The front page headline of an influential US business magazine last summer referred to a phenomenon which had a profound impact on the behaviour of world financial markets throughout last year. This was "the brave new world of Greenspan", or the "new paradigm" as the Federal Reserve chairman labelled it himself.
These terms seek to describe a world where strong economic growth and historically low unemployment can be consistent with stable inflation. This is, indeed, what happened during 1997. It resulted in a very benign scenario of rising equity markets and falling long-term interest rates. The sense of calm was thrown into some disarray in the final quarter, however, as the Asian crisis forced investors to reconsider the theory and led some to conclude that the stable prices of the last couple of years could be replaced by falling prices - or deflation - in 1998.
The US economy was the one where the "new paradigm" gained most credence. Real gross domestic product (GDP) expanded by almost 4 per cent, unemployment fell to 4.6 per cent in November and yet inflation the same month was running at just 1.8 per cent. Prior to 1997, few would have believed that the US economy could sustain an unemployment rate much lower than 5.5 per cent, without generating significant wage pressures and ultimately higher inflation.
The reasons for the changed behaviour are many. They include greater job insecurity as part-time employment gains in popularity, the opening up of new low-wage and low-cost economies in South America, Asia and central and eastern Europe, greater competition among retailers and strong consumer resistance to price increases.
These factors are also evident in many other industrialised economies. The main benefits of this new environment were manifested in buoyant equity markets and sharply higher government bond prices and lower long-term interest rates.
With the Asian crisis now unfolding at a frightening pace, many commentators are already talking alarmingly about deflation in the world economy. Deflation describes a situation where prices are actually falling and the value of money is rising.
Japan is really the only industrialised country which has been experiencing such a situation. Although measured inflation there has been in positive territory, the real level of prices has actually been falling. In contrast, countries like Germany, Britain - and especially the US - have been experiencing "disinflation". This describes a slowing down of the rate of inflation, but the overall level of prices continues to rise.
There have been examples of deflationary periods in the past, with 1929 to 1933 the most notorious. During those years prices fell at an average rate of around 8 per cent per annum, with dire consequences for many. Typically, periods of deflation are driven by cyclical economic downturns which get out of control. Research has shown that these cyclical downturns have been accentuated by the inability of the commercial banking system to extend credit and ultimately have often involved numerous bank failures.
Such considerations are relevant to what is going on in the world economy at the moment. The Asian situation has highlighted the inherent structural problems affecting many of the former "tiger" economies.
After years of heavy investment, industrial capacity is excessive and external deficits are quite severe in many cases. The South Korean banking system is now under heavy strain and the risk of failure is rising. At the very least this will seriously curtail the ability to extend credit. At worst, it could lead to a collapse of the domestic financial system, with serious consequences for the financial system world-wide.
The Japanese economy is also on its knees, with growth plummeting and no obvious recourse open to the authorities to stimulate growth in any meaningful way. Of most concern here also is the health of the banking system.
The upshot of events in Asia is that growth in the region will be seriously curtailed over the coming year, and it is possible that the major economies such as Japan and South Korea may not record any growth at all. Deflation could become a real issue for the region.
How this would impact on the rest of the industrialised world is not quite clear just yet, but there are clues. Most forecasting agencies have already trimmed more than 1 percentage point off their estimates for world growth in 1998 and the possibility is that these estimates will be revised down again over the coming months.
Furthermore, the sharp fall in the value of Asian currencies will have a major impact on the price of exports from the region. For example, South Korea accounts for just over 3 per cent of world trade, and it competes with Japan and the West in sectors such as automobiles, electronics and chemicals. This will put considerable downward pressure on the price of those products world-wide and will compound the disinflationary trend in evidence in the US and Europe.
The Western authorities will now be very aware of the threat of deflation and will have to be ready with a response if the situation deteriorates over the coming months. At the very least, interest rates will remain on hold for the foreseeable future, and reductions cannot be ruled out. This should provide a good environment for bond markets, but equities could be in for a shaky start to 1998.
Jim Power is chief economist at Bank of Ireland Group Treasury. The views expressed are personal.
