The ghost of deflation could be dragged out of the closet

Manic Monday, Dow plunged 800 points before it bounced back. But the Dow still tumbled below 10,000 for the first time in four years.
With asset markets tumbling, commodity prices plunging the most in 50 years and banks keeping a tighter grip on credit, as LIBOR rose to 4.33 percent, the highest from January and Ted spread rose to record as well. As Federal Reserve Chairman Ben Bernanke and his global colleagues fight the worst financial crisis since the 1930s, one danger is looming larger by the day: deflation.

The deflation scenario might go like this: Banks worldwide, stung by $588 billion in writedowns related to toxic assets will further reduce the flow of credit. That will push house prices lower, forcing additional losses and making banks even more reluctant to lend. As the credit crisis worsens, businesses will find it almost impossible to raise prices. Prices are already falling in parts of the world economy. Home values dropped more than 10 percent in the U.K. and in the U.S. in the past year. Oil, copper and corn drove commodities toward their biggest weekly decline since at least 1956 on Oct. 3. So for now, a global recession is already looking more likely.

It makes us to stir memories of Japan's decade-long struggle with deflation in the 1990s, the Lost Decade”. It started from a stock and property price crash at the beginning of 1990s. The caution of Japan's leaders -- who waited until 1999 before using taxpayers' money to bail out the banks -- cost their economy dearly. Lending shrank, unemployment more than doubled to 5.5 percent, and Japan experienced three recessions between 1990 and 2002. From 1997 to 2007, consumer prices dropped 2.2 percent. In the U.S., prices climbed 29 percent in the same period.
Fed chairman Ben Bernanke, who has studied Japan's ``lost decade'' of deflation and of course Great Depression since his graduate school, pointed out governments and central banks must respond immediately to such a deflationary shock by dropping money into the banking system.

When credit markets started seizing up in August 2007, Bernanke set up more than $1.4 trillion in emergency borrowing for financial institutions. Fed also has chopped its benchmark rate 3.25 percentage points since August 2007 to 2 percent. Today, the Fed said it's doubling emergency loans to commercial banks to as much as $900 billion.

The ECB, Bank of England, Bank of Japan and other central banks have set up similar lifelines. It included China Central Bank which fought for inflation for a long time. For ECB, inflation target is its top interest since its inception, but now, European policy makers have considered reversing their decision in July to raise their benchmark rate.

The Fed has already responded to one deflationary scare this decade. With inflation approaching 1 percent in 2003, then- Chairman Alan Greenspan slashed its rate to a 45-year low of 1 percent and kept it there for a year, which its critics say helped fuel the property and credit boom that is now unraveling.

This time, the crisis is an increasingly dysfunctional banking system that may not be able to continue making loans that grease economic activity. Such a pullback, combined with slowing growth and falling asset and commodity prices, makes deflation more of a threat.