Originally published in THE BOSTON GLOBE

Tuesday, November 11, 1997

Foreign economic turmoil not likely to spread here

No Asian contagion looms

Martin and Kathleen Feldstein

"If there were a serious shortage of demand in the United States, there might be some reason for concern."

With financial markets in turmoil around the world, there is growing concern that the economic problems in Asia could spread to the United States. We read more and more in the popular press that deflation, or falling prices, and even a global recession could be in our economic future.

These discussions tend to overlook factors that insulate the US economy from events in Asia. We don't know whether there will be a major recession in Southeast Asia, but if such a downturn were to occur, it is unlikely to pull US economy with it. US exports to that region and other financial links are just too small for that to be a large risk.

That's not to say there would be no spill-over effects. There is a danger that problems in Southeast Asia will spread to Japan, which is the largest exporter of goods and credit to the countries of Southeast Asia. But Japan's imports from the United States are still small and have been insensitive to the level of economic activity in Japan. Japan has been hovering on the brink of recession for some time, but even if the Japanese economy does fall into a recession, that event should not have a sufficient impact on our trade to cause a US recession.

It is also safe to say that we don't have to worry about importing deflation from abroad. Even if the rest of the world were experiencing deflation with prices falling at 5 percent a year, if the Federal Reserve were pursuing a strongly expansionary policy with rapid growth of the money supply, prices would be rising at a comparably rapid pace here.

In this scenario, the difference between our inflation and the deflation in the rest of the world would be matched by a falling value of the dollar so the price of foreign goods, expressed in US dollars, would rise at about the same rate as the prices of domestically produced products.

But even if importing deflation is extremely unlikely, is there a chance that deflation could result from current domestic policy? The rate of inflation has been on a steady downward path since the double-digit inflation of the late 1970s and early 1980s. Indeed, inflation registered less than 2 percent in the past 12 months. Despite statements by Federal Reserve chairman Alan Greenspan and his colleagues that the goal of Fed policy is price stability, this declining trend in inflation is enough to raise specters for some of negative inflation rates in the not too distant future.

If there were a serious shortage of demand in the United States, there might be some reason for concern. When consumers become unwilling to spend and companies stop investing in plant and equipment, as they did in the early years of the 1930s Depression, falling prices develop as a symptom of the underlying economic problem. But a shortage of demand is hardly a concern in the United States today. The US economy has been enjoying strong growth, accompanied by buoyant consumers and strong business investment.

Japan is a different story. Years of mismanaged government policies in Japan have produced a long phase of very slow growth. A recent example of poor government policy was the decision to raise the national sales tax, despite the fact that Japan has been suffering from insufficient demand. Not surprisingly, Japanese consumers cut back yet further on spending in response to the tax hike. Falling prices in Japan are the symptom, but not the explanation for the structural problems in that economy.

Unlikely as deflation is for the United States, we should add that it wouldn't be all bad if prices were falling at 2 percent instead of rising at 2 percent. There would be gainers and losers just as there are in an inflationary economy. Among the losers would be firms with long-term fixed interest obligations that would find the burden of their debt increased. But many would be better off than in an inflationary environment. Falling prices would be accompanied by lower interest rates so existing bond holders would benefit and more people could afford to buy homes.

Shareholders would no longer be penalized by capital gains taxes on artificial inflation gains as they have been in the past. Indeed, shareholders might actually get to realize real capital gains without having to pay taxes on those gains because of the offset from the lower price level. The lower real tax on capital gains might well have a positive impact on the stock market.

Fortunately, the fate of the US economy rests on decisions made by the Federal Reserve and not on events in Asia. For nearly two decades those decisions have been directing the US economy toward greater strength and stability.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.