Deflation threat

Economists and financial analysts are starting to pay closer attention to President Bush’s intentions in the Mideast, especially Iraq. The reason is that a war with that country will have profound effects on the global economy.

Consumer confidence in this country is at its lowest point in nine years, indicating the world economy is not in good health. A full-scale war in the Mideast will make it much worse.

Each of the three previous global recessions, according to The Guardian newspaper of London, has been at times of trouble in that region. All three produced sharp hikes in oil prices, rising inflation, higher interest rates and slower growth.

Lehman Brothers reports managers of hedge funds and equity funds at central banks are very concerned over the risk of deflation, that the results of last year’s interest rate cuts have faded; that the U.S. and Europe may repeat Japan’s recent economic experience and that the stock market could drop another 40 percent before it hits bottom.

The attitude of many analysts seems to be: if there is going to be a war, let’s get it over with quickly. That would be beneficial for the markets by ending the uncertainty, shortening any spike in oil prices and restoring consumer and investor confidence.

If Saddam were to be removed,oil prices would drop even more while oil shipments would rise, cutting business costs and boosting consumer incomes. However, a spike in oil prices is expected

at the commencement to the war.

Accordingly, a protracted war in Iraq or the extension of war to other countries in the Mideast would have a disastrous effect on the economy and the markets.

Nobody anticipates any serious interference with oil shipments, but the attack on a French tanker a little over a week ago shows how vulnerable the West may be.

Iraq supplies only 3 percent of global oil production, but its neighbors account for an additional 17 percent. Demand for oil is weakening, according to the International Energy Agency, but any hint of disruption in the supply line would send prices soaring.

Secondly, increased oil prices could trigger a cutback in consumer spending. The biggest threat, however, from a Mideast war is not inflation but deflation. Higher energy prices would mean slimmer profit margins for companies and lower incomes for workers. Demand would be lower, creating even more deflationary pressure.

That would force policymakers to take action to bolster demand. The Fed may have to trim interest rates again next month. Some observers think rates may be near 1 percent by the new year and remain there all through 2003.

Comstock Partners, a mutual fund management firm, noted many financial journals are running articles on deflation. This is happening, they say, because the available evidence supports those views.

Comstock said the present pattern is classic. First there is a period of excessive credit creation, then over-investment, a buildup of excess debt, massive over-capacity and a very speculative market.

That leads to sharp cutbacks in capital spending, weak pricing power, competitive devaluation, trade protectionism, plant closings, debt defaults, recession and a major bear market. Comstock said the bear market is far from over.

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