Deflation may sound scary, but a little can be a good thing.
When Lord Kelvin spelled out the second law of thermodynamics in 1850, the bit about entropy got all the press. In Victorian England, a fertile ground for hysteria, the notion that eventually everything falls apart struck a morbid chord. Etchings of shivering families, dressed in rags and huddling in a frozen landscape, illustrated scientific explanations of the "heat death of the universe." Brrr. What could be scarier?
Deflation, that's what. That term, too, is steeped in disintegration and despair, conjuring up a world where products and services lose value with each day - commercial entropy. The difference is that deflation is not a scenario in theoretical physics, but something that haunts the world today. Japan has been deflating since the late 1990s; Hong Kong, Taiwan, and Argentina have joined it over the past year. When US price indices started to fall in late 2001, economists worried that even the world's largest economy might not be immune. Such miserable talk crops up in every seriously down market, and for good reason: the horrifying example of the Great Depression, when prices fell by 25 percent and a quarter of the workforce was left on the streets. Today, the threat of such big-D deflation in America is far more remote. But another more benign kind of deflation is here to stay as a fundamental element of the new economy. The carrier of this little-d deflation is technology.
The difference between the two is that technology-driven deflation affects only some parts of the economy, while big-D deflation is felt across the board. Big-D can take the economy into depression. Little-d just tends to keep inflation in check, while enhancing overall growth.
Tech deflation came of age along with the microchip. When, as Moore's law ensures, the price of a million calculations falls to half of what it was 18 months ago, something in the real world also gets cheaper. This is where the digital revolution gets its power: The cheaper things are, the more they spread and the greater their impact. Were DVD players too expensive for you during Christmas 2000? They probably weren't in 2001 (bye-bye, VHS). This is true for digital cameras and virtually everything else with silicon in its soul.
Commodity prices have been falling as well, in part because technology allows companies to find and extract everything from oil to ore more cheaply. Technology can augment and replace people in service industries, cutting prices there, too: Look at anything from brokerage fees to automated call centers. And technology accelerates globalization, allowing manufacturers to take better advantage of cheaper foreign labor.
The results are striking, and mostly welcome. Consumers get more for their money, effectively increasing real earnings. Within companies, getting more for less leads to higher productivity. And higher productivity is the single strongest factor in economic growth. This is where Alan Greenspan got his confidence in the new economy; so far, despite the slump, the evidence still seems sound.
Living with deflation is nothing new to most tech companies; it is the natural state of sectors from telecom to consumer electronics. Cisco and Nokia are case studies in the profits to be found when cheaper products expand markets, reaching more consumers. Companies adapt to shortening shelf lives by accelerating innovation and build-to-order production - Dell may be the most deflation-hardened firm on earth, and it's better for it.
Could little-d turn into big-D? Absolutely. Consider the scenario of a weak economy with plummeting consumer confidence. Buyers know most things will only get cheaper, so they defer purchases. Inventories pile up and cause more price cutting. Corporate profits shrink and stock markets fall. GDP growth follows, and the economy sinks first into recession, then depression. Debt turns crippling, as old loans are repaid with ever-more expensive dollars. Companies lay off workers, and the cycle turns vicious.
This is what makes Japan such an unhappy place at the moment. But America is in far better shape. Countering the deflationary effects of technology are two equally important components of the economy, both of which tend to be inflationary: Wages tend to rise, since employees won't stand for salary cuts. And property, a limited resource, tends to appreciate over time. Japan went wrong by allowing a corrupt and inefficient banking system to fuel a property bubble. America's excesses do not compare.
After the Victorians got over the bleak entropy aspects of thermodynamics, they started looking at the rest of the heat laws. They found the physics that led to the internal combustion engine. In today's rethinking of deflation may lie the seeds of a new economic machine every bit as productive.
