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March 1, 2004

The Specter of Deflation: Shilling, Prechter and Makin Take a Pessimistic View

By Kathryn M. Welling

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Independent economic researcher A. Gary Shilling's last two books have been all about the "D" word, and he is still a true believer. The Elliott Wave Theorist's Bob Prechter's latest book is "Conquer the Crash," in which he talks about a coming deflation and how to cope with it. John Makin, an American Enterprise Institute Scholar, who also works the hedge fund side of the Street, hasn't published a book on deflation,

but says he "probably should. I'm really looking at continuing disinflation and the Fed's seeming indifference thereto." And John has written copiously and cogently on same. This trio, quite evidently, are marching to a different drummer than the herd of optimistic prognosticators whose economic predictions already have produced any number of cheery "outlook" pieces this year. So what do they think they see that most economists are missing, amid their celebrations of booming GDP and quiescent inflation? Deflation, of course. I gathered them into a conference call last week, and challenged them to worry me.

They did a pretty good job -KMW

Okay, fellows, convince me that inflation isn't the next big issue.

Shilling: Kate just this morning sent me your latest piece, "The Opposite of Stagflation," and I apologize, John. I'm only about halfway through it. But I think the gist of what you're saying is, "Hey, in the face of all this stimulus, inflation is fading. There must be something else going on."

Makin: Yes, we have lots of excess capacity. If I were trying to explain this to a classroom I would have to say that we have a highly elastic aggregate supply schedule that's shifting out faster than demand-and that's amazing. Demand is shifting pretty fast itself, but it's probably going to slow down.

Shilling: You also made the very interesting point that policymakers are really geared watching for big shifts in demand, but they are quite unaccustomed to big changes in supply. In other words, they haven't really incorporated globalization in a policy sense.

Makin: That's right. Look, if growth were 3 percent and we had the same inflation numbers we have today, I think they would be a bit less casual.

Shilling: Yes, when you put together globalization and the tremendous excess capacity built in the 1990s - we haven't seen anything like that since the 1920s.

You spend enough time in D.C. to know they're not going to look at the raw numbers, John.

Makin: Well, the Fed staff has a model and like most of the models that people use, it's really demand-driven. Meanwhile, a lot of people are having difficulty facing investment decisions this year because lots of money has come in the door and it's a little tricky to figure out what to do with it. If we are going to have another great year for stocks, we probably have to have a tepid interest rate environment, such as last year's. And if we get that, that's probably because we're not getting any inflation growth - so maybe it gets a little tricky for the stock market here.