The overriding economic factor for the first half of this decade will be deflation i.e. an economy where prices are falling. Deflation is going to affect every area of the world capitalist economy, particularly profitable investments. If businesses cannot raise prices and are engaged in a life and death struggle to compete by lowering costs while prices fall, then there are going to be more business deaths. If a capitalist business borrows money it is going to find that the value of that debt will grow as prices fall and it will have to pay back more in real terms than it lent even if there were no interest charged. At the same time, it will only be able to pay debt back by driving down its production costs to make a profit because it cannot raise prices. And that is an economic environment that is crippling for capitalism.

And deflation is invading the world capitalist system like a flu virus for the first time since the 1930s. Hardly anybody has noticed that in the US prices in the shops have been falling for the last six months, not much by just 0.3%. And prices are still a little higher (about 2%) than they were this time last year, but the gap is narrowing fast.

Prices at the factory gate in the US have dropped 1.1% compared to this time last year for the year and for the last six months have fallen at an annual rate of approximately 5%! US companies are going to face pricing pressure like they never have. More and more manufacturing jobs will leave the US, as companies are forced to either shut their doors or manufacture offshore.

The cause of this deflation is partly the decline in investment by US companies, partly the slowdown in American household demand for goods, but also an unprecedented fall in prices of imported goods. In 2001, import prices dropped nearly 9%, the biggest fall on statistical record.

What is happening is that in this world economic recession, the main exporting countries are trying to lower their prices by devaluing their currencies so that they can maintain their share of world markets. This "beggar thy neighbour" policy means they are exporting deflation to the US and Europe at a dramatic rate.

Take Japan. Its economy fell back 5% last year and is now at its lowest level for six years. Prices are now back at 1990 levels. Such trends have not been seen since the 1930s. Japanese national debt is at 130% of GDP. If you add in the bad debt that the government will have to assume from the cascade of bank failures that will happen in the next few years, the debt load will increase to 160%. That is huge. And that is debt that is on the books. Off-budget debt such as government guaranteed pensions in an ageing country is not included and would take the national debt to over 300%.

Japan is rapidly approaching the end of its rope. Its politicians have tried to stimulate the economy by public spending, Keynesians-style. They've spent taxpayers' money and borrowed the savings of Japanese citizens to finance huge public building projects to keep the building contractors working. They've spent and spent and spent, but for little result. Tax receipts are going down, and spending requirements are going up. But to raise taxes would drive the economy down further.

Bad debts in Japanese banks are huge - around 40% of annual GDP. Many of these banks are more than technically insolvent. The negative net worth of the Japanese banking system is somewhere above the yen equivalent of $1 trillion. Capital is being loaned to companies that are basically brain dead and have no chance of growth. But Japanese banks continue to loan money in order to avoid bankrupting companies they do business with.

Japan depends upon exports for its very survival. But it now competes with the rest of Asia in a number of its key industries, especially for the attention and money of the US consumer. And exports are down to dangerously low levels; growth is negative and getting worse; deflation is ravaging the country; unemployment is at an all-time high; banks are collapsing left and right.

So the capitalist government there is trying to save itself by devaluing its currency to make its exports cheaper. Japanese policy makers have been quite brazen about seeking a weaker yen. The yen has already dropped to Y130/$ and could fall to Y150/$ over the next few months. And only a few years ago, the yen was worth as much Y80/$. This means that, if you are a Japanese consumer, it already takes 60% more yen to buy a dollar and your government is hell-bent on adding another 40% cost increase.

And for Japanese business it means their products are cheaper outside of Japan. If the US steel industry thinks it has problems competing now, just wait till later this year. Japanese manufactured automobiles will be even better value within another few months. That's a nightmare for GM or Ford. No wonder Ford is planning 32,000 job losses over the next two years.

The idea is that Japanese products will be so cheap that everyone will want them and thus the Japanese economy takes off. And Japanese businesses will have less competition from abroad and can improve their profits and their balance sheets at the expense of the Japanese consumer. But it means that US companies will have to keep their prices low at the expense of their profits. Indeed, they will actually have to lower prices - deflation

But it gets worse. Much of the rest of Asia will not sit idly by and watch their competitiveness versus Japan deteriorate. So they will also to devalue their currencies. Malaysia's Prime Minister Mahathir Mohamad has said his country may be forced to devalue the ringgit if the Japanese yen continues to decline in value. South Korea signalled it would take measures to weaken its currency as the yen's decline threatens Korean exports. "The weaker yen creates a burden for our exporters"' said Finance Minister Jin Nyum. When Korea, Thailand, Malaysia, Singapore, Taiwan and others drop their currency values in line with the yen, that not only keeps them competitive with the products for which they directly compete with Japan, but also the entire spectrum of their products.

But what if you are a company doing business in Asia? Your products now cost more to those consumers, so you sell less of them. Further, your profits as denominated in dollars are less, so your US balance sheet is weaker.

In essence, Asia will be exporting its deflation to the US and Europe. And this threatens any economic recovery. As the American Enterprise Institute for Public Policy Research put it in its latest report: "Japan's deflation and debt crisis now constitute systemic risk to the global economy."

If deflation comes to the advanced capitalist countries, it spells disaster for all those heavily indebted corporations. Take Enron. The collapse in the stock price of this company would appear to hurt only the shareholders. But Enron is more than its stock. Billions of dollars were lent by banks and others to Enron, which is, have gone up in smoke. This paper burning is deflationary. Every dollar that disappears is deflationary. And it is not just companies. Argentina's debt has gone up in smoke because of deflation.

How can capitalism get out of this? US Fed chairman Alan Greenspan is the great guru of US capitalist growth. His answer is to try and reinflate the economy. The best way to do this would be to lower the value of the dollar. But today the dollar is the reserve currency of the world. As fast as Greenspan prints it, other nations are buying it. If he prints it too fast, bringing back inflation, the world would lose faith and the dollar could drop like a rock. That would lead into an even more serious world recession. But print dollars too slow and we have deflation and depressed economy.

The real problem is that capitalism only prospers when there is profit and that means proper investment in labour power and sufficient spending by consumers. Just expanding the amount of money in the system does not do the trick. Indeed monetary expansion may delay depression and only to make it last longer. As the great capitalist economist, Joseph Schumpeter put it in the 1930s: "the economic recovery is sound only if it comes of itself. For any revival that is merely due to artificial stimulus leaves part of the work of depression undone and adds to an undigested remnant of maladjustments, new maladjustments of its own". Thus capitalism needs depression, falling production and rising unemployment to 'cleanse' the system of overcapacity and overproduction.

That has yet to happen at the start of 2002. The credit bubbles continue in the stock market (US), and in property (US and UK). As one economist from the Dutch bank, ABN-AMRO, Chris Wood remarked: "The Greenspan approach should be viewed as an effort to cheat nature and the business cycle. Like any effort to cheat it is ultimately not going to work, with the only question of how much more debt is generated in a vain effort to keep the consumer in the game."

The key to recovery under capitalism must be rising profits and falling interest rates. There is no sign of the former in the US. The big US bank, JP Morgan forecasts that company earnings in 2002 will not grow at all. Morgan Stanley chief economist Stephen Roach said US corporations will continue to have difficulty raising prices. That means reduced profit margins and lower profits, which is precisely what we are seeing in the current data.

Lower profits mean lowered capital spending. We are at decades-long historic lows in capacity utilisation. Businesses do not buy products (capital spending) to increase capacity unless they see an increase in demand or a way to lower production costs for existing demand.

But the economic and financial excesses that have built up in the US economy during the past four to five boom years are the worst in history. The last time the US economy experienced protracted weakness was from 1989 to 1993. Taking the actual credit expansion as a measure of excess, during the second half of the 1980s, total credit (private nonfinancial and financial) increased $3.4trn. In the second half of the 1990s, it expanded by more than $9trn.

As one economist, Kurt Richenbacker put it: "this is a virtual Pandora's box of interrelated and interdependent bubbles, and the one thing that is keeping all these bubbles afloat is the illusion of an imminent V-shaped recovery and blind faith in the magic of Mr. Greenspan. Who or which demand component could possibly lead the predicted US economic recovery? Rising capital spending by debt-laden corporations confronted with collapsing profits? Or higher spending by the debt-laden consumer confronted with huge wealth losses in the stock market, rising employment and stagnating or shrinking disposable income? One thing is beyond any doubt: the V-shaped US economic recovery is impossible."