Is This Axis Evil?(Could Wal-Mart, China and the Internet cause deflation)

It may not be evil, but it is an axis. Quietly, the strengthening powers of China, the Internet and Wal-Mart are fueling a global surge in cutthroat competition, driving down prices worldwide. China continues to evolve as the world's largest and cheapest manufacturer. The Internet is uniting all shoppers in a kind of global consumer cartel, chipping away at the price of everything from home mortgages to plane tickets and used dolls. Wal-Mart has established itself as the world's largest company--mission: "to lower the world's cost of living"--for the second year running and probably for our lifetimes, says Fortune magazine. And unlike the Axis of Evil, there's no question that the links in this triumvirate are real: Wal-Mart became No. 1 by exploiting Internet technology to cut costs and to sell mountains of cheap goods, often made in China.

Those who hate anything big and global will hate this axis, too. Those who embrace free markets will celebrate the cutthroats, since they contributed mightily to a spectacular rise of productivity in the 1990s and helped smother inflation. Now, however, no big national economy is strong, all too many factories are underemployed, and one has to wonder whether price pressures are heightening the opposite risk: deflation. The United States, which has been haunted by the nightmare of deflation since its stock and Internet bubbles started popping in early 2000, is particularly vulnerable now that growth has slowed; core inflation is less than 2 percent. Cary Leahey, a Deutsche Bank economist in New York, gives deflation a 1-in-20 chance of striking the United States, up from 1-in-50 in 2001. "You could build a case for deflation as the dark side of the productivity miracle," he warns.

The D-word is now a watchword. The U.S. Federal Reserve has been eyeing Japan, which has been subject to the wealth-destroying effect of deflation since its stock and real estate markets crashed in the early 1990s, and Fed governors have made clear their commitment to stave off a similar scenario in America. But competition in the global economy is now so intense that companies are rapidly losing the power to raise prices. Overall, prices in department and discount stores have been falling for six years, and the price of clothing in the States fell 3 percent in February from the previous year--thanks largely, analysts say, to the Wal-Mart effect. That's changing consumer expectations. "We have to move to more global buying to get huge cost savings," says the economist for a giant European multinational. "Consumers believe a price is just a starting point."

The Fed has learned to control the boom-bust swings seen in the 1970s and 1980s, but that's why inflation rates sail closer to zero. That leaves less of a margin for error in the case of a downturn, like the one we're in now. The outlook for inflation is lower than when companies borrowed to expand in the 1990s, which means it will be more expensive to repay than they had expected. This is why Moody's has been downgrading the credit of so many big companies, says John Lonski, chief ...