| eir businesses on price cutting. Dell cut prices by outsourcing the design and production of personal computers and captured enough global demand to become the world's largest PC seller. Kmart cut prices, but at the cost of less choice for consumers and declining service, and found itself losing customers and piling up debt. The macroeconomic version of price cutting is deflation, and some economists are now suggesting the U.S. economy is on the verge of a deflationary cycle. If so, are we headed on the path of Dell or Kmart?
Disinflation—a falling but still positive inflation rate—is often good for an economy, and even mild deflation—in which that rate drops below zero—may be no worse than mild inflation, if it reflects rising productivity. For example, technological advances and strong demand have enabled the semiconductor industry to steadily improve the power of chips so, in effect, the price of a given chip steadily falls. Imagine a version of the same thing on an economy-wide scale, and you have benign deflation.
But deflation also can be malignant, as Japan demonstrates. There, a collapse in stock and real-estate prices triggered falling demand and rising unemployment. Consumers cut back, and so did firms; and as the economy slipped into recession, normal inflation receded. Bankruptcies spread, demand and employment fell further, and prices and wages began to actually fall. And the Japanese government found itself virtually powerless.
The numbers in America are getting worrisome. The consumer price index, which rose 3.4 percent in 2000, inched up just 1.6 percent in 2001. Over the four quarters up to June of this year, it increased barely 1 percent. This is strong disinflation, heading toward deflation. Economists were not surprised, because inflation or deflation can often be foreseen by looking at the gap between an economy's potential and what it actually produces. The economy's potential to produce more goods and services depends on how fast workers' productivity increases and how fast the work force expands. For example, when productivity grows 2.5 percent a year and the work force grows 1 percent a year the economy's potential grows 3.5 percent. When the economy grows faster than its potential, economists expect inflation.
Still, there's no reason to expect the United States to endure anything like the spiral of deflation, debt, and bankruptcy that has gripped Japan. U.S. stocks did experience a bubble, but there's little evidence of another one in real estate that could burst. Deflation won't make us stronger, as price cutting did for Dell; nor will it drive us to a Kmart-type bankruptcy, as it nearly has in Japan. Rather, the mild deflation that seems most likely here will probably dampen growth in the short term, but maybe with some long-term benefits.
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