Capitalism Depends on Mild Inflation

Thea Alberto reports from the Phillipines

President Gloria Macapagal-Arroyo allayed fears anew that the Philippines would be affected by the US economic meltdown, saying that local banks were stable and only had little exposure to the bankrupt investment firms in the US.

"The US financial crisis appears deeper than most anticipated. Any slowdown or even recession in the US is not good for the global economy. That said, the Philippines appears in relatively good shape," said Arroyo.

"The potential exposure of our banking sector to the asset deflation triggered by the sub-prime mortgage losses in the US accounts for less than one percent of the total system assets here in the Philippines; This exposure is fully reserved our banks are well capitalized and the innate conservatism of our bankers is matched by the prudence of our regulators," she added.

Arroyo claimed that despite the unstable US market, the government has continued to work hard to manage inflation.

"We have been working hard on all fronts to manage inflationary pressures," said Arroyo, noting how the country’s inflation rate continues to level off.

Michael A. Fletcher writes in the Washington Post

"It was just a few months ago that everyone was obsessed with inflation. Now it's deflation," said Bill Gross, co-chief investment officer at Pimco, an investment management company. "I think it's a possibility."

The value of a wide range of assets, from commercial real estate to stocks and bonds, has declined over the past year. Concerns about falling asset prices are compounded by a banking and credit crisis that has quickly become a global contagion.

For now, even as Gross and many other analysts see declining prices as cause for concern, they are reluctant to say the country has entered a deflationary period. And if prices fall much further, they said, the Federal Reserve has been given the tools necessary to stave off disaster.

"Right now, the declining supply of money for investment and credit is a reality," said Jacen A. Dinoff, managing partner of KCP Advisory Group, a financial consultancy. "We have lending institutions who are being very careful. They are closely scrutinizing new loans and tightening belts on existing ones. Could deflation be around the corner? It could be."

Some economists note that a period of price adjustments does not necessarily signal the start of a deflationary spiral.

"Deflation is not the problem we should be worrying about," said Adam Lerrick, an economist at Carnegie Mellon University. "A drop in the level of prices for some goods must be distinguished from a continuous fall of prices. Oil is down to $90 from $140, but does anyone expect it will be $55 a year from now and $35 in 2010?"

Analysts said that a few months of price declines should not be a problem for the economy.

But if prices continue to fall across the board for a prolonged period, the declines will weigh heavily on businesses and consumers, particularly those juggling a lot of debt, which must be paid back even as money is harder to come by.

"For a few quarters, I say bring it on, but not for too much longer," Gross said of deflation. "Capitalism depends on mild inflation. Unless we get it, the dynamics of capitalism sort of move in reverse."

Japan is the cautionary tale that economists point to when it comes to deflation. Beginning in the 1990s, the nation spent a decade wrestling with flat growth as consumer prices declined about 1 percent a year. The result was not only painfully slow growth, but also rising joblessness -- a problem that economists said was fed by the slow response by Japanese central bankers to a stock and real estate crash that sparked the downward spiral.

In the United States, policymakers have been much quicker to respond to deflationary threats. Five years ago, as inflation approached 1 percent, spawning deflation concerns, Alan Greenspan, then the Federal Reserve chairman, cut the Fed's benchmark lending rate to 1 percent and the threat was never realized. It is an outcome that gives assurance to some economists.

"As long as governments print money and run deficits, you cannot have deflation," Lerrick said.

William Pesek comments on Bloomberg

The big powers of the day cut interest rates this week to avoid another Great Depression. Joining the Federal Reserve, European Central Bank, Bank of England and Bank of Canada was the People's Bank of China.

Yesterday, South Korea, Taiwan and Hong Kong also got into the act, trimming interest rates. All Japan, which pretty much has nothing to cut, could do was pump 2 trillion yen ($20 billion) into the financial system.

What can be made of this flurry of Asian activity? Two things come to mind. One, the inflation concerns that dominated the region just a few months ago are swinging toward deflation. Two, the balance of economic power in Asia is shifting faster than many observers expected.

The spreading financial panic is leading to a realization of how vulnerable these countries are. As the $14 trillion U.S. economy slows, it will take much of Asia with it. Asia is highly dependent on the spending patterns of Americans who have yet to feel the fallout from the global credit crisis. The coming recession will change that, and fast.

Hence China's move to cut its key rate 0.27 percentage point, the second reduction in a month. The Bank of Korea and Taiwan's central bank lowered their rates by a quarter of a percentage point and Hong Kong cut its benchmark to 2 percent. Those moves followed the Reserve Bank of Australia's biggest rate cut since a recession in 1992.

'Set to Collapse'

The aggressiveness of Australia's one percentage-point cut to 6 percent was a surprise to just about everyone except Rory Robertson, an economist at Macquarie Group Ltd. in Sydney, who predicted a bigger-than-consensus action.

With unemployment heading higher, oil prices coming down, wage and price pressures subsiding, U.S. consumer-price inflation is ``set to collapse over the coming year, from about 5.5 percent at present to maybe 1 percent or less,'' Robertson says. "Within a year, U.S. discussions will again have turned to the growing risk of deflation.''

Not everyone agrees, least of all Aaron Smith, managing director of Superfund Financial Singapore. Smith's concern isn't so much the U.S.'s $700 billion bailout of the credit markets, but the Fed's historic efforts to pump liquidity into the economy.

"The commodity that may do the best is cotton,'' Smith says. "Why? U.S. dollars are made of cotton, and Ben Bernanke has been printing dollars like crazy.''