Global deflation is a good scare story but where's the evidence?

Diane coyle On the financial world's latest fad

It is always a surprise to realise the extent to which fads and fashions dominate the world's financial centres. This is not a question of sartorial trends, although red braces and ties with dollar signs have had their bouts of popularity. It is more to do with the story the analysts and salesmen and traders tell to try and make sense of the trends in the markets and predict what will happen next.

All of a sudden everybody in the markets is talking about global deflation, a scare story of falling prices, industrial over-capacity and trade wars, all triggered by the Asian crisis. Like any myth, this has elements of truth. The notion that the world economy is poised for a rerun of the 1930s with nobody willing or able to buy a glut of goods is a logical possibility. It is just that there is absolutely no foundation for it in the evidence.

Let's try to give the new deflationists the benefit of the doubt. There is a good case to be made that as the slide in Asian stock markets and currencies drags on, the outlook for the still-fragile Japanese economy will get worse and the spillovers into the rest of the OECD will be bigger than anybody first thought. Each day of falling share prices in Japan, South Korea and Hong Kong magnifies the impact.

As far as the UK is concerned, the spillover effect could be quite large, according to a new report from investment bank Kleinwort Benson. Economist David Owen predicts that GDP growth will slow sharply, to 1.7 per cent, in 1998, partly because turmoil in Asia will add to the effects of the strong pound, higher interest rates and tight fiscal policy.

He sees several channels through which a sharp slowdown in the Far East will affect the UK. One is a drop in exports to the region, and rise in imports from it, because of the exchange rate change. The pound has climbed more than 50 per cent against the Thai baht and about 33 per cent against the Malaysian ringgit and Indonesian rupiah. Exports of British goods to Asia (including Japan and China) amounted last year to nearly 3 per cent of GDP. Exports of services were equal to about 2 per cent of GDP.

In addition, Britain has been a big investor in East Asia, and earnings remitted from those investments were equivalent to about 3 per cent of GDP. In other words, the scale of the British economy's vulnerability to a slowdown in Asia is more than twice as big as as the exposure through trade in goods, the figure normally cited.

However, if Mr Owen is right, Britain is a special case. Other countries are less exposed to the former tigers. In total the 10 biggest Asian economies' imports were worth about as much as total US imports last year, but this includes Japan - where demand was already sluggish before this year - and China and Taiwan, which have not slowed down. So growth prospects in countries other than the UK will have been dimmed for the same reasons by the Asian crisis but the extent is still unlikely to be huge.

Economists at James Capel, for example, predict domestic demand growth in the region next year will be 5.4 per cent, compared with their pre- crisis forecast of 8 per cent. This is a significant slowdown in an increasingly important market for OECD exports, but not an implosion or meltdown - popular as these words have become with many commentators.

But the global deflation story does not rest just on weaker exports to Asia. The argument is that the world has significant overcapacity and is producing too much for demand to absorb it all following the slowdown in the small but once rapidly-growing Asian economies. These countries, it is argued, will use their weaker exchange rates to slash prices of their exports.

In turn this will slow growth in the OECD economies as their imports rise and exports fall, raising unemployment and reducing domestic demand. Eventually the entire global economy will be characterised by weak demand, excess capacity and falling prices. Trade tensions will grow as the US deficit balloons again, especially vis-a-vis Japan; and Congressional refusal to grant President Clinton "fast track" authority in trade negotiations is an early warning of 1930s-style protectionism.

What are the flaws in this story? The first point is that there is no evidence of global overcapacity except in one or two industries like semiconductors, steel and cars. The problems afflicting prominent manufacturing sectors are taken as symbolic of the whole economy, when this is far from the truth.

The new report from James Capel shows that the contribution of investment spending to GDP growth within the OECD has been on a long-term downward trend although it is currently near a cyclical high. Investment spending by the Asian tigers, or ex-tigers, has grown very rapidly during the past decade. However, much of this has been on domestic infrastructure. The net addition to world industrial capacity has been relatively small.

Author Keith Skeoch writes: "It is far from certain that global capacity is expanding as quickly as it did in the 1950s and 1960s, when inflation was low but there was no tendency towards deflation, and many of the same arguments were levelled against rapidly industrialising Japan."

So the overcapacity part of the deflation story might be logically possible but in practice it is not very important. Likewise with the trade part of the story. Asia, excluding Japan, happens to be in deficit to the rest of the world - they import more from us than we import from them, by a likely $30bn this year. The sharp devaluations of currencies will eventually trim this deficit and boost Asian exports.

This will only be deflationary in a global sense, however, if world export demand is slowing down. The continuing rumblings of the stock market might eventually slow growth in the US and Europe - although the Dow remains 20 per cent up in the past 12 months - but for now the signs are that demand growth is strong to accelerating. The US and UK are at full capacity and Europe is recovering. The recent IMF forecasts predicted growth in world GDP of above 4 per cent for the next five years and even faster world trade growth. Both will be boosted when agreements liberalising financial services and telecommunications come into effect before the millennium.

So again, a sharp slowdown in world demand, such that increased Asian exports could not be absorbed without deflation, is a possibility. But it is far from being a probability. The trouble is that the storyline "Somewhat slower growth than we first thought" is nowhere near as attention- grabbing as "The sky is falling". It will be a while before global deflation goes out of fashion.