Big gains in capacity raise deflationary fears

PUBLISHED : Tuesday, 03 September, 1996, 12:00am
UPDATED : Tuesday, 03 September, 1996, 12:00am

Just when investors are worried about rising inflation, deflation is in danger of popping up and punching them in the nose.

Inflation, in its simplest form, is where too much money is chasing too few goods. An inflationary spiral can kick in when the price of commodities and wage bills push ahead also, triggering another round of price rises to consumers.

At present, investors are worried about inflationary pressures emerging in the United States as the economy reaches its capacity constraints and prices start to rise in overheating economic activity.

Super Bear, Dr Marc Faber, in his recent 'The Gloom, Boom and Doom Report', argues inflation fears are misplaced.

The doctor is worried massive political change on a global scale, technological and major incremental productivity gains have increased the world's manufacturing capacity potential.

The migration of jobs, especially unskilled jobs, from the West to low-cost labour regions, however, has not increased the world's capacity to consume.

Herein lies the potential for a deflationary spiral, the doctor argues. Cheap or free-flowing capital can actually accentuate the forecast problems as it provides finance to pay for the migration of jobs and manufacturing in record time.

The threat of a deflationary spiral kicking off some time over the next six to nine months is higher now than at any time since the late 1920s.

Dr Faber, the territory's arch contrarian, looked at the last two really big deflationary spirals, in 1873 and in the 1920s.

Prices, especially of the US economy mainstay, agricultural produce, collapsed in 1873 because of huge changes which opened up the West to mostly agricultural exploitation.

Canada, Australia, Russia and Argentina experienced massive opening up of new territories. A truly global economy was emerging as railway and shipping links grew. Price falls in staple produce were deepened by huge productivity gains in agriculture due to changes in technology.

The deflationary spiral of the 1930s was triggered by massive productivity gains and a build-up in stockpiles in agriculture and manufacturing. Interest rates tumbled after the 1929 Wall Street crash with the re-discount rate falling from 6 per cent to 2.5 per cent. This apparently cheap money, in fact, fuelled the deflationary cycle further as it triggered an interim period of over-investment in key sectors like construction, which in itself increased productive capacity.

In both cases, deflation was the outcome of huge economic growth - not inflation.

Japan saw an unprecedented run of economic growth in the 1980s. Despite a collapse in interest rates the economy fell into a slump with massive asset deflation.

The opening up of Eastern Europe, the Asia-Pacific and emerging markets to low-cost labour production, has increased the world's potential to make things on the same kind of scale that the opening up of the West allowed increased agricultural productive capacity in North America last century. Massive incremental productivity gains are being made throughout the globe through technological change.

In addition, historically cheap money is actually fuelling and prolonging the present boom, which will mean the deflationary period to follow will be deeper and longer. The signs of future problems already are here. The nine-month boom and bust cycle seen in semiconductor memory chips this year is an example of how quickly huge margins attract massive capacity followed by big price falls.

'Everywhere I go in the developing world, I notice huge capacity expansion in all industries, from autos, chemicals, brewing, pulp and paper, mining and consumer electronics to real estate,' Dr Faber says.

'All I can say is that, if final demand growth has been over-estimated, then the world is likely to be in for a nasty little shock in the form of a deflationary economic contraction.' And here endeth the lesson.