Over the past two decades central bankers have held the uniform view that their primary task is to fight inflation. Few in this exclusive fraternity seem to have reflected on the danger implicit in their uniform opposition to inflation. Specifically, given the amount of independence granted to most major central banks and the tools at their disposal, if all central bankers continue to fight inflation, eventually they will succeed.

Indeed, if they succeed too well--as they have in Japan and as they may in Europe--they will have to stop worrying about inflation and, unless the inflation battle has been conducted with uncanny accuracy, face the danger of an overshoot. Such an overshoot would require overt efforts to reverse deflation. The first sign of such efforts is the strengthening aversion to a strong currency in Europe.

Over the next year or two, world financial markets and economies will be deeply affected by the answer to an important question: Which major central bank will first move proactively to push down its currency? Will it be the Bank of Japan, faced with deflationary expectations of 2 percent and rising? Will it be the European Central Bank (the ECB), designed to be an inflation fighter par excellence, yet coming into existence when European inflation is drifting close to zero or perhaps below when corrections are made to price indexes. Or will it be the Federal Reserve, which initiated rate cuts of seventy-five basis points over six weeks following the end of September to restore the stock market to all-time highs?

So far the most interesting aspect about the behavior of the major central banks is the inverse relationship between the proactive reflationary measures undertaken and the degree of deflation confronting them. The Bank of Japan--facing the most acute deflationary problem--has failed to follow through on a program of aggressive monetary expansion indicated on September 9. The European Central Bank and its proxy, the Bundesbank, enacted a modest rate cut of thirty basis points early in December, as European inflation approached zero. Finally, with inflation rates in the 1-1.5 percent range, the Federal Reserve cut rates by seventy-five basis points, as noted. Although the Fed’s latest, November 17 rate cut was aimed at Brazil, it hit the U.S. stock market.

Resisting Orthodoxy

Smaller central banks have displayed a willingness to resist the prevalent inflation-fighting orthodoxy of central bankers. The first dramatic example came in September 1992, when the central banks of England, Spain, and Italy, albeit reluctantly, abandoned exchange-rate targets amid a din of forecasts that inflation and ruin lay ahead. That those economies outperformed other European economies while no inflation materialized was remarked on but not analyzed, perhaps for fear that the supposed vice of reflationary depegging might spread among other central bankers like drug use among bored urban teenagers.

Recently, another group of countries, largely unnoticed, has used the modest reflationary pressure from currency depreciation to mitigate acute deflationary pressure. Australia, a commodity-based economy in the midst of a collapsing Asian economy, has allowed its currency to float; over the past year it has depreciated against the U.S. dollar by about 20 percent. As a result, Australian exports have remained competitive; despite the deflationary pressure from weaker commodity prices, depreciation of the currency has helped to stop modest deflation in Australia and turn it into modest 1 percent inflation. In the year to September, Australia had one of the world’s healthiest economies, with growth of about 5 percent.

But the characterization of Australia’s performance is odd. The Financial Times, in a December 4 commentary, terms Australia the "lucky country." In the same article Paul Krugman, an advocate of reflation in Japan, calls Australian performance "nearly miraculous." That Australia, as a small, open economy, has chosen to abandon the hard-money, fixed-exchange-rate orthodoxy so characteristic of central bankers and has prospered is not a matter of luck or a miraculous event. It simply represents a choice by Australia to shift demand onto its exports by devaluing its currency. A slight reflation in a deflationary world makes sense. Brazil, please take note.

New Zealand offers a contrasting case. New Zealand, which shares with Australia the role of a commodity exporter, chose to raise interest rates and defend the currency--a policy combination that pushed the country into outright recession with negative growth over the first half of 1998.

Among European countries, Sweden’s economy has fared better than most. Since September 1997, the Swedish krona has depreciated by about 13 percent against the Euro, while inflation has actually declined. Meanwhile, Swedish growth accelerated from a low of 1.3 percent in 1996 to close to 2.5 percent during 1998.

Currency depreciation cannot work for everyone--unless global deflationary pressures are present. If every central bank undertakes to depreciate its currency by easing monetary conditions, the result is a concerted effort to cause money to depreciate relative to goods. Though usually called inflation, it is more politely called reflation if we start from a negative number or a low inflation number. Reflation is justified when deflation is threatening to accelerate.

That may indeed be the case in today’s global economy, and central banks need to reexamine their inflation-fighting orthodoxy in the context of this threat. The drop in commodity prices of nearly 25 percent in a year (as measured by the Commodity Research Bureau’s index) and of 9 percent from mid-November to mid-December (after a brief rally late in August after the Russian debacle) suggests that global aggregate demand is still weakening. Producers who anticipate the need to supply more goods normally bid up the price of commodities as they prepare to use them as inputs for intermediate and final goods, which in turn will meet rising demand.

The Entrenchment of Deflation

Since World War I there has been a long wave of generational trends in the behavior of prices in the world economy. The 1920s saw a reversion to disinflation after the inflationary excesses of World War I. A decade of disinflation and investment-led growth in the United States finally resulted in a stock market bubble that burst in 1929. But deflation really did not become entrenched in the United States until 1931.

In September 1931 Great Britain abandoned the gold standard, and nervous money fled to the United States. Great Britain had already experienced deflationary pressure following the repegging of sterling to gold at an overvalued exchange rate in 1925. The effort to defend sterling’s peg to gold led to deflation in the United Kingdom, which finally forced the country off the gold standard in 1931. The funds that flowed to the United States as a safe haven created concern at the Federal Reserve about inflationary pressure in the United States despite the disinflationary environment. Efforts to "mop up" the resulting excess liquidity turned out to be a serious mistake.

The increased funds flowing to the United States were demanded by nervous households and businesses anxious to hold more cash and less bank money in the uncertain economic environment in the United States. By draining this cash inflow into the U.S. banking system, the Fed precipitated a liquidity shortage and bank failures that in turn caused the money stock to collapse as it dropped by a third. A bank holiday was declared in March 1933, followed by a sharp devaluation of the dollar against gold; the official gold price jumped from $22 an ounce to $35 an ounce. The Federal Reserve and the Treasury finally had to abandon orthodox monetary policy in the deflationary crisis. Thereafter, prices began to stabilize.

The memory of the Great Depression and the deflationary environment led to a postwar emphasis on reflation and the avoidance of unemployment by policymakers. The Employment Act of 1946 essentially mandated the federal responsibility to maintain full employment.

In contrast to the 1930s, the twenty years following World War II were characterized by increasing attention to maintaining adequate demand growth with less concern about the inflationary consequences. This period of U.S. reflation was followed by outright inflation beginning in 1967, when the United States elected to pursue a guns-and-butter strategy with the Great Society and the Vietnam War. The inflation episode persisted until 1979 with rising prices, a weakening dollar, and a growing conviction among central bankers that inflation was the root of all evil. The era of disinflation began at the end of 1979, when Paul Volcker became determined to wring inflation out of the system.

The first dramatic evidence of disinflation came with the unexpectedly large budget deficits after 1983. Revenue estimators had counted on considerably higher inflation than what actually materialized. Lower inflation resulted in lower tax receipts and a larger budget deficit. The Fed maintained its anti-inflation stance throughout the 1980s, and disinflation continued.

A New Deflation?

The deflation of the 1930s spawned the focus on full employment and the reflation of the 1950s and 1960s, which ultimately became the inflation of the 1970s. The disinflation of the 1980s and 1990s now threatens to create the deflation of 1999 and thereafter. Japan’s own cycle of reflationary policies in the 1980s followed by disinflationary and, now, actual deflationary policies in 1997 and 1998 proves the dangers of too much preoccupation with past inflations.

Some analysts at the Bank of Japan still explain the bank’s passive stance on reflation by citing the dangers of a return to the inflationary bubble economy of the late 1980s. Japan’s central bank is to some extent a prisoner of its past. This condition is all the more remarkable because Japan’s overlong adherence to the gold standard during the Showa Depression of the late 1920s and early 1930s created problems similar to those faced by Japan today. Not until 1932, when a new finance minister, Korekiyo Takahashi, abandoned the gold standard and followed reflationary policies, did Japan begin to emerge from its own serious depression of the late 1920s and early 1930s.

Central bankers, probably for good reason, have a hard time making the transition from the needs of an inflationary environment to the needs of a deflationary environment. Moderately rising prices and growth or rapidly rising prices and growth are far more typical than falling prices and shrinking output. When world nominal output (the money value of all goods and services produced) is growing with rising output and rising prices, a strong currency and a firm stance against more inflation make sense. The strong currency helps to moderate inflationary pressure from escalating costs and simultaneously helps to attract capital inflows to finance investment, which in turn provides sustained noninflationary growth. In short, when the pie is growing, a watchful stance against inflation is called for, and the pressure to devalue should be absent, with some benefits going to those maintaining firm currencies.

But when world nominal output is falling with dropping output and prices, the need for a weak currency arises. Excess demand gives way to the far less typical problem of excess supply, which may in turn be exacerbated by an investment-led recovery such as Japan’s in the 1980s and the U.S. rebound in the 1990s. A weaker currency helps push up demand for excess output while moderating deflationary pressures. Japan’s predicament comes especially to mind. If all nations feel the deflation-induced requirement for a weak currency, then money must be depreciated against goods; reflation is called for. Without a gold standard, the option to devalue overtly against gold is absent. Monetary expansion simply propels the average money price of goods and services. That is reflation.

What are the symptoms of this dangerously accelerating deflation? To answer this question, it pays to look simultaneously at the behavior of interest rates, exchange rates, and stock prices. Normally a strengthening currency and rising interest rates together constitute a sign of economic vigor since upward real returns can generate that observable combination of price movements. Simultaneously one would expect to see stock prices climbing as a reflection of higher expected real returns. Investors in such circumstances would be switching from bonds into stocks as expected earnings rose faster than interest rates. International capital then flows into the country with rising real returns to buy into the higher expected real growth; this process leads to the popular notion that a strong economy means a strong currency. The demand for cash is stable with higher incomes pushing it up while ascending real interest rates quash cash demand and induce substitution into bonds and equities. This situation prevailed in the United States from mid-1995 to mid-1998.

Japan’s Lack of Wisdom

The picture changes in a world of accelerating deflation, especially when the government, as Japan has unwisely done, proposes to fight the deflation with more spending and tax cuts. Keynes identified absolute liquidity preference (he never mentioned a liquidity trap) as a situation in which investors have an absolute preference for cash over bonds because interest rates are so low that they expect them to rise. The conviction that bond prices can only fall (or interest rates can only rise) produces a strong or absolute preference for cash. Stock prices too are expected to fall because accelerating deflation pushes down expected earnings as the attendant rising expected of real yields on bonds and cash draws funds away from stocks. In this environment a rising currency and rising interest rates are matched by a falling stock market. This combination has appeared intermittently in Japan over the past several months and signals an urgent need for reflation.

Japan’s manifestation of the most serious deflationary symptoms demands a closer look. Japan has made a disastrous policy error by promising to fight deflation with higher spending and lower taxes. Under this plan the weaker the economy gets (and it is getting weaker, as seen in recent reports such as the Bank of Japan’s December Tankan survey), the larger the expected supply of bonds becomes. The rise in the expected bond supply supports the Keynesian notion of absolute liquidity preference by reinforcing the idea that bond prices will fall (interest rates will increase) and so funds rush into cash and out of bonds, stocks, and foreign assets. Foreigners can participate in the switch out of bonds and into cash by buying yen, selling Japanese government bonds (JGBs), and selling stocks.

The switch out of Japanese bonds and stocks and into cash was given a boost by the Bank of Japan’s December Tankan survey, which showed a weaker economy and a jump in deflationary expectations. While business conditions turned out to be even worse than had been expected in September, deflation was stronger. The more virulent deflation, coupled with a further gain in the expected supply of JGBs, accelerated the shift into cash and out of stocks and JGBs.

Japan’s market pattern of higher interest rates, a stronger yen, and lower stock prices is extraordinary and extremely dangerous--especially if it leads to calls for still more fiscal stimulus from politicians. Such stimulus would only reinforce the pattern of absolute liquidity preference, whereby investors fearing higher interest rates sell stocks and bonds and move into cash. In this environment expectations of deflation rise along with interest rates until investors are prepared to add to their holdings of government bonds instead of cash. Alternatively, the Bank of Japan could promise to buy up all government bonds in an effort to pull money out of cash and into bonds, but the concurrent collapse of the yen--which the Japanese government still fears because of U.S. criticism--will probably prevent this for a time. Meanwhile, the rest of Asia claims to be happier with a stronger yen. Thus an unfortunate confusion arises because the stronger yen is viewed, mistakenly, as a sign of Japanese economic recovery instead of as a symptom of dangerous accelerating deflation.

The proximate reason for the recent upturn in interest rates in Japan is, as noted, the large increase in the supply of government bonds needed to finance a budget deficit that probably will approach 11 percent of the gross domestic product in 1999. This is more than twice the budget deficit as a share of GDP experienced by the United States in the mid-1980s during the worst of its fiscal problems. True, Japan as a large saving nation can absorb an outpouring of government bonds--but at what price?

At 1 percent, Japanese households and investors clearly prefer cash to bonds. The preference is reinforced by Japan’s 2 percent deflation providing a riskless return to cash holders that dominates a slightly higher inflation-adjusted return on bonds. With bonds yielding around 1 percent, any prospective investor reflecting on a possible Japanese recovery realizes that Japanese bond yields would return to at least 3-4 percent in a rally. An investor who purchased a bond with a 1 percent coupon would lose a great deal of capital in such an environment; this realization has produced the modern-day equivalent of Keynes’s doctrine of absolute liquidity preference (a strong preference for cash over government bonds).

The Strength of the U.S. Economy

What about the outlook in Europe and the United States? In Europe a combination of falling interest rates, an appreciating currency, and laggard stock prices suggests that inflationary expectations are falling. Indeed the inflation data imply that this is true, especially in France and Germany. Such a combination pleases the traditionally oriented central bankers in Europe. But declining inflationary expectations can eventually turn into rising deflationary expectations. From that scenario can emerge the virulent combination of increasing interest rates, a stronger currency, and dropping stock prices that has emerged in Japan.

While Europe’s fiscal picture is far better than Japan’s, the expansionary noises from new, left-leaning governments in France and Germany hint that core Europe’s extant budget deficits of around 3 percent of GDP could be expanding. As market behavior in Japan has demonstrated, more expansionary fiscal policy is a dangerous weapon in an environment of accelerating deflation, where absolute liquidity preference (a decision to move from bonds into cash) is a possibility.

As so often over the past half decade much to the consternation of doomsayers in Europe and elsewhere, the U.S. economy appears to be the most healthy of the major economies. A steady downward drift in interest rates coupled with a slightly weaker currency and a stronger stock market suggests that the world’s largest economy--and the one least in need of modest reflationary stimulus--is getting just that stimulus and prospering because of it. The modest weakening of the dollar along with falling interest rates implies that U.S. market interest rates are declining slightly faster than U.S. inflationary expectations. According to the rising stock market, the drop in U.S. interest rates is more of a support to the stock market than the penalty implied by falling earnings estimates.

The uneasy conclusion from a review of economic conditions implied by market behavior in the world’s three largest economies is that the U.S. consumer, willing to increase spending at a rate 50 percent higher than income growth, is standing between a modestly expanding global economy and a possible bout of dangerous deflation. The jump in the U.S. stock market since early October, coinciding with a period of Fed easing, will probably put the Fed on hold at least until February 2 and perhaps beyond, particularly if the stock market and spending growth hold up. But the deflationary pressure in the rest of the world creates exogenous negative pressure on prospective U.S. corporate earnings both by virtue of a lack of pricing power for U.S. producers and by shrinking markets for U.S. products. If global nominal output growth during 1999 falls close to zero, U.S. producers cannot maintain profit margins.

Analysts’ expectations for profits for 1999 for U.S. firms imply a 25 percent growth rate of earnings. That would be the highest growth rate of earnings in the entire expansion and, in view of the continued slowdown in the growth of nominal world incomes, looks virtually unattainable.

The currency of the world’s strongest major economy, the U.S. dollar, has depreciated modestly over the past several months and thereby has helped to mitigate the downward pressure on prospective profits. This situation challenges the sustainment of the current situation in the United States: risi ng stock prices, a slightly depreciating currency, and falling interest rates. The currencies of Japan and Europe must depreciate instead to avoid worse deflation.

The Path Ahead

Unfortunately, downward pressure on earnings and an eventual slowdown in consumption spending will probably topple U.S. stock prices before either Japan or Europe proactively reflates. Meeting the conditions for such events is not unimaginable. If U.S. stock prices merely stagnate around current levels for lack of easing by the Federal Reserve, U.S. spending growth is unlikely to revert to income growth of about 2.5 percent. These figures, along with the drag on net exports implied by shrinking nominal incomes in the world economy and especially a sharp weakening of Latin American economies such as Brazil as mandated by the International Monetary Fund, suggest that U.S. growth could easily drop to zero or 1 percent and subsequently below should stock market prices actually fall in a slowing economy.

The Fed will be reluctant to peg the stock market with lower interest rates, particularly if instead of the average Standard & Poor’s company earning an expected $50 a share--which at 5 percent yields on ten-year bonds would put the S & P index at about 1,000 under normal conditions--the companies will more likely earn $40 a share with ten-year rates going to 4 percent. The latter outcome also implies an S & P index around 1,000, or about 15 percent below its current level. Should earnings disappoint further, say to $36 a share with 4 percent ten-year yields (which would require another fifty basis points of Fed easing), the S & P index could dip to 900, or more than 20 percent below its current level.

Based on the signs of outright deflation in Japan and approaching deflation in Europe and the tenuous support for continued growth in the United States, one must hope that in 1999 central bankers, especially those in Japan and Europe, will overcome their ingrained fear of inflation and will adopt a more healthy fear of the dangers of deflation. Japan’s central bankers, when pressed for reflationary measures, have reverted to a claim that not only do they fear inflation but that the reflationary measures will not work. If a central bank starts to print money and prices do not rise, then absolute liquidity preference has clearly taken over, and a rising demand for cash causes consumers simply to hold the additional money created by the central bank. In short, a central bank afraid that reflationary measures will not work had better get started trying them and pray that indeed they do work.

Meanwhile, there is another reflationary option. The United States, with its modest budget surplus and stable prices, could help stimulate growth at home and globally with a simple across-the-board reduction in tax rates. Lower tax rates always enhance economic efficiency and, augmented by a stable monetary policy, would modestly stimulate U.S. growth while causing the dollar to strengthen. Supporting U.S. growth with tax rate cuts would be unambiguously helpful to the global economy since the firming of the dollar would help to shift demand onto the output produced by weaker economies and thereby help growth to increase abroad while ensuring U.S. price stability.

But U.S. tax cuts, even if possible, are passive measures that will not be decided until next fall. For now, active monetary easing is needed. The Bank of Japan must ease aggressively enough to stop the dangerous accelerating deflation appearing in Japan and Asia. The amount of work left for European and American central banks depends on whether the Bank of Japan can abandon its fear of inflation and expedite reflationary measures. If it fails to do so while Europe remains passive, the Federal Reserve must choose between supporting the U.S. stock market and allowing global deflation to accelerate.

John H. Makin is a resident scholar at the American Enterprise Institute.