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Deflation close to home Featured

9:59am EDT July 22, 2002

What does deflation mean to you? Consider this scenario.

After prospering through the '90s, a Northeast Ohio manufacturer spends $1.7 million for a new facility and equipment. It finances 70 percent-or $1.2 million-and pays the rest out of cash reserves.

The company expects a 15 percent increase in annual earnings (before interest and taxes) on this investment-roughly $250,000 a year. With the bank loan fixed at a rate of 10 percent (OK, it's high, but it made the math easier), annual interest-only payments are $120,000. So overall, the expansion produces an additional $130,000 a year in net earnings.

But as deflation creeps across the ocean from Asia, things change. Prices for the company's finished product are forced down for two reasons: buyers overseas can no longer afford to purchase American goods with their own shrinking currencies and back home in the United States, the dollar buys an ever-increasing amount of exports shipped here by foreign competitors.

Within months, the company's price cuts-designed to compete with low-cost imports-are eroding operating profits, even as overseas orders drop.

The increased capacity resulting from the expansion is no longer needed; the third shift is laid off and the new equipment sits idle for a third of each day.

The $250,000 annual return on investment is now down to $120,000-just enough to make the interest payments.

As this scene is played out in industry after industry, domestic orders start to decline as well and another $20,000 in earnings disappear. With its cash reserves depleted from the expansion, the company is forced to sell land or equipment to address the cash flow problem and to comfort its increasingly wary banker.

That's standard practice when sliding prices are driven by competitive forces-industrywide overcapacity or new technology, for instance.

But in an environment of true deflation, "it's happening to everybody and there's no market," explains Dr William Peirce, chairman of the economics department at CWRU's Weatherhead School of Management.

Besides, he notes, who is going to pay $1.7 million for equipment that produces only $100,000 a year in profit?

The assets would actually be worth closer to $667,000, Peirce figures, even though the bank still wants $1.2 million for it.

"In that case, you may as well just walk away and go to Peru with a stash of gold coins," says Peirce. "Let the bank handle it as a nonperforming asset."

That's true deflation-when the economy contracts at all levels. Assets are devalued because the finished goods they produce suddenly command lower prices. Shrinking prices force wages down. Breadwinners, with less money coming in, hold onto their cash waiting for better prices. Suddenly there's more product than apparent cash to pay for it, which drives prices down again into an inescapable spiral.

"It's a pretty messy and painful process for business owners," Peirce says. "When assets begin to be devalued, it becomes difficult for a business to survive."

That's precisely what is happening in Japan today, where companies are scrambling to sell devalued assets just to pay their bills.

Few credible sources predict such desperation here. More likely is a mixed bag of winners and losers, says Peirce.

"Deflation would affect everyone, but especially those companies with debts. They would be the hardest hit."

Also hurt would be companies that produce raw material commodities, such as chemicals. "Those companies are already suffering now from low worldwide prices," explains Jack Kleinhenz, senior economist and director of research for the Greater Cleveland Growth Association. "There would be a difficulty in reducing costs any further and they couldn't pass along the price changes because prices would have fallen further. So it certainly could have a contractionary effect."

Service businesses that support large companies-law firms, accounting firms, management consultants, etc.-would feel the pain next, says Kleinhenz, a former economist at the Federal Reserve Bank of Cleveland. "Ultimately, it will impact retail and general business to the extent that individuals who were no longer employed aren't going to have the spending capabilities like they had in the past."

But, counters Michael Bryan, an economist at the Cleveland Fed, "For every instance of an industry that's getting creamed, there's another doing better."

These include companies that have excess cash, which carry minimal debt, or which are heavy users of raw materials.

So how can you use this information? One strategy for companies that export is to emphasize business in countries with strong economies.

"If our dollar value was lower, that would mean our products would be lower priced," explains Russell Leach, executive director of the World Trade Center Cleveland. "That means in those countries that are performing well, our products would be more affordable. That could act as a driver for exports."

That's what happened last year. While the region's exports to Asia were off 31 percent through the third quarter of last year (the most up-to-date figures available), exports to other regions of the world blossomed. Overall, Northeast Ohio exports were up 11 percent through the third quarter of 1998, compared the same period in 1997.

"Our companies are extremely fast on their feet," Leach says. "They recognized that the Asian economy had tanked so they looked for new outlets for their products."

Similarly, should signs of deflation materialize, the Fed would keep the money supply from contracting, explains Bryan. That would keep consumers spending, which in turn would keep the economy flowing.

This is why economists say the odds of a deflation are slim. "There are too many controls in place today," says Peirce. "We could certainly see the beginnings of a deflation, but the central bank (the Fed) wouldn't let it happen."