have too much capacity.

Growth comes from (among other things) business investment and new jobs. But there is little (or no) growth in business investment and no (or negative) growth in jobs. The US economy will probably grow less than 1% this quarter, barring some resurgence in business investing that is not now on the horizon.

Stephen Roach of Morgan Stanley points out that the US consumer was responsible for 64% of the growth in the world's economy from 1995-2001, roughly twice what our share of world output was during the same period. The world economy is dependent upon the US consumer. As the US economy has slowed down, the world is slowing even more.

The problem is that there is no other engine for growth. Germany, the third largest economy, is on the brink of a recession and is close to deflation. Europe may slip into recession before the US. South America is in shambles. The world's second largest economy - Japan - is severely hurting the rest of the world and creating deflationary forces that are causing major problems in Asia. China and India are years away from being a major force for growth in the world economy.

There are only two areas of the world capitalist economy that is keeping it from slipping back into an even deeper recession than that experienced in the middle of 2001 - the worldwide property boom and consumer spending stimulated by rising house prices and the very cheap cost of borrowing.

That tells you what will be the trigger for a slump. If jobs are cut back across the US and Europe as corporations try to restore profit margins, workers' incomes will fall back. Even though interest rates may be low, property prices will become too high for many to afford to buy. The property market will tail off and turn down - just as it did in Japan about two years after the Japanese stock market began to slump in 1989. In the last decade, the stock market in Japan has collapsed to new lows in 2002 and house prices have tumbled along with the Japanese economy.

If the American mortgage refinancing boom ends before a new investment boom begins, consumer spending will fall away before investment rejuvenation has begun and the US global economic locomotive will grind to a halt. As jobs and wages decline, consumers would end their ability to incur debt and thus spend less. Unemployment would rise as businesses increase lay-offs in an effort to increase earnings. That scenario looks like panning out over the next year. Instead of world capitalist economic recovery, the prospect is for a worldwide recession by this time next year.

And behind this prediction is the terrible spectre of global deflation. Those of us who remember the 1970s and 1980s used to think that the Achilles heel of capitalism was rampant inflation of prices in the shops that forced capitalist authorities to raise taxes and interest rates and stem an 'overheated' economy, thus creating a boom and bust cycle.

But deflation is a much bigger danger to world capitalism. If prices don't rise, then capitalist companies cannot make a profit without cutting the cost of production. That means investing in new technology (itself an extra cost) to increase productivity and so lower costs per unit of production, or reduce the labour force to cut wage costs. But reducing the labour force means less production. And it means that workers have less to spend on the goods and services produced. So sales do not grow and prices have to fall further. It's a vicious circle of falling sales, jobs and prices - in other words an economic depression (far worse than a recession in the boom-bust cycle).

This is a real danger. Prices of goods at the factory gate in the US are falling at a nearly 1% a year rate. It's only in the services sector that prices are still rising moderately. And globally, world price rises have never been lower.

One of the key drivers of deflation is China. This huge country has become a major industrial powerhouse. With a seemingly endless supply of cheap labour and substantial flows of capital coming in from abroad, Chinese industrial production and exports are rocketing. Chinese factory prices are continually falling and they are sucking up bigger and bigger shares of world trade in all sorts of products. China has increased its share of Asian exports by 50% in just the last year. Chinese exports are putting downward pressure on prices not just for US businesses, but for all businesses worldwide.

But it is not just China. Japan is clearly creating a deflationary wind across the world. Hong Kong, Taiwan, Singapore and much of the rest of Asia is in deflation. Deflation forces country after country to devalue their currency against the dollar, so that they can compete for sales to the American consumer. This keeps the dollar strong, just at a time when it would be convenient for it to weaken. This puts more pressure on American business, which must cuts costs in order to remain profitable. If the rest of the world continues to devalue their currency to keep attracting the American consumer, then we are in for deflation in the US.

And deflation is really bad news for capitalism. America's private sector debt loads are currently at their post-World War II highs. The household debt-to-GDP ratio currently stands at 76%, compared to 63% back in 1992. Corporate debt has now climbed to 69% of GDP, higher than in the year of the last major crash in stock markets in 1987. The US is now copying Japan in the 1980s. Japanese corporate sector debt reached 175% of GDP by 1993; rocketing to 235% by 2001. Household debt rose from just 61% in the early 1980s to 74% in 1989 and then increased to 77% in 2001.

Inflation is always great for borrowers. That's because what they borrow now is worth much less in real terms after ten years of inflation, especially if they've used the money to buy a house where prices have risen even faster than the average rate of inflation. That's why bankers (lenders) don't like inflation and demand interest rates rise to curb it.

But the repayment of debt becomes onerous when prices start to fall because in real terms that debt is worth more while the value of houses or land may be falling. Household wealth is destroyed, as it has been in Japan. Bankers may like deflation, but the rest of the capitalist economy loathes it.

If global deflation sets in, it will express just how weak capitalist economic growth has become. It will cause countries to try and escape depression by devaluing their currencies to steal a march on their rivals. That will just intensify the deflation. And deflation means that the real cost of debt rises and borrowers will go bust in a big way, intensifying depression. That's the prospect for capitalism over the next year or two.