Louis Uchitelle writes about the danger of deflation--and wonders why more people aren't worrying about it. I think the answer is that people are worrying about it. However, it's not yet a crisis, or even a clear and present danger. But it does seem to me that it could become a clear and present danger in a year, if things do not break favorably.
Cost-Cutting Can Start a Ruinous Circle: ...Why isn't that danger uppermost in everyone's mind? Why are forecasters like James Glassman, a senior economist at J. P. Morgan Chase, so optimistic? In a nutshell, they expect an infusion of demand from somewhere that will reverse the cost-cutting and persuade companies to expand investment, production and hiring. Their main hopes are more tax cuts, more growth in federal spending and more interest rate cuts by the Federal Reserve. They also count on people to finance consumption by continuing to extract equity from their homes, which are still rising in value. Mainly, though, it is stimulus from Washington that for Mr. Glassman will save the day. "If Washington cannot get us moving toward full employment within a year," he said, "then there will be more federal stimulus. We have learned a lot since the Depression about how to fix the economy."
August 25, 2002
Cost-Cutting Can Start a Ruinous Circle
n Alice in Wonderland fashion, we talk of expansion and ignore the contraction all around us. We convince ourselves that out of cost-cutting will come prosperity. But while cost-cutting can lift a single company or two, when practiced widely enough it can pull down an economy. And that is happening today.
Few economists acknowledge this dynamic. Corporate cost-cutting and labor-saving layoffs appear in the forecasts as the golden road to greater productivity and rising profits. Never mind that we have just fired the workers and extinguished the salaries that would have been spent on the merchandise and services to fatten the profits. With sales revenue failing to rise, we cut costs more. The process feeds on itself — until there are not enough workers and salaries left to generate sales and profits.
There is hyperbole in this description, but not much. As a nation, we are caught in the strangest and perhaps most perilous recovery since the Depression — featuring a dynamic that William Dudley, chief domestic economist at Goldman Sachs, characterizes as "the corporate paradox of thrift."
"If everyone tries to cut costs and save more, no one saves more," he said. "If you and everyone else cut costs, costs do indeed go down, but revenue also goes down, so profits eventually go down, too. Collectively, we can't cut our way to prosperity."
Individual companies — defending themselves, not the economy — have good reason to throw themselves into this behavior. In one profit report after another this summer, the story has been the same: Sales revenue was flat or barely rose in the second quarter, but don't worry, profits were up. Cost-cutting and labor-saving efficiencies fattened the bottom line, and revenue will soon rise as lower costs allow us to cut prices and take sales away from competitors.
That is fine, for a while, for the winning company. But consider what happens in an imaginary country where Burger King and McDonald's are the entire business sector and the total national output — 100 hamburgers a day, evenly divided between the companies — matches the demand from this nation's consumers. Demand and sales revenue, however, stay flat. So Burger King lays off two workers and uses the saved wages partly to fatten profits and partly to discount prices by just enough to take sales and revenue away from McDonald's. And McDonald's responds in kind.
But soon, the four laid-off workers, with little income, buy fewer hamburgers, and the nation's total consumption drops to 95 hamburgers a day. That sets off another round of cost-cutting and price discounting, and our imaginary nation sinks gradually into stagnation or deep recession not unlike America in the 1930's.
Why isn't that danger uppermost in everyone's mind? Why are forecasters like James Glassman, a senior economist at J. P. Morgan Chase, so optimistic? In a nutshell, they expect an infusion of demand from somewhere that will reverse the cost-cutting and persuade companies to expand investment, production and hiring. Their main hopes are more tax cuts, more growth in federal spending and more interest rate cuts by the Federal Reserve. They also count on people to finance consumption by continuing to extract equity from their homes, which are still rising in value.
Mainly, though, it is stimulus from Washington that for Mr. Glassman will save the day. "If Washington cannot get us moving toward full employment within a year," he said, "then there will be more federal stimulus. We have learned a lot since the Depression about how to fix the economy."
BUT perhaps not enough. Perhaps we have become too accustomed to the other post-World War II recoveries, which were so different. There were no excesses to overcome from a stock market bubble and an insane rush by business to expand far beyond demand. Instead, when consumption rose, there was shortage and rising prices. To control inflation, the Fed pushed up interest rates. In response, consumption subsided, provoking a recession — until rates came down and pent-up demand reasserted itself. Business stepped up investment to keep output abreast of demand, and recovery was on its way.
In the current cycle, however, consumption — particularly for cars, housing and appliances — never tapered off from very high levels during the nine-month recession that started in January of last year. It has still not tapered off, but it is not rising, either, and that is a problem. Recovery requires increased consumption and business investment to make the economy grow. The danger today is that demand will decline instead, and recession will return — or there will be prolonged stagnation. Unfortunately, Mr. Dudley's "corporate paradox of thrift" is pushing hard in that direction.