There are two economic situations where prolonged deflation could occur:

1. Globalization: In the last several centuries, there have been specific periods, each stretching up to several decades, when there were significantly increased flows of goods and services across national borders. During these times, the less developed countries had figured out how to produce goods that require older technologies efficiently. Hence, they could trade these goods at significantly lower prices. Also, improvements in transportation enabled the free trade of these goods. For example, the late 19th century was one such period. I quote from Professor Jeffry Frieden's Global Capitalism (p. 8), "From 1873 until 1896 prices dropped by 22 percent in the United Kingdom, 32 percent in the United States, more elsewhere. ... ... Prices and earnings declined but debt burden remained constant. Expectations of further price declines caused uncertainty and pessimism. More important, the price declines were not across the board. The prices of goods that entered readily into world trade fell particularly rapidly, such raw materials as wheat, cotton, and coal by 59, 58, and 57 percent respectively. But the prices of other goods and services fell more slowly or not at all. For example, American farm prices declined by more than a third, mining prices by nearly half, but construction costs stayed constant."

2. Depression: In a depression situation, due to severe miscommunication of price signals, the economy invariably goes into a chaotic condition. Firms lay off employees in large numbers expecting a severe downturn. The result is that consumers don't have the incomes necessary for purchasing goods. Inventories pile up and firms have to cut prices. However the more the firms cut prices the more is their losses, and they have to lay off more employees and reduce production. In the worst case, a quarter or a fifth of the working age population is unemployed. This cutting of production and prices and laying off employees leads to a downward spiral of contraction, deflation and unemployment, where these three factors reinforce each other. Thus there is a prolonged period of spiraling downwards, in particular a deflation in prices, before some external event puts an end to it. This was the situation in the Great Depression of the 1930s. During its worst phase, the GDP contracted by a third.

It is clear that the current economic crisis of 2008 would not lead to unemployment above 20%, nor a contraction of a third of GDP. Moreover, due to massive accumulations of capital, like social security and pension funds, consumers could continue to maintain their usual level of spending on essential goods even if they lose their jobs. Thus the re-appearance of a dire economic situation like the Great Depression cannot be cited as a reason for prolonged deflation in contemporary times.

Next, during the current phase of economic globalization, the phenomenon of 'China price' has been hitting the global economy since the 90s. These deflationary forces have been successfully managed so that there would not be severe destabilization of the global economy. This is the great contribution of Alan Greenspan, that he allowed the stock market to boom right into 2000, even though he worried about a bubble in the stock markets as early as 1996. China's supply of manufactured goods at low prices helped to keep inflation low, and enabled America to continue to grow with unemployment rates well below that specified by the Non-Accelerating Inflation Rate of Unemployment (NAIRU). On the demand side, the wealth effect created by the stock market boom enabled consumers to keep spending so that the economy could keep growing, which in turn allowed an increasing trade deficit with China. Thus Greenspan's stewardship ensured that America and China developed a stake in each other's well-being. Moreover, the case for globalization producing a prolonged period of deflation this time around is not compelling at all, since the resulting deflationary forces have been successfully managed for the last 15 years or so.

So why are several famous economists still warning against the dangers of a recurrence of the Great Depression? Depending on their preferences, these economists are either advocating inflationary monetary expansion, or huge fiscal spending to the extend that the budget deficit next year could be a trillion dollars. These are in addition to the massive expansion of the Federal Reserve's balance sheet (from $900 billion to $2.3 trillion so far), the $700 billion TARP program, and the large scale off-balance sheet programs announced by the Fed and the government for rescuing financial corporations and buying all kinds of securities.

Well, it appears that a consensus has been developing among economists in the advanced industrial economies that by enacting massive fiscal spending programs, they could re-engineer entire economies of the West so as to shift their focus on manufacturing and construction, and possibly away from services. As Professor Paul Krugman put it in his recent New York Times column, Life Without Bubbles, "By selling more to other countries and spending more of our own income on U.S.-produced goods, we could get to full employment without a boom in either consumption or investment spending". Other famous economists like Professor Robert Shiller, Professor Nouriel Roubini and Professor Joseph Stiglitz have written in expressing support for a massive fiscal spending program with the goal of maintaining full employment.

Well, there is some strength in this argument. Infrastructure is definitely crumbling in many parts of the United States. It would be appropriate to recall here that not long ago, a large bridge on an Interstate highway collapsed in Minnesota killing dozens of people. Schools, public libraries, courtrooms, police stations, airports, railway stations and other public buildings require upgrades urgently. Moreover, potholes have been springing on most public roads, and the local governments have only been doing patch-work on them for lack of funds. Similarly, the manufacturing industry has been languishing for several decades now. So there is definitely a case for upgrading infrastructure and reviving the manufacturing industry in the Western economies.

However, I should also point out that expending all the political capital that the left has won in the recent elections (for US President and US Congress) on a one trillion deficit spending program may not be the 'best bang for the buck' (to borrow Professor Stiglitz's lingo). At present, the most economic benefit that the United States can obtain is to recover its standing among the world nations by conducting its foreign policy with vastly improved diplomacy. In particular, spending the far less amount of $20 or $30 billion towards Millennial Development Goals and eradicating poverty would improve the goodwill for America around the world. As a result, America would obtain much better long-term economic benefits by spending just 2 or 3 percent of the trillion dollar deficit program.

Re Developing nations also need to enshrine the notion of “policy space” in the World Trade Organization.

Here is the text that I proposed in a consultancy report (consultant's opinion) to the Economic Partnership Agreements (post Cotonou agreements between the European Union and the Africa Caribbean Pacific countries) in a study on the investment clauses. It was rejected by the EU.

Objective: Address “policy space” issues for the possibility by a government to carve out a sector for strategic reasons and the local context faced by least developed, landlocked and island States.

This part will endeavour to define Policy space, its justification, its place in IIAs, the derived concept of Special and Differentiated Treatment and the possible use of it in EPA negotiations.

2.6.1 What is Policy space?

Policy space may be defined as “the space to be able to institute policies for national development”. Good faith would probably say that developing countries need “policy space” because there is “no single formula” for economic growth, as seen historically for “more developed countries.

EPAs like any other north-south trade agreement should preserve government authority to regulate foreign investment in order to achieve national sustainable development policies. Governments should be able to protect public interest laws from suits and establish performance requirements in order to support an emerging productive sector or meet community development plans. Equally, governments should be able to impose capital controls to protect their economies and citizens from destructive flows of speculative investment.

EPAs should preserve the authority of ACP government to regulate foreign investment, avoid prohibiting performance requirements, and have no investor-state clause. For instance:

 EPAs should provide the space for participating countries to create policies that retain and create jobs that respect labour standards from the ILO.

 EPAs should contribute to rural development strategies, in the ACP regions, especially in Africa, that promote subsistence and small-scale farms, dedicated to enhance food sovereignty and environmental sustainability. Countries should be able to enact legislation that protects products with special economic, social or cultural importance, such as corn and beans, from trade liberalization.

The development needs of developing and least-developed countries require special domestic policies, measures and laws as well as direct assistance. Therefore policy space is linked, if the overall WTO logic should frame the EPAs (this might be a hypothesis), to Special and Differential Treatment (S&DT). The logic holds that S&DT is an exception to a general rule where “one-size-fits-all”. Some might question the fact that by accepting an S&DT, one accepts the general rule. If one accepts the general rule, the next question is “for how long can one bargain the exception, 10 years, 12 years, 30 years?”

Box 11 – Definitions and Principles of Policy Space

I. Policy Space as Freedom

Policy space is about freedom of choice. For developing countries, it is about their freedom to choose the best mix of policies possible for achieving sustainable and equitable economic development given their unique and individual social, political, economic, and environmental conditions. It refers to “the scope for domestic policies, especially in the areas for trade, investment and industrial development” and reflects the idea that governments should have the leeway to “evaluate the trade-off between the benefits of accepting international rules and the constraints posed by the loss of policy space .”

II. Principles of Policy Space

Policy space is therefore essentially a fusion of three key principles in international law and policy. These are:

 The principle of the sovereign equality of States – i.e. the binding nature and application of international rules and disciplines are dependent on the free and equal exercise of national sovereignty and self-determination by participating States;

 the right to development; and

 the principle of special treatment for developing countries – i.e. the provision of special and differential treatment so as to be responsive and accommodating to developing countries’ specific development needs and circumstances.

Source: Policy Space for the Development of the South, November 2005, N°1 South Centre

Today a hot topic…as ever before…

Box 12 – Development and Policy Space

In a communication in 2002, India (WTO 2002: 1) stated that:

Development is a complex process. There is no single formula that can fit into every economic situation in such a manner that it inevitably leads to growth. Developing countries, therefore, need policy space so that they can determine for themselves how the process of economic development can be speeded up and the welfare of their citizens enhanced. This also includes the policy space to determine the manner in which investment shall be regulated and channelled. Any multilateral discipline that seeks to limit this policy space, by its very definition, would reduce the policy options available to developing countries to use foreign investment for promoting development.

http://commerce.nic.in/wto_sub/Invest/sub_invest-W148.htm oct 2002

The European Community responded, stating that it “fully supports the view that developing countries should maintain their right and their policy space to pursue their policies and that no international agreement should prevent them from doing so” (WTO 2003: 1).

"Policy space", an issue that featured most prominently at the UNCTAD eleventh session in Sao Paulo in 2004, has re-emerged as a burning issue at the UNCTAD Mid-Term Review (MTR) meeting held in Geneva in May 2006.

Developing countries reaffirmed the importance for them to have the space to choose between different policies options for their development strategy, and that this could be eroded by international trade and economic rules or conditionalities linked to loans or aid.

They stressed at the MTR meeting that one of the main achievements of UNCTAD XI was the agreement attained on the policy space issue, in paragraph 8 of the Sao Paulo Consensus, which was the first time an international consensus had been adopted on this issue.

However, the United States said "policy space" could not be used as a roadmap for UNCTAD's work and "certainly not" as a new principle in the international economic debate, adding that the concept was of "dubious value" not grounded in fact.

The MTR thus was a re-visit of sorts of the heated debates that took place prior to UNCTAD XI when the developing countries led by the Group of 77 and China insisted on having the concept incorporated in the UNCTAD XI outcome, while many developed countries resisted and in the end tried to dilute the language.

Eventually, a compromise was reached at UNCTAD XI to produce paragraph 8 of the Sao Paulo Consensus as follows: "The increasing interdependence of national economies in a globalizing world and the emergence of rule-based regimes for international economic relations have meant that the space for national economic policy, i. e. the scope for domestic policies, especially in the areas of trade, investment and industrial development, is now often framed by international disciplines, commitments and global market considerations.”

"It is for each government to evaluate the trade-off between the benefits of accepting international rules and commitments and the constraints posed by the loss of policy space. It is particularly important for developing countries, bearing in mind development goals and objectives, that all countries take into account the need for appropriate balance between national policy space and international disciplines and commitments."

This was one of 11 paragraphs on cross-cutting issues in the Chapeau of the Sao Paulo Consensus. Other issues include globalization, the role of the state, development strategies and the role of UNCTAD in cooperating with other organizations to enhance coherence of policies for development .

History tells

Looking at the history of industrial policies in the Western hemisphere, one surely has to accept that before the countries would go to the point of leaving sovereignty over national policy, they had during some centuries, the opportunity to leverage primitive accumulation of capital and exercise agro and industrial policies. Those “national policies” allowed the emergence and the consolidation of their entrepreneurial tissue, the proliferation of their “Mittelstand” SME sector and the international aura of privatised industrial blue chip companies, which for some were part of a national state-company before (France Telecom, British Telecom, Dutch State Mines, etc.).

Mirror…mirror, tell me the truth today

Let’s ask ourselves which are the sovereign nations in the “developed world” which today are willing to give-up their policy space? If one lists the G7 countries, supposing that they could serve as a demonstration, one would have difficulties. Even if these countries would abandon their policy space, many other “less rich” countries are not in the position of being well industrialised, rich or able to joggle with balance of payment deficits for instance by selling national debt in printing paper. Now if one considers the case of least developed, landlocked and island States, there seems hardly any argumentation possible for a “one-size-fits-all” policy.

“Developed” countries are not ready TODAY to abandon their policy space

Even if some hostile or “unsolicited” take-overs are theoretically possible within the European Union (which obeys a relevant treaty amongst them, which is not comparable to outside EU), member states still flex their muscles to keep some industries “national” (Suez/Gaz de France versus an Italian bid). In the US, national policy is as vivid as ever: In 2006, the backtrack of Dubai Ports came hours after House and Senate GOP leaders bluntly told President Bush that “Congress would kill the U.S. portions of the company's $6.8 billion acquisition of London-based Peninsular and Oriental Steam Navigation Co. (P&O), which has operations at six major U.S. ports, including New York and Baltimore”.

A good summary of the issue is given herewith

“Nations of the world have embarked on a new round of global trade negotiations—the so-called Doha Round under the World Trade Organization (WTO). Developing countries agreed to enter a new round of trade negotiations only on the condition that development would be the centrepiece. There are growing concerns that this promise will go unfulfilled. Key among those concerns is the notion that a new trade agreement will not give the developing world the “policy space” to use the very instruments and tools that many industrialized nations. To varying degrees all of these authors argue that the WTO and the international financial institutions are shrinking the ability of nations to put proper polices in place for sustainable development. Indeed, many of the authors argue that the economic rationale for preserving policy space in trade negotiations is justified now more than ever. During the 20th Century nations in East Asia, Latin America and elsewhere successfully balanced states and markets to grow from lower to middle income countries. Today, in the face of increasing poverty, inequality, and environmental degradation, states need as many tools as possible to raise the standards of living of their people.”

Let’s recall the experience of one of the “Tigers”

Box 13 – How the use of industrial policies has allowed rich countries to become today’s free traders

South Korea used the carrot-and-stick method through providing extensive financial incentives to TNCs, while at the same time imposing extensive performance requirements.

The most important policy measure was a restriction on entry and ownership, with the result that in the 1980s around 50 per cent of all industries and around 20 per cent of manufacturing industries were still ‘off-limits’ to FDI. Other policy measures were also used, such as screening the technology of the TNC, and prescribing local-content requirements. Investors who were more willing to transfer technologies were selected in preference to other potential investors. The investment regime of Korea was drastically liberalised after 1996, in part due to the pressure of International Financial Institutions.

Key facts:

A growing number of international agreements now restrict the national ‘policy space’ of developed and developing countries alike. Actually, the policy space world is shrinking.

 There is an overall agreement, in view of history, that restrictions on policy space yield adverse effects on countries in earlier stages of economic development. This is the whole aspect of the “evolution” and “structural” differentiated treatment underlying the development theories and policies commonly accepted.

 It is evident that the playing field resulting from international trade agreements, that have ostensibly equivalent rules for all contracting parties, may provide a much smaller policy space for developing than developed countries because of differences in initial conditions and national policy implementation capacities. There is no even playing-level field between the so-called and self-called “developed countries” and …the others.

 Therefore special and differential treatment (S&DT) for developing countries under the MTS needs to be enhanced and made more actionable and effective in order to provide developing countries with essential national policy space for development .

 Affirmative action which was the recognized theme of the Lomé Agreements means non-reciprocity of obligations so as to protect the weaker and allowing time and costs to “develop” towards being able to play on an even field. This is contrary to the Most Favoured Nation (MFN) clause which entails that all treatments should be equal. The MFN clause makes de facto arrangements to require “reciprocity” or to be “symmetrical”. Therefore some ask if asymmetry in plain English wasn’t after all what was meant by preferential treatment in the General System of Preferences (GSP)? Some would ask: “why having to exit through the door in order to have to come back through the window?”

 Two exceptions are accepted:

- Free Trade Agreements in the framework of a regional integration between members of WTO. This need for regional integration is why Regional Trade Agreements are sought after. In many regional blocks, free trade and custom integration have barely started, let alone regional industries. Time is obviously needed to consolidate these regional blocks before opening-up to international competition.

- Non reciprocal preferences extended to all LDCs. However this faces a series of questions on the definition of it and would have to take into consideration the choice of some regional agreements to differentiate between themselves those members at different stages of economic strength, e.g. CARICOM/CARIFORUM and the Organization of Eastern Caribbean States (OECS).