Saturday, February 7, 2009

What Falling Prices Are Telling Us

What Falling Prices Are Telling Us

Consumer prices in the U.S. fell at a breathtaking annual rate of nearly 13% in the last three months of 2008. Prices plummeted for all sorts of goods, ranging from clothing to TVs to furniture, as retailers advertised sale after sale.

But deflation missed big chunks of the economy. For all of 2008, college tuition and fees increased by 5.8%, followed closely by price increases for hospitals and legal services. Even fees for preparing tax returns are going up.

This inconsistency in prices casts doubt on the usual explanation for the recession, which is that it's mainly due to the credit crunch and the resulting squeeze on demand. It also hints at why government efforts to fight the downturn have been ineffective so far.

Here's the big idea: If the lack of demand that the Obama Administration is fighting were the only problem, you'd expect prices to fall across the board. Instead, it appears that supply—that is, oversupply—is at least as important a factor. The sectors in which prices are falling are those plagued by an excess of factories and ways to get goods to consumers, often because of huge investment in plants in China and other developing nations. Most services, in contrast, are not in severe oversupply and have domestic labor as their main ingredient. Consider this: Prices of goods fell 4.1% last year; prices of services rose 3%.

The government's deflation-fighting weapons—low interest rates, financial bailouts, and spending packages—can boost demand but do little to deal with oversupply. As Microsoft (MSFT) CEO Steven A. Ballmer and General Electric (GE) CEO Jeffrey R. Immelt have observed, long-term demand growth has been "reset" downward. The world's productive capacity is simply too big. That means prices need to fall further, or more factories need to close in the U.S. and abroad, or some combination of the two.

That's not to say the Obama Administration is on the wrong track with its nearly $900 billion-plus stimulus plan. But it's important to have realistic expectations. The stimulus can ameliorate the downturn, but not prevent continued contractions in the sectors of the economy where global overcapacity is the most extreme. Examples? The world is able to make 90 million vehicles a year, but at the current rate of production, it's making only about 66 million, according to estimates from market researcher CSM Worldwide. Global production of semiconductor wafers is running at only about 62% of capacity, estimates market researcher iSuppli.

Such overhangs hurt not only manufacturers, but retailers who sell goods and the truckers who distribute them, not to mention the financial wizards around the globe who abetted the buildup of overcapacity through foolish lending and financial inventions. (Finance is one service sector where prices are falling, in part because banks lent so heavily in housing.)

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