www.economist.com/finance/displayStory.cfm?story_id=1325469
Yet most economists and policymakers do not expect a double-dip recession in America or elsewhere. This week Horst Khler, the IMF's managing director, was the latest to play down the risk of recession. Yet this misses a crucial point: even if economies continue to expand over the next year, growth may not be strong enough to prevent the onset of deflation--falling prices--in several countries. Investment remains weak, after dropping for seven consecutive quarters--the longest unbroken fall since the second world war. But optimists pin their hopes on the American consumer, who continues to spend (and borrow) with reckless abandon. But the jobless rate, which is based on household surveys, is notoriously volatile. The monthly payroll figures, which are more reliable, show that America's labour market remains weak. Private-sector employment was virtually flat in July and August. This weakness, along with lower share prices, has already dented consumer confidence (see 56 article). With Japan still sickly and America experiencing a wobbly recovery, one might hope that Europe would ride to the rescue. Germany's economy may now be contracting again: its IFO business-sentiment index has fallen for three consecutive months. In the euro area, demand is being squeezed by a stronger currency, as well as by the fall in share prices. Many forecasters have revised their predictions for growth in 2002, to below 1%. A double-dip recession in America--or indeed in Germany--is certainly possible. But a more likely outcome is that America could suffer a few years of below-trend growth as the economy's imbalances, such as excessive debt and insufficient saving, are put right. A couple of years of modest growth, so long as it remains positive, may not sound so bad. But this misunderstands the relationship between inflation and the output gap (the difference between actual and potential GDP). Letting off air Contrary to popular opinion, inflation does not always rise when the economy expands, nor fall when it shrinks. Instead, the future path of inflation depends largely on the size of the output gap. If the level of GDP is below potential (meaning there is spare capacity), inflation can fall and keep falling, even if the economy is growing briskly, until GDP rises back to potential and the negative output gap is eliminated. After the 1990-91 recession, America still had a large negative output gap until 1993; A similar decline to that experienced in 1990-91 would take it into deflationary territory. Indeed, according to Dresdner Kleinwort Wasserstein, corporate America is already living with deflation. The risk of deflation in the euro area as a whole remains much slimmer; But Germany's inflation rate is only 1% and it could well drop over the next year, as weaker growth causes its output gap to widen by more than elsewhere. Even if the European Central Bank's (ECB's) monetary policy is appropriate for the euro area as a whole, it is too tight for Germany alone. As a result, there is a risk that, before the end of 2003, the rich world's three biggest economies--America's, Japan's and Germany's--could all have negative inflation rates. A sharp jump in oil prices as a result of America invading Iraq could, of course, push up headline inflation. But the longer-term impact of higher oil prices would be deflationary, not inflationary. Higher oil prices operate like a tax that depresses growth, so their medium-term impact would be to heighten the deflation risk. DeAnne Julius, a former member of the Bank of England's monetary policy committee, argued in a recent speech that there is a one-in-three risk of a significant deflationary period in the main economies between now and 2005. But many of today's central bankers, brought up to believe that their job is to fight inflation, seem to be underplaying the risk. Falling prices encourage consumers to postpone spending in the expectation of cheaper goods tomorrow; Most dangerous of all is a cocktail of deflation and debt. Deflation pushes up the real burden of debt, while the value of assets linked to that debt, such as house prices, may have to fall even more sharply in nominal terms to return to a fair level. This has already caused severe balance-sheet problems in Japan, and now America and Germany may be at risk: in both countries debts have surged to record levels. Central bankers in America and Europe--but not in Japan--still have room to cut interest rates. So long as inflation remains above the ECB's target of "less than 2%", the bank will be in no rush to ease policy. The Fed is also widely expected to keep rates steady at its policy meeting on September 24th. Once deflation sets in, monetary policy can do little to revive an economy. If economies perk up and a rate cut turns out to have been unnecessary, it can be reversed: with ample excess capacity, the risk of inflation taking off is low. Many central bankers do not seem to grasp that this economic cycle is different from its predecessors. The recession was caused not, as before, by inflation taking off, but by the bursting of an asset-price bubble. American economists blame Japan's deflation on the incompetence of its policymakers. There is some truth in this, but the awkward fact is that post-bubble economies tend to be deflation-prone. Even with interest rates at zero, Japan might have escaped deflation two years ago, when the American economy was strong, by devaluing the yen. That is why central banks in America and Europe need to heed the danger now.
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