Deflation hits services sector

By Neville Bennett

Friday 25th October 2002

The future growth of the world economy is under increasingly anxious scrutiny. On every side, there are downward revisions. Strong growth is occurring now only in China and South Korea: Europe is flat and most of Asia is in deflation. The world needs a vibrant US economy.

The performance of the US economy excites some controversy. It appears to be faltering and the clouds have been fostered more recently by the Iraq war crisis; high oil prices will reduce consumer expenditure on other items. The Wall Street plunge and employment concerns are eroding confidence.

The US Federal Reserve continues to forecast a gradual upturn but leading indicators show the economy is losing momentum.

Moreover there is no pricing power in the foreseeable future, even if the Fed's forecast unexpectedly proves accurate. Economic growth needs to accelerate to above the trend to reverse the downward pressure on prices.

Global markets are sending desperate signals that inflation could be negative in a year's time. There is reason to doubt that modern economies can handle falling prices as they are built on a foundation of credit that becomes a major problem when prices fall.

Deflation is apparent in commodity markets: lumber prices signal that the US recovery is over already, copper is falling and gold is going sideways. Periods when gold and the US dollar are weak are rather rare and indicate deflationary risks. Government bonds worldwide are sliding, too.

The root cause of this deflation is quite possibly the Chinese economy. Its share of the US import bill has advanced from 5% to 11% in the past decade. Its prices have fallen 15%.

As it becomes the major foreign supplier of tradable goods to the US, it has forced other Asian countries to devalue to remain competitive. Even Japan is trying to force down the value of its currency.

Asia is the epicentre of excess capacity, which is forcing down the price of goods worldwide and also hurting profits globally.

Pricing trends in the services sector are also deflationary. When looking at the economy most economists place stress on confidence, consumer spending and final demand for products. The mirror image is the businesses that satisfy that demand. It is an unexplored avenue.

Goods are not a large part of the modern US economy. The reality is that 78% of the US private sector workforce are in services. They account for 53% of GDP and 59% of the CPI.

The usual view is that services are in good health, are innovative and are registering productivity gains. Economists also assume, with much less reason, that services are non-tradable and that protects the US from the winds of competition.

The argument is that services cannot be traded, so prices must be determined by domestic factors that are immune to foreign competition. It is also assumed prices keep rising, therefore creating a cushion against deflation.

This situation has changed. Services are increasingly globalised. Moreover, their prices are beginning to be influenced by price cycles. Goods have always been cyclical but recent research by Stephen Roach of Morgan Stanley reveals some price deflation in services.

This finding is unsurprising. Services have been subject worldwide to deregulation and also cross-border mergers. Business has been deeply affected by the internet, which has greatly increased competition and reduced the price of getting information before the public.

The US CPI is at a 48-year low. Goods are deflating by about 0.6% a year. Services are still mildly inflationary but competition is hotting up.

Mr Roach concludes that the US "is in the throes of the most disinflationary pricing cycle ever experienced in services."

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