Forget stagflation. Stagdeflation sounds scarier

Updated: Jan 27 2008, 06:42am hrs
Nouriel Roubini isnt known for subtlety. His pronouncements about the global economy have an uncanny knack for raising eyebrows and making headlines. Such is the case with the chairman of Roubini Global Economics LLCs recent talk of stagdeflation.

Its an intriguing many will say overly pessimistic take on the already raging debate about stagflation risks facing the US and other major economies. If stagflation means no, or slow, economic growth combined with inflation, stagdeflation is falling prices and growth.

One could argue the term stagdeflation is gratuitous, given that deflation is normally a product of economic contraction. Yet Japans experience in the 1990s -- and even today shows that the phenomenon can occur amid solid growth and, at times, rising stocks.

At the moment, of course, Japanese stocks are under pressure. Less than one month into 2008, the Nikkei 225 Stock Average is down almost 15% as investors brace for potential recessions in the US and Japan.

In Japans case, several years of economic expansion have yet to send consumer prices consistently higher. Even with oil prices near a record, the best Japan can expect is for consumer- price inflation to exceed the central banks estimate of zero percent, Bank of Japan Governor Toshihiko Fukui said this week. Thats significant because of all the

US-going-the-way-of- Japan chatter in markets these days. Here, Roubinis concerns about stagdeflation are worth considering.

Demand shock

The New York-based economist says concerns about stagflation are overdone because of the rising risk of a sharp and globally destabilising US slowdown.

Such worries arent warranted as a U.S. hard landing, followed by a global economic slowdown, represents a negative global demand shock that will lead to lower global growth and lower global inflation, Roubini wrote in a January 21 note to clients.

Hence Roubinis view that stagdeflation, is more likely than deflation if a US hard landing materializes and leads, as is likely, to a slowdown in global demand and growth.

Again, this view could prove overly pessimistic, particularly with the Fed's emergency rate cut on January 22. Then again, the most consistent element of the turmoil in credit markets has been the propensity of investors to claim the worst is over.

Containable

If you received a dollar for every time some pundit, policy maker or investor called the fallout from the US subprime meltdown 'containable', you could probably open your own hedge fund. In that context, efforts this week by Japanese Prime Minister Yasuo Fukuda to talk up the sliding stock market were anything but reassuring.

Its possible that the Feds move to cut its benchmark interest rate by three-quarters of a percentage point will prompt peers to do the same. Central banks in Taiwan, Japan, the Philippines and elsewhere are under pressure to reduce rates. Until now, they were preoccupied with inflation. Risks of a US recession are changing that.

Another possibility is that lower rates wont do much good with the USs troubles deepening. The recent talk of 'recoupling' between Asian economies and the US is just silly. How can economies that never decoupled recouple If the US moves into a prolonged, Japan-like funk, Asia's outlook will darken immensely.

That's not the consensus view at the moment. Economic fundamentals in Asia, such as levels of savings, liquidity and leverage, are much healthier today and should be able to offset, to a certain extent, weaknesses from a slowdown in the US, says Jimmy Koh, head of treasury research at United Overseas Bank Ltd in Singapore.

Dangerous territory

China and India also are growing rapidly, offering a bit of a cushion for Asia.

The trouble is that the world's biggest economy is moving into dangerous territory, and US policy makers are treating the symptoms of its weaknesses, not the causes. The Feds actions are aimed at propping up asset prices and getting consumers to continue spending. The nation's negligible savings rate and dependence on foreign capital aren't being addressed.

The indebted state of American households and huge losses at banks could limit the effects of Fed rate cuts. And with too many big investors like sovereign wealth funds -- owning too many dollars, a day of reckoning may be afoot.

Bust

The current crisis is not only the bust that follows the housing boom, its basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency, billionaire investor George Soros said at the World Economic Forum in Davos, Switzerland. Now the rest of the world is increasingly unwilling to accumulate dollars.

At last years Davos confab, Roubini got some grief for his dire pronouncements about credit markets.

The system is becoming very complex, he said. The risk of some crisis happening is rising. Was it ever.

It wasnt until the fall of 2007 that a critical mass of investors began agreeing with Roubini. Few are likely to agree with him now that a simultaneous drop in growth and prices is in the cards. That doesn't mean it cant happen.

Bloomberg / William Pesek