Applause, please, for Alan the acrobat

Actions speak louder than words, so we should know by Wednesday just how seriously the Federal Reserve is taking the risk of deflation in the United States. The fact that financial markets are debating whether Alan Greenspan will cut interest rates to 0.75% or "merely" to 1% tells its own story. The Fed is taking the threat very seriously indeed.

Nor do the markets believe that the anti-deflation package will end there. They are looking for Greenspan to signal that the US authorities will start buying back government bonds, a move that would reduce bond yields and so bring down long-term interest rates for companies and individuals. As John Shepperd of Dresdner Kleinwort Wasserstein said last week, the Fed is insisting that the US should be safe from deflation yet is prepared to act to make sure that it is right.

"The acrobat should not fall, implies Greenspan, but the safety net has been taken out, fully checked, and has been firmly tied in place."

Deflation threat
This is a sensible move. Winning the war against Saddam Hussein was the easy bit; the right image for the global economy is not that of a formula one car with the pedal to the metal - rather a trick cyclist wobbling across a high wire. A safety net seems a very good idea.

The DKW team thinks it quite possible that interest rates in the US will stay below 1% for the next two years, that rates in the eurozone will hit 1% once the European Central Bank realises the extent of the deflationary threat, and that rates in the UK will come down to 3.25%. These rates are extraordinarily low by any standards, but rather than being evidence of a global economy in glowing health are a sign of how close it is to severe trouble.

"We are not quite at deflation but we are close," eminent American economist Lester Thurow said in London last week. Computerisation, offshore production, outsourcing, deregulation, privatisation - the full nine yards of globalisation, in other words - had resulted in excess capacity in every industry in the world, he said.

In an environment where inflation is already low, excess capacity plus inadequate demand equals a big risk of deflation, the biggest since the depression. Given that the 1930s have left an indelible mark on the conduct of US economic policy ever since, it is hardly surprising that Greenspan should be worried.

He dropped a pretty broad hint about his concerns earlier this month, when he said he had "not yet seen any major impetus to a pick up", adding that the Fed was "far more inclined... to be taking out insurance against economic weakness" and saw the need for a "wider firebreak" to contain deflationary forces. The warning signs are certainly there. Japan's descent into deflation was presaged by its measure of core inflation, excluding food, shelter and housing costs, with a broader measure of price changes following it down after a lag. The US seems to be following a similar pattern, with core inflation excluding housing and medical care rising only marginally above zero in recent months.

This may seem strange at a time when the US economy is still expanding, but the problem is that it is not living up to its potential. There is downward pressure on prices all the time that actual output falls short of potential output, and the size of this output gap is growing. At some point disinflation - ever lower levels of inflation - turns into deflation unless something stops it.

Greenspan rightly appears unconvinced by those who argue that Japan was a special case and that therefore it could not happen in the west. As Graham Turner explains in his timely new book about the Japanese descent into deflation, the root cause of its difficul ties lay in "unbridled speculation, excessive borrowing and overinvestment". The US has had all three. Personal sector borrowing in the US is now well above the levels witnessed at the time of the Wall Street crash of 1929, and falling interest rates have not resulted in lower debt servicing costs because the level of borrowing has risen so quickly.

And, as Japan showed, once inflation turns negative, the real cost of borrowing rises because nominal interest rates cannot fall below zero. In those circumstances, the real value of debt increases, consumers stop spending in anticipation of even lower prices and companies go bust because the "stickiness of wages" means the cost of labour falls far less quickly than prices, thereby leading to big falls in profitability. Even when prices were falling at 15% a year in the depression, wages - for those lucky enough to be employed - were still going up, Thurow said last week.

Various reasons have been put forward to explain why the US will not be the new Japan, but Turner argues that none of them is especially convincing. While it is true that the Fed has moved more rapidly to bring down short term interest rates, US companies have not seen any fall in their aggregate borrow ing costs since the bear market in shares began three years ago. The reason for this is that US business is highly dependent on the corporate bond market, where investors have taken fright at the wipe out in equities and demanded a higher risk premium for lending to companies. This has been especially true for highly leveraged companies in the junk bond market. Net corporate interest payments are actually higher than in the first quarter of 2000, when the stock market bubble burst.

Nor, says Turner, should we be taken in by all the talk of America's productivity miracle. Japan's productivity in the 1980s was impressive, and over the past two decades it has grown 15% faster than America's. But productivity is not the same as profitability, and in both cases what happened was that the expansion in productive capacity meant that supply exceeded demand. Low inflation, seen in Japan in the late 1980s and the US in the late 1990s as evidence that the good times would last for ever, was in fact a warning sign that companies were unable to raise prices in a highly competitive business climate. The bubbles were the result of investors failing to look closely enough at the bottom line: in the case of the US, profits did rise in the second half of the 1990s, by 30%. In the same period the S&P index of shares rose by 300%. Wall Street still looks overvalued, with the risk that the recent run-up in shares is a repeat of the rallies in the Nikkei seen in the 1990s. Another downward lurch in equities would make deflation even more likely.

Simple cure
The cure for deflation is actually simple. Print money. Inject some inflation into the system. Ensure that people spend rather than save. Keynes argued that the right approach was first to reduce short-term interest rates as far as you could, which the Fed has just about achieved. The next step is to reduce long term borrowing costs by buying back bonds. Once you have exhausted monetary policy as an instrument, and only then, you use expansionary fiscal policy, either through borrowing for public spending or by unfunded tax cuts. George Bush has rather pre-empted this option by allowing the US budget deficit to balloon.

Even so, there is little doubt that Keynes would approve of Greenspan's overall policy thrust and he would no doubt have been impressed that just by jawboning about deflation, the Fed has managed to shave more than half a point off bond yields without spooking Wall Street. What he would have said about the ECB is quite another matter. As Mr Shepperd pointed out, in Europe the "safety net is rolled up and locked in the storage cupboard". It is time somebody went to look for the key.