Dr. Doom strikes again: Get set for three years of deflation

This observation may send the inflation hawks scurrying back to their nests: New York University economics professor Nouriel "Dr. Doom" Roubini says excess capacity in the global economy may lead to a deflationary period lasting as long as three years.

"There is already excess capacity in the global economy because of the over-investment in capacity by China, Asia and other emerging markets," Roubini told Bloomberg News in Singapore Wednesday. "Without an increase in global demand, we will have even more excess capacity," and China "is not building domestic demand," he said.

More cheery news

In the U.S., Roubini said housing, consumer goods and commodity prices will be held down by excess capacity and weak demand, and "this will lead to deflation in the next three years." Roubini added that he expects both economic data and corporate earnings to disappoint.

Many economists expect the U.S. economy, which has been in a recession since December 2007, to enter a recovery phase by Q4. Even so, global trade is expected to contract 9 percent for the year -- international trade's largest decline since World War II, according the the World Trade Organization.

Further, Roubini predicted that 2010 U.S. GDP growth is going to be very low, totaling only 0.5 percent. "Prospects for recovery in Europe and Japan are even worse than in the U.S.," Roubini said, Bloomberg News reported.

Deflation - - a protracted, systematic decline in prices and wages - - occurs in pronounced recessions and other conditions where demand is non-existent, and it robs companies of the ability to increase revenue and hurts the economy's ability to grow. If it takes hold, that's another hurdle policymakers will have to grapple with as they attempt to end the U.S. and global recessions.

Through fiscal and monetary policy, the United States has added a record $12.8 trillion in stimulus and liquidity to the economy and financial system, a policy that economic conservatives have argued will to lead to rising inflation.

"Roubini is on the mark"

Economist David H. Wang, an economic modeler, agreed with Roubini that those concerns are misguided -- because we have a more serious problem to worry about. Although there are "inflationary forces acting on the economy," Wang said, "the deflationary forces are stronger, currently."

"Roubini is on the mark. In the U.S., the housing hangover is the biggest factor because it is a large component of the cost of living. Also, when houses are not bought in large numbers, neither are the goods that go in them, and that has led to downward price pressure on consumer goods," Wang said. "Internationally, we can see a clear overproduction in autos, and this is rippling through other sectors, including commodities like steel, and electrical components. Nine of my ten international industrial variables have deflationary readings, so the bigger danger is deflation, at least through mid-2010."

Wang said, ironically, a rising price of oil -- historically the bane of the industrialized world -- could be a savior here, by counteracting deflation pressures. However, although oil burst through $55 per barrel Wednesday on talk of a recession bottom, Wang expects the price to retreat to "well under $45, due to excess supply, taking more cost pressure off prices throughout the system."

Once an obscure, little-regarded academic, Roubini rose to prominence in 2008 after he successfully predicted -- two years in advance -- the current global financial crisis and recession. Roubini was the first economist to predict massive mortgage and housing-related losses for U.S. banks, which he originally pegged at $1 trillion; Roubini's most recent estimate now sees those losses totaling $3.6 trillion.

Economic Analysis: Inflationary pressures exist, but again, the deflationary pressures are stronger. That is not to say that government spending from the stimulus can't cause "pocket" price surges – such as a rise in local food costs in an area that builds a new U.S. Navy submarine or major alternative energy facility, for example. But nationally the demand is not there, due to high unemployment, and, according to Roubini, international demand is still insufficient to eliminate the surplus of manufactured goods built up during the previous expansion. With both domestic and international demand so light, the contours are in place for a period of weak pressure on prices, which historically has led to low, or, worse yet, negative, inflation.

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