For stock market bears, the theory has become a very handy way of re- justifying their stance. In recent times stock market corrections or bear markets have generally been caused, at least in the Western world, by deteriorating liquidity as central banks raise interest rates to combat inflation. Plainly there's a bit of that going on in Britain right now. After yesterday's clutch of economic indicators, it rather looks as if last week's quarter point on interest rates won't be the last. Even so, this hardly justifies the present bout of jitters. Inflation is still in abeyance in most of Europe and North America.
Instead, the turbulence in Western markets has been caused by the opposite thing - the fear of deflation. The contagion has spread, moreover, not from Wall Street into the rest of the world, as it usually does, but from the Far East, from the developing Pacific Rim economies into Japan and then into the US and Europe. One feature of this phenomenon has been a tendency for bond and equity markets to decouple, for bond prices to rise even as equities are falling, much as they have done in Japan since the stock market bubble burst at the end of the 1980s. This is highly unusual, for the two normally track each other, and a clear indication of deflationary forces at work, the argument runs.
Taking the real economy, the deflation theory works like this. The crisis in the Pacific Rim economies may not be of critical importance to the US and Europe, but it is to Japan, half of whose exports go to Asia. Here there's a double whammy for Japan's already weakened economy. Nobody will be buying on past levels and even if they were, Japan's competitiveness has been severely undermined by currency devaluation in the region. What's more, the consequence of excessive investment in the region is overcapacity and too many goods looking for a market.
Still reeling from the after effects of Japan's own speculative stock market and property bubble, Japanese banks now have a whole new raft of bad loans to come to terms with. No wonder Barton Biggs, Morgan Stanley's stock market guru, is advising clients to quit waiting for a recovery, cut their losses and bail out of Tokyo.
With no Asian market to turn to, Japanese companies and their counterparts in the region will fix their efforts on the one big growth market left, the US. In the words of Andrew Smithers, of the London based investment boutique Smithers & Co, "a weak yen would be part of the general devaluation of Asian currencies and would exacerbate the growing disparity in the US between the rise in costs of labour and services and the price of traded goods. This would pose a major threat to the profits and cash flow of US corporations." A fall in the yen thus becomes the trigger for a further fall on Wall Street. In a worst case scenario, there's a trade war, pressure for protectionism, and, hey ho, it's the 1930s all over again.
Compelling isn't it? But actually rather unlikely, at least in this form. Here's the other side of the coin. World capacity and output have not been growing at an unusually fast pace; investment spending is at around, or below, its long-run average relative to OECD and world GDP, although it is at a cyclical peak in the US. There are gluts and falling prices - but only in a handful of commodities, in particular in semiconductors, steel, possibly chemicals and cars. Because they are high-profile they exercise a tyranny over popular thinking.
Although some OECD countries have high unemployment, this is structural. Others - the US, UK, and the Netherlands - have unemployment rates at 20 or 25-year lows; wages are rising faster than inflation across most of the OECD. The Asian slowdown will affect the rest of the world; but world GDP growth is still expected to be 3-4 per cent, well above the post-war trend. Asian growth forecasts have been cut from 8 per cent plus to 6 per cent, or about 4 per cent excluding China - still not a slump.
Commodity prices, the bottom of the price chain, are not falling. Outside Japan, real interest rates are relatively high; if there were any evidence at all of a troubling economic slowdown, central banks could easily tackle it by cutting interest rates. This is not to argue for complacency. The repercussions of the Asian crisis are still far from clear, and it does seem highly likely there will be real economic damage both to Japan and the US. But that it will cause a slump, or even a recession in the US looks at this stage rather improbable. A reduction in US economic growth? Certainly. An end to Wall Street's bull market? Very probably. A big Wall Street correction? Possibly. But worldwide deflation? Mmmm.