Al Breach was Russia economist with UBS and Goldman Sachs and is currently managing partner of TheBrowser.com. The views expressed are his own.

HOSTENTAL, Switzerland - How bad was Japan’s “lost decade”? As we look east for clues as to the possible fate of western economies, it is worth dwelling on what actually happened, and not just how it was reported.

Japan’s stock market bubble burst at the end of 1989, and house prices started to fall about a year later. Asset prices at the peak were wildly inflated. Stock prices were trading at ratios of well above 50 times boom-time earnings, while the total value of housing represented around 300 percent of GDP.

These bubbles had formed after decades of rapid growth and, critically, even more rapid credit expansion. Total bank credit to the private sector had risen to 200 percent of GDP, doubling over 20 years.

(more…)

–James Saft is a Reuters columnist. The opinions expressed are his own–

Rest in peace, Great American Consumer. We will not see your like again.

“Cash-for-clunkers” aside, consumers seem bent on actually paying back debt rather than racking it up, a change that if sustained, as it is likely to be, will dampen economic growth not for months but for years, and not just in the U.S.

Outstanding U.S. consumer borrowing fell by a jaw-dropping $21.6 billion in July, according to data released this week by the Federal Reserve, five times more than analysts expected and the second largest monthly drop since the end of World War II.

June’s borrowing was revised to negative $15.5 billion from what had been an impressive minus $10.3 billion.

Over the past year, the stock of consumer loans outstanding has dropped by 4.2 percent, or nearly $110 billion, leaving the total now lower than it was before the crisis began in 2007.

Over the long term, this is exactly what needs to happen. With household wealth badly hit by the housing and stock market crashes balance sheets are stretched. And with a huge baby boomer cohort hurtling towards retirement age also, spending and borrowing were bound to be curtailed.

The question really becomes how entrenched the trend towards the new frugality becomes.

“Memories of debt are very powerful. The generation that grew up in the 1920s and 1930s, was wary of getting into debt as it - and its parents - had experienced two periods of deflation,” Lombard Street Research economist Gabriel Stein wrote in a note to clients.

“We are now in another period of debt repayment and deflation. The thought that US households will forget 2007-2009 and begin to borrow and spend as they did in the early 2000s, is fanciful at best.”

For years the mantra on Wall Street was “don’t bet against the American consumer,” a creature so fabulously resilient as to be almost super human.

Wars and recessions did little to brook consumption and the debt that grew alongside. Even the September 11 attacks saw healthy month on month growth in borrowing in the aftermath.

Whole industries, some now vanished, were predicated on Americans continuing to borrow and spend. It’s an overstatement, but only a slight one, to say that the global economy was predicated on U.S. consumption, which in turn was predicated on consumers borrowing.

THE NEW FRUGALITY

It is doubtless true that lenders of all stripes are making credit harder to get. But there is a good bit of evidence that individuals are changing their preferences. Much of the cash from stimulus handouts earlier this year was used to pay down debt rather than goosing consumption.

A Gallup poll asking Americans how much they had spent in the past day, not including major purchases or normal household bills hit $63 when most recently measured, down from above $100 a year ago.

Now on the face of it, that reduction must be overstated. If consumption had fallen by that magnitude, we’d be in a depression rather than debating the strength of a recovery.

But of course the Gallup poll is a self reported one, and I would be willing to bet that people are now exaggerating how frugal they are, where once they would have exaggerated how much they were spending. That in itself is an important marker of a social trend. Once you wanted the nice people at Gallup to think you were a big shot leaking money, now you probably want them to see you as a saver.

Gallup also looked at the data by generational group, and found that it was not just those in or approaching retirement who were cutting back on self-reported spending. So-called Generation Xers and Millennials, who followed the boomers into the workforce, are also cutting back in similar scale.

But the issue isn’t the rate of savings but the stock of savings as compared to liabilities. While it is reasonably possible to cut back on spending and so increase your savings rate that is far different from suddenly becoming financially robust.

The other thing to bear in mind is that there is a huge difference between stocks and flows. A person can quite quickly raise her savings rate - as we have seen - but that does not mean that her debts are quickly paid off.

If U.S. consumers cut debt as quickly as Japanese corporations did in the 1990s, it will still take them until 2018 to get their debt down to 100 percent of GDP from recent peaks of 130 percent, according to a study from the San Francisco Federal Reserve.

If the trend in consumer borrowing continues, it will not be long before the conversation will turn back to stimulus, quantitative easing, and a relapse for the U.S. economy.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

For most policymakers, deflation is the stuff of nightmares -- scarier even than bank failures and stock market collapses. As the economy stumbled, deflation became Lords Voldemort and Sauron rolled into one.

In recent months, however, this economic supervillain seems to have lost its power to intimidate.

With growth reviving, many economists now believe that deflation is highly unlikely to materialize.

Another group suggests that deflation is not nearly as nefarious as often portrayed. Since falling prices are not generally associated with depression, we were wrong to be frightened in the first place.

Sadly, both of these reassuring premises are wrong. We should still be afraid of deflation.

First, the notion that deflation is a misunderstood and potentially benevolent economic force is only partially true. Supporters of this theory often cite research from the Federal Reserve Bank of Minneapolis, which showed that falling prices seldom coincide with depression.

Looking at data for 17 countries over more than a century, the Minneapolis Fed concluded that "nearly 90 percent of the episodes with deflation did not have depression."

A swelling dollar can clearly be good news for shoppers as well as for those who are sitting on cash. Deflation is often a result of economic progress -- productivity improvements that increase spending power. This was the friendly species of deflation caused by surging Chinese output from the 1990s onwards.

The current variety of deflationary pressure is far less benign. It stems not from efficiency savings but rather from weak demand. Worse still, it is accompanied by record levels of debt.

Despite frantic efforts to pay off loans, household debt is still around 130 percent of disposable income. This was precisely the combination that Irving Fisher warned about in his celebrated 1933 article on debt deflation.

Under these conditions, the rising real value of debts encourages households and businesses to sell their assets to pay down loans. As fire sales reduce asset prices -- stocks and property -- real net worth declines further. Output and employment decline, accelerating the slide in prices.

To add to the pain, real interest rates increase whether central bankers like it or not, discouraging borrowing and promoting even more savings.

"The more debtors pay, the more they owe," Fisher wrote, since "the liquidation of debts cannot keep up with the fall of prices which it causes."

But with the U.S. economy clawing its way out of recession, surely the danger has passed? Not quite. Prices are the ultimate economic straggler.

In Japan, for example, the country only started to experience falling prices roughly three years after the start of the recession in 1991. Wages didn't start to fall until 1997. The United States could still follow Japan's lead.

Downward pressures on prices in the United States continue to intensify, according to the latest research by Capital Economics. Core inflation may have held at a respectable 1.5 percent, but this is deceptive. U.S. goods inflation has defied gravity in part because of hefty increases in tobacco taxes over the past six months. A 28 percent increase in tobacco prices from a year ago is adding one percent to core goods inflation, according to Paul Ashworth of Capital Economics.

"Without this, core inflation would already be matching the lows reached at the end of 2003," he says. The tobacco effect will soon fade.

Services inflation, meanwhile, has been very weak. Here the key factor has been weak rental prices, which account for about 40 percent of the total core index. Unemployment and foreclosure will continue to put relentless downward pressure on rents. Already the rental vacancy rate is at a record 10.6 percent.

So we are right to be afraid of deflation -- very afraid. It still has the potential to sap energy from the American economy for years to come.

The Federal Reserve is preparing to lay down its unorthodox monetary policy instruments. But it may have to dig deep into its tool box before too long if deflation takes hold.

– James Saft is a Reuters columnist. The opinions expressed are his own –

Sure, seeing your economy shrink at a 15 percent annual clip is depressing, quite literally, but if you believe in even a tepid global economic recovery in the second half, then Japan is actually attractive.

There is no way to sugar coat the first quarter Japanese gross domestic product figures released on Wednesday: they are breathtakingly bad viewed from virtually any angle.

The economy shrank by a record four percent in the quarter, or an annualized fall of 15.2 percent, leaving the economy no bigger in real terms than it was in 2003. Net exports fell sharply, by themselves pushing GDP 1.4 percent lower and, perhaps even worse, capital spending shrank by more than ten percent and private consumption fell by 1.1 percent.

What’s more, stocks of inventory remain high when compared to sales, so there is plenty left to sell without placing new orders.

But just as global trade, and with it Japan’s economy, had an extended and sudden plunge in the wake of last year’s panic, there are signs already of an improvement.

Industrial production in March in Japan actually rose from the month before, up 1.6 percent, a rise echoed softly in the Reuters Tankan survey of confidence among manufacturers which showed less gloom than the month before.

A recovery will require a substantial recovery in exports, industrial output and household spending, according to Julian Jessop, chief international economist at Capital Economics in London.

“The strong rebound in the survey evidence confirms that this is realistic,” Jessop wrote in a note to clients. “The extent of the previous declines in exports and investment also leaves plenty of room for a decent bounce.”

That decent bounce could result in a nice return on Japanese shares, which have rallied in sympathy with global stocks.

Significantly, Tokyo shares actually rallied after the GDP news even despite a rise in the yen which crimped the competitiveness of exporters. And measured on a price-to-book value basis, Japanese shares, especially smaller cap issues, are among the world’s cheapest, implying decent potential for gains if the economy as a whole surprises.

Japanese shares as a whole are trading on a one year prospective price-earnings ratio of about 30.

LEVERAGED TO CHINA AND U.S.

Japan’s economy is very highly leveraged to global trade, making this perhaps the key call in any bet on a recovery there. Japan’s position is better than it might seem because those things which it does still successfully export are of high quality and technical specification and less vulnerable to cheaper substitutes from China or elsewhere.

A Barclays Capital composite leading indictor for Japanese exports, which tends to be three to five months ahead, has recently turned positive after a sustained and precipitous drop.

The index includes U.S. stock prices, commodity prices, new orders in the U.S. in both transport machinery and information technology, Chinese auto production and the relationship between U.S. inventories and sales.

Efforts by China to jump start auto sales seem to have worked particularly well, recording an 18.5 percent gain in April from the year before. Similarly, there is a reasonably good chance we are in the midst of a U.S. recovery of some sort, though the risks are it is short lived or chronically feeble.

As this happens look for a rebound in exports and production in Japan and even, at some point, in actual investment. This leaves us with the 20-year running sore that is Japanese domestic consumption.

The fear, and it is not a small one, is that employment and income suffer after a downturn of depression size and that already falling consumption retracts further. The gap between Japan’s output and its capacity is eight or nine percent now, making the risk of deflation, and with it the possibility of a negative spiral in spending, quite high.

Balancing that is the fact that Japan’s healthy savings rate gives its consumers an option less available to their U.S. peers when income falls, they can make up some of the shortfall by simply saving less.

Further, Japan is feeling the impact of a substantial fiscal stimulus, with at least some of the tax cuts finding their way into shopkeepers’ hands. Japan also has front loaded infrastructure spending.

As with all such spending, the impact of this is transient and, with the possibility of an election soon, there is no guarantee that further extra budgets will be forthcoming.

It won’t be glamorous, in part because the engine of growth will be elsewhere, but between now and the end of the year a rebound could be surprising and, depression-era style economic statistics notwithstanding, surprisingly profitable.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

– John Kemp is a Reuters columnist. The views expressed are his own –
For part one of this column, please click here.

The current downturn and fears about falling prices are prompting a plethora of historical comparisons with previous periods, many with the Great Depression of 1929-1933, some based on a very shaky understanding of the historical record.

HISTORICAL BUSINESS CYCLES

The attached chart provides a long-term overview of developments in both U.S. output and prices for the last century using official data published by the Federal Reserve and the Bureau of Labor Statistics. To remove some of the month-to-month volatility, the chart shows the twelve-month percent change in both series for a rolling three-month period, providing a better indication of the underlying trend (http://customers.reuters.com/d/graphics/us_business_cycle.pdf).

Three points stand out immediately:

(1) The business cycle was much more pronounced in the first half of the period from 1913 to the early 1950s when there were massive booms interspersed with regular slumps. Year-on-year changes in industrial output of more than 10 percent and occasionally more than 20 percent were the norm.

Since 1950, the cycle has been much more muted. Only twice in the last 50 years has output grown briefly by more than 10 percent year-on-year, and only once has it shrunk more than that amount.

What made the Great Depression 1929-1933 unusual was not the suddenness of the contraction (which was not abnormal for the period) but its duration and depth. Previous downturns lasted a few months but this one dragged on for years with a massive loss of cumulative output. Industrial activity peaked in September 1929 and did not begin expanding again significantly until the second half of 1933.

What seared the Great Depression even more deeply into the collective memory was that by mid 1938, barely five years after the expansion had resumed, the economy slipped into another deep though mercifully much shorter slump, with output down by almost a third compared with the previous year. Only the advent of war ensured a sustained expansion for the next five years, before another slump in activity in 1946 when the economy was demobilized.

(2) Changes in real output were far more pronounced than changes in consumer prices throughout the 1913-153 period. Falling prices undoubtedly made conditions worse, especially for farming communities and other primary producers. But the loss of output and jobs created far more misery.

(3) Changes in output tended to occur ahead of changes in prices. In each slump, causality ran from falling output to falling prices, not the other way around. In the crucial 1929-1933 period, output began falling from October 1929, while inflation turned negative from March 1930 onwards. By May-July 1930, output was down 17 percent compared with the previous year, while prices were down only 2 percent. Deflation is best viewed as a symptom of severe business-cycle downturns, not the cause.

THE GHOST OF TOM JOAD

Much of the folk memory about the horrors of deflation stems from two factors:

(1) Prolonged deflations in the United Kingdom after the Napoleonic Wars and in the United States between 1879 and 1896 were characterized by an especially brutal compression of agricultural prices and wages that had devastating impacts on rural economies and rural states (especially southern and western parts of the United States during the final quarter of the nineteenth century).

Something similar though far less enduring occurred to rural communities in the United States during the early 1930s. Poverty and unemployment were widespread, but it was rural farming communities that were hit hardest by a combination of falling prices and prolonged drought.

Perhaps the most iconic representation of the Depression, the Joad family, in John Steinbeck’s “The Grapes of Wrath” were farmers driven west by a combination of depression and crop failures.

(2) What characterized all these prolonged deflations was an attempt to restore convertibility of the dollar and sterling to gold at the pre-war parities after they had been suspended during wartime conditions.

Britain tried to restore sterling to the pre-Napoleonic gold parity; the United States restored gold to the pre-Civil War parity; and both the United States and the United Kingdom restored convertibility at pre-1914 parities during the 1920s.

In each case, economic conditions, relative prices and the stock of money had changed significantly during the wars.

Policymakers were well aware resuming previous parities would involve a downward adjustment in wages and prices. But in each case, officials decided to attempt this compression because of the symbolic importance attached to resuming pre-war parities as an indication that pre-war “normality” could be restored.

Unemployment and a downturn in “trade” (as the business cycle was then known) was considered a price worth paying for the resumption of convertibility and a return to old certainties and sound money.

William Jennings Bryan, the Democratic Party’s populist presidential nominee in the 1896 election, captured the political calculations that lay behind these resumptions of the gold standard and deflations in his famous speech to the party’s convention in Chicago in July 1896:

“Having behind us the producing masses of this nation and the world, supported by the commercial interests, the laboring interests and the toilers everywhere, we will answer their demand for a gold standard by saying to them:  You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold”.

THE POLICY OF LIQUIDATION

The same strategy intensified the Great Depression, as the United States and other countries initially tried to sacrifice employment and output in an ultimately failed attempt to protect their links to gold at the old parities.

This approach (sacrificing real values to monetary goals) reached its apogee in the chilling and now infamous notorious advice of Treasury Secretary Andrew Mellon to President Herbert Hoover:
“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … purge the rottenness out of the system”.

Like other liquidationists at the Treasury and in the Federal Reserve System, Mellon believed the slump was a necessary (and desirable) corrective to the excesses of the late 1920s (including excessive borrowing and speculation) and that only in this way could the crucial link to gold and sound banking and economic practices be maintained.

It was these episodes, in which employment and output were sacrificed for gold and “soundness” that have been seared into the collective folk memory giving rise to a horror of falling prices.

But in no case was deflation the cause of the slump. It was the consequence of policy decisions taken largely to defend gold parities in a world of fixed exchange rates. The deflations of the nineteenth and early twentieth centuries are simply not relevant in a world where flexible exchange rates have freed monetary and fiscal policy to respond to a downturn in demand.

OUTPUT AND EMPLOYMENT

Policymakers’ fixation with the theoretical dangers of deflation has been a dangerous distraction from the real issue: the need to stabilize output and employment. Past experience suggests once output and employment have been stabilized and start expanding again, deflationary forces generally disappear.

The emphasis on preventing deflation (largely through monetary policy) risks diverting policymakers from the more urgent and important task of stabilizing output and jobs (which can only really be achieved through fiscal policy).

But there are signs of a shift. President-elect Barack Obama used the Democratic Party’s weekend radio address to commit his incoming administration to saving or creating 2.5 million new jobs over the next two years. Obama’s senior adviser Lawrence Summers has advocated a substantial and sustained fiscal stimulus.

This is a much more promising route out of the crisis. If the incoming administration can successfully end the spiral of pre-emptive production and employment cuts by business, falling real incomes, and declining consumer spending, the stabilization of real activity will lead to a stabilization of prices as well, and worries about deflation can return to the textbooks where they belong.

– John Kemp is a Reuters columnist. The views expressed are his own –

LONDON, Nov 24 (Reuters) - For the second time in less than a decade, the spectre of deflation is stalking western economies and filling acres of newsprint. But the focus on deflation is based on a misreading of history and risks diverting attention from more pressing problems.

First time around, the mistaken focus on falling prices caused the Federal Reserve to leave interest rates too low too long in 2002-2004, fuelling the surge in U.S. real estate and subprime loans that now threatens to overwhelm the global banking system.

This time, the obsessive focus on deflation threatens to become a distraction from the real problem confronting policymakers: how to stabilise output, employment and home values, rather than worry about marginal and largely theoretical declines in consumer prices that have little impact on the business cycle.

DEFLATION AND ITS DISCONTENTS

There is a fairly widespread consensus among economists and policymakers that the appropriate target for monetary policy is “price stability”.

Like inflation, deflation is problematic because genuine price signals may be lost amid the noise. But there are at least four reasons why economists are especially concerned about a generalised, sustained fall in prices:

(1) Once deflation becomes embedded in expectations, households and businesses may postpone major purchases of durable goods and capital equipment in the hope of buying them more cheaply later, intensifying the cyclical downturn.

(2) Because wages and salaries are harder to cut than prices for goods and services, nominal wage rates tend to hold up better than prices during a deflationary slump. The result is a perverse increase in real (inflation-adjusted) wage rates encouraging firms to cut even more jobs, intensifying the loss of household income and spending power, at precisely the moment when real wages need to fall to limit the rise in unemployment.

(3) Most debt contracts are fixed in nominal terms (especially for repayment of the principal). As deflation cuts corporate cash flow and household income, the burden of servicing and amortising mortgages, consumer credit and commercial loans rises, increasing the risk of default.

(4) Central banks cannot cut interest rates below zero (the so-called “zero interest rate bound”, ZIRB). In a world of deflation, monetary policy may become ineffective. Even as nominal interest rates are reduced to zero, falling prices make real inflation-adjusted interest rates positive. The faster prices decline, the higher real interest rates become. Deflation can lead to an unintended tightening of monetary policy.

For this reason, most economists prefer a low but positive rate of inflation to a world of static or falling prices. The Federal Reserve and other central banks have mostly defined “price stability” as consistent with a positive inflation rate of 1-3 percent to avoid the operational difficulties created by a world of falling prices.

THE YEAR OF FALLING PRICES

It is very likely the United States and some other major economies will experience a decline in the general price level over the next twelve months. The massive escalation in food and energy prices that pushed up headline inflation over the last year has now gone into reverse and will now drag down headline inflation rates sharply over the next 12 months.

As recently as mid July, U.S. gasoline prices were still 37 percent higher than prior-year levels; now they are 32 percent below. The massive decline in energy and agricultural prices will probably push the headline rate below zero during H1 2009.

But is this really deflation, in the sense of an ongoing fall in the general price level?

During 2006-2008, policymakers were anxious to shift the focus away from the headline inflation rate to the core rate excluding food and energy items, distinguishing between a one-off adjustment in the price of some items (food and energy) and a more systematic and self-sustaining rise in prices throughout the economy.

Senior Fed officials argued policy should focus on the (much lower) rise in core inflation rather than try to push back against the surge in headline inflation driven by soaring oil and food prices.

In the present circumstances, there is an even stronger case for ignoring the impact of a one-off fall back in oil and food prices to focus on the core rate in the rest of the economy. Core prices are stabilising after a sharp run up in 2006 and 2007, but show no signs of widespread and self-sustaining declines yet.

OUTPUT AND JOBS MORE IMPORTANT

While problems with the ZIRB, deflationary psychology, and the downward rigidity of both nominal wages and debt contracts are interesting theoretical curiosities, there is not much evidence they have been decisive drivers of downturns in practice. Sharp declines in output, and the associated loss of jobs, incomes and spending power are far more important.

Particularly in the United States and certain other Anglo-Saxon economies, consumers display strong rates of time preference. Recent experience indicates they prize consumption now much more highly than in the future, and have been willing to incur substantial debt to fund purchases now rather than save to buy them later. It seems unlikely consumers would postpone the purchase of autos and other big ticket items for a year or more to benefit from a small 2 or 3 percent reduction in the ticket price.

Heightened fear of unemployment, slower wage growth and loss of valuable overtime have played a much stronger role restraining consumer spending. Retail spending has plunged in the United States and many other countries in September and October at exactly the same time the intensifying banking crisis began to filter through into sharp job losses and fears of a deep recession.

Fears about recession are becoming self-fulfilling as the sharp pull back in consumer spending and business investment causes retailers and manufacturers to pull back, announce store and factory closures, and begin layoffs.

THE PARADOX OF EMPLOYMENT

John Maynard Keynes famously wrote about the “paradox of thrift”. But it is hard to blame households for increasing their saving or encourage them to continue spending as the threat of unemployment rises, or to blame businesses for cutting back output and employment to prepare for a downturn in sales. He might as easily have written about the paradox of retrenchment.

To have any chance of averting a deep recession, or at least ameliorating it, policy has to find a way to break this negative feedback loop by guaranteeing output employment levels (at least in aggregate if not for individual households and businesses).

By making a commitment to keep output and employment high, policy can given households and businesses the confidence to continue spending and investing, or at least minimise the amount of retrenchment. In effect, the government provides an “insurance policy”.

Insuring the economy against a prolonged and deep slump will almost certainly require a substantial increase in public spending.

Monetary policy is paralysed by widespread uncertainty about the solvency of households and corporations amid a deteriorating outlook. Tax cuts, the other traditional form of stimulus, are more likely to be saved or used to pay down debts than spent at present.

In contrast, public spending provides an immediate boost to output and employment. More importantly, increased spending, especially on infrastructure, is easier to roll back once the crisis is past, limiting the long-term fiscal damage, unlike tax cuts, which have proved very hard to reverse.

Rather than worrying about a modest decline in the price level, policy needs to focus on guaranteeing households and businesses against the worst aspects of the downturn to minimise the decline in spending and investment. Policies that create demand and jobs, while limiting foreclosures and bankruptcies, rather than fight the deflation chimera or worry about falling asset values are now the urgent priority.

– James Saft is a Reuters columnist. The opinions expressed are his own –

With the U.S., Japan and Britain — nearly 40 percent of the global economy — facing the threat of deflation, it’s going to be just too easy for one, two or all three of them to get the policy response horribly wrong.

The global economy is so connected, and our experience with similar situations so limited that the scope for error is huge.

Think of it as having three pilots flying a jet plane, one each operating a wing and the third managing the tail.

Oh yeah, and they all work for different airlines.

Though there will be much talk of international coordination in the next year, and though the central banks and governments of the world will likely be rowing in the same direction, their ability to gauge the effects of monetary policy and government spending on their own economies will be pretty limited, and even more so on the whole.

Failure when fighting a global recession, a global balance sheet adjustment, a global banking recapitalization, debt deflation and very possibly actual deflation can take many forms.

“It’s very hard to calibrate and it’s awfully easy to overshoot or undershoot, both of which would be disastrous,” said Lena Komileva, London-based strategist at Tullett Prebon.

Under clubbing the response to falling prices means you could slip into a self-reinforcing deflation, making your debts, be they consumer, housing or government, heavier and setting up a cycle where businesses and consumers defer consumption and investment.

Over-reacting risks fomenting a new bout of inflation and potentially causing a new bubble. (Who knows what that would be — dirt, water, baseball cards?)

And remember too, when deflation was last an issue on this scale globally during the 1930s, the global economy was nowhere as near as integrated.

As for now, the signs are clear: deflation is a growing threat in much of the world’s economy, though still to be sure not the central forecast.

U.S. producer prices dropped by 2.8 percent in October, the largest decline on record. Core intermediate goods and core crude goods prices, which show inflation at earlier stages in the production cycle, fell by a big 1.7 and a staggering 17 percent, respectively.

Consumer prices, which are usually sticky on the way down, fell at a record rate in October, down one percent and even falling by 0.1 percent in the month when plunging food and energy prices are excluded. That will kill corporate profits and shows a business community racing with consumers to see who can capitulate fastest.

HERE, THERE AND EVERYWHERE

Inflation is falling rapidly in Britain too, with overall consumer price inflation down 0.2 percent in October, the first monthly fall since the annual January sales and the first in October since 2001, just after 9/11.

Japan meanwhile has slipped back into recession, domestic demand is weakening, wages are falling and deflation may develop some time next year, a scenario Barclays Capital rates as a 40 percent chance.

Even China, where inflation has tumbled to 4.0 percent in October from a 12-year peak of 8.7 percent in February, has moved its focus to averting deflation.

Be in no doubt, central banks have the tools to fight deflation; while interest rates can only be cut so much, officials can step up the quantitative easing now happening, they can commit to hold rates at zero for an extended period of time, they can drive down their own currency by purchasing foreign bonds or finally, simply print money and drop it from the famous helicopters.

The issue is not the tools, but the speed of the printing presses or size of the bond purchases needed to get the right result, especially when it is interacting with what will be huge tax cuts and deficit spending.

A mix of monetary and fiscal policy will work, but it’s got to be the right mix and it has to be reasonably well coordinated internationally.

None of this is without risk. Remember the last deflation scare in the U.S. in the early part of this decade, which in retrospect caused the monetary bubble which was nursemaid to the housing bubble.

Print money or borrow excessively and you could lose the confidence of the currency market and experience a run, which certainly will help to fight deflation but is no-one’s idea of good policy.

In theory the amount the state will need to borrow will be in part offset by the amount individuals save, or more to the point pay down in debt and decline to invest privately. That theory will be put to the test by the number of governments who are going to be selling a very large number of bonds, which will after all have to be paid back.

Next year is looking as if it will be as unconventional as it is scary.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

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