Cecchetti Plays Down Deflation Fears

Stephen Cecchetti in an article in this morning's Financial Times attempts to persuade us that deflation fears are overdone. Cecchetti is a serious economist and his arguments bear consideration, so what are they? He differentiates between falling prices in one or more sectors, and a generalised decline in prices, only the latter, clearly, constitutes deflation.

Deflation is when prices are falling on average, not when some prices rise and some fall. The objective of most central banks is to stabilise prices on average, which means that some prices will be falling while others are rising.People running the companies whose product prices are falling are not going to be happy about this. They are going to whine that something needs to be done about this "deflation".

This is generally true, although it isn't necessarily true that the relevant companies will necessarily 'whine'. It is important to differentiate here between sectors such as technology where a decline in prices can produce (depending on elasticities) rising revenues and profits, and declining industries (like steel) or agriculture and raw materials where declining world prices produce discomfort in some sectors. There are non-monetary solutions available for this latter class of problems like protectionism and subsidies (both currently practised by the Bush administration), although whether these are adviseable or desireable is another matter. as Cecchetti indicates since the CPI is an average some prices will always be always be rising less than the inflation level. Logically then , as this level approaches zero, some prices must be declining. So where is the worry, well:

As long as central banks do not allow sustained, steady deflation, we shall be fine. After decades of suffering from inflation of 5-10 per cent, we are now close to price stability. Let us congratulate policymakers for providing the foundations for stable long-term growth.

OK, fine. But before we start cracking open the champagne and congratulating our politicians central bankers, perhaps we might stop to consider the 'as lomg as.....' caveat. Because isn't that just the problem, isn't this what those who are worried about inflation Krugman, De Long, Roach (yours truly) are worried about, that we might drift into sustained, steady deflation (I think we understand the difference from sectoral problems and the statistical properties of an average, thanks. Oh, and by the way we are 'preoccupied', not 'whining' - isn't this what dogs do, there's really something I find disagreeable in the use of this metaphor). So what is the explanation of why this sustained, steady deflation is unlikely:

Related to these deflation fears is concern that monetary policy has become ineffective. People maintain that interest rate cuts no longer have the impact they once did and that, with the federal funds rate at 1.25 per cent, the Federal Reserve is going to run out of ammunition pretty soon. I do not believe either argument. Monetary policy has always acted through corporate investment, consumer borrowing and the current account and it still does .......generally they [these effects] are alive and well.

I'm sorry, this argument doesn't convince, corporate investment is moving to China, and (perhaps) in the case of services to India, consumer borrowing is growing alright, but the negative effects of this on the current account is only to clear. Most notably the dollar isn't adjusting sharply to compensate. The big question then is, why is this? Here Cecchetti is silent, since clearly the explanation needs to be looked for globally, and it is here that the limitations of a US centric, 'business as usual' approach are most apparent. The dollar is not falling anywhere far, fast, because there is no-one else about to go up. This is the force of Roach's points about the lack of a rival growth engine to pull the train, and the global character of the deflationary headwinds (strangely, now I think of it, the word globalisation doesn't appear anywhere in the article. Perhaps this is why he things the traditional monetary effects are alive and well, although in fact many of the 'changes in the system of financial intermediation ... that allow many borrowers to bypass conventional banks' (and which are his specialist area) are among the processes most affected by globalisation.

Going back to the current account problem. One traditional response would be to lower interest rates to drive down the currency. But wait a minute, interest rates are already at 1.25%:

What about the zero nominal interest-rate floor, the point at which central banks supposedly become impotent? Listening to officials from the Bank of Japan, you would think that once they set their interest rate target to zero, there was nothing else they could do about stagnant growth and falling prices. Again, I do not believe it. We all know that whatever a central bank does, it does it by adjusting its balance sheet - buying and selling securities and making loans to commercial banks. And, uniquely, the central bank can expand its balance sheet without limit. None of this changes when the nominal interest rate hits zero. Monetary policymakers can still buy securities, enlarging their balance sheet, increasing the amount of money in the economy and eventually driving prices up. These "unorthodox" methods are not all that mysterious. Federal Reserve policymakers know how they work and will use them decisively if and when the time comes.

Again, everything seems fine, except that, well listening to Cecchetti you would think that once the BOJ had set their target rates to zero, then they had done nothing else about stagnant growth and falling prices, you would think they hadn't thought about adjusting their balance sheet - buying and selling securities and making loans to commercial banks. Listening to Cecchetti you would think they hadn't done any of this, but you wouldn't be right. On this topic I'm afraid Cecchetti is simply ignorant, and is showing his ignorance in public. If this is meant to re-assure, then I'm afraid it might have the opposite effect. In fact the BoJ has been systematically raising it's monthly rinban buying operation of Japanese Government Bonds (JGBs) from ¥400 billion to ¥600 billion to the current ¥1000 billion (a figure which may be about to go up again sometime soon). And again Cecchetti is wrong, the central bank cannot simply 'expand its balance sheet without limit' as the Japanese have discovered to their cost: the ratings agencies start downgrading you. Ignorance about Japan is perhaps our main enemy right now, so I'll take the liberty of quoting Morgan Stanley's Japan commentator Takehiro Sato at some length:

We had thought the BoJ held a monopoly on "ZIRP" (Zero Interest Rate Policy), but the FRB rate cut on November 6 suggests that macro policy globally may be heading into the "World According to ZIRP." The Japanese economy can be viewed as the front runner in a global deflation race with no apparent end. The central banks of other industrialized economies will gradually come to understand the BoJ’s struggle, having completely exhausted traditional policy measures. Central banks fought inflation through the mid-1990s, but the battleground has changed to the uncharted territory of deflation. In some respects, it is positive that overseas policy authorities and academics will begin coming to terms with the tough challenges of fighting deflation in a ZIRP environment, which is something that only Japan has experienced until now. The BoJ should benefit from overseas financial authorities giving serious consideration to the implications of a "purposeless" policy of quantitative easing (basically a zero interest rate with a ¥15-20 trillion reserve floor) should the FRB and ECB move into the ZIRP realm. The unfavorable scenario for the BoJ would be foreign central banks having unexpected success with quantitative easing and such easing ironically spurring a recovery for the global economy. In this case, the BoJ is likely to face criticism for being slow on the draw with policy action.

Japan’s experience thus far suggests slim chances for the latter scenario. Once the policy rate drops into the lower 1% range, the game is already over for monetary policy. While monetary policy can be effective in restricting total demand when necessary, it lacks the wherewithal for demand creation. Since the elasticity of real money demand from nominal rate fluctuations rises to an extreme level with a zero interest rate, the short-term money market endlessly absorbs liquidity supplied by the central bank, just like spraying water in a desert. Liquidity never makes it to the real economy. This can also be understood in terms of zero opportunity costs for reserve deposits. There is no pain from holding an infinite amount of reserves ("no pain, no gain"). Additionally, the BoJ has gradually raised its liquidity provision mechanism of Rinban operations (which is equivalent to coupon pass). However, these operations wind up strengthening flattening bias on the yield curve, and actually contribute to deflation expectations through the financial market’s expectation formation dynamic. ZIRP poses the danger of getting caught in a policy trap that cannot be easily escaped. Other central banks should give careful consideration to the siren call of ZIRP.

In retrospect, efforts in 1995 to reenergize markets by taking stronger-than-expected additional monetary easing were a significant milestone on the road to ZIRP. In fact, the economy itself, and not only financial markets, shifted from inflation to deflation expectations from 1995. Data for various key macro parameters, such as relationships between short-term rates and the long-term/short-term rate spread and the current account surplus and long-term rates, show a major dislocation occurring in 1995. Nearly two and a half years have passed since the IT bubble collapsed (around 10 quarters), and the US is approaching the point at which the deflation impact from Japan’s stock price collapse started to manifest itself in the real economy.
Source: Morgan Stanley Global Economic Forum
LINK

The argument which Saito presents and which Cecchetti ignores is that of expectations. You see, it seems the deflation turning point comes when consumer and corporate expectations shift to a deflationary scenario, then it becomes logical to postpone both investment and consumption decisions, thus giving traction to an environment of secular deflation which may prove extremely difficult to pull out of, especially if the deflation turns global. This postponment can give rise to a situation where an economy's productivity grows more rapidly than growth in the real economy on a sustained basis, the so-called output-gap scenario. Unfortunately Cecchetti does not let us know his feelings on these arguments, and since they are among the most forceful explanations as to why the deflation danger may be real, they certainly merit consideration.

As to why all this might be happening, there is an almost total silence. Regular readers of this column will know I have tried to spell out three factors which may help understand why we have a global deflation watch call out right now. Firstly is the 'industrial revolution' currently taking place in China. A 'revolution' produced by massive internal restructuring, with a huge surplus population driving down real wages to such an extent that China itself is experiencing deflation. This deflation - due to the sheer magnitude of China's population - is then being systematically exported to the rest of the world. Secondly we are living globally through what could be called the 'third technological revolution' of the modern epoch (the invention of agriculture 10,000 years ago did, of course, constitute a technological revolution, and since the current 'revolution' is informational it is not necessarily an industrial one) this is driving down prices globally in the technology sectors and the strategic nature of such sectors (GPT's and all that) means that falling prices here are transmitted across the OECD economies generally. Thirdly, all the OECD country populations are ageing. The proportion of the working population in the 50-65 age group is growing steadily, and this is producing a subtle shift in the relationship between saving and current consumption along with a growing sense of price importance (the Coale/Hoover hypothesis) producing a bottom line which tends towards a deflationary environment.

Has Cecchetti made his case. I leave the reader to decide.

ECONOMIST CONTINUES TO FRET ABOUT DEFLATION

The economist is again worried about the danger of Germany falling into a deflationary cycle. With reason I think, and even more so now the ECB has maintained interest rates unchanged for yet another month:

America does not yet have deflation. Still, its GDP deflator fell to 0.8% in the year to the third quarter; so long as the level of GDP remains below potential, inflation will keep falling. Deflation currently seems unlikely in Britain or the euro area as a whole, but Germany is at risk. German consumer prices have fallen at an annual rate of 0.4% over the past six months. More worryingly, Germany, unlike Japan in the early 1990s or America today, is not free to cut interest rates or run a looser fiscal policy. Interest rates are set by the ECB on the basis of economic conditions in the whole euro area, and budget deficits are limited by the European Union's stability pact. The risk of deflation may therefore be greater in Germany than in America.

Deflation is particularly deadly when an economy has lots of debt, because falling prices swell the real debt burden. In America and Germany, firms and households have borrowed heavily in recent years, lifting total debts of the non-financial private sector to 150% and 160% of GDP respectively. In the early 1990s Japan's debt burden was equivalent to almost 250% of GDP. Japanese firms are still much more in hock than those in America or Germany. On the other hand, American households look more vulnerable. Even at the peak of Japan's bubble, households remained big savers. Last year German households saved as much as 10% of their income; Americans saved only 1.5%.
America's demographics are more favourable than Japan's, where the population is both shrinking and ageing. A shrinking labour force implies a slower growth rate, future problems for financing public-sector pensions, and greater opposition to reform than in a more youthful country. Germany again appears similar to Japan. Its working-age population is expected to shrink by 0.2% a year over the next decade, compared with likely annual growth in America of around 1%. Our analysis suggests that Germany has more symptoms of the Japanese disease than America. America's bigger bubble infected its economy more severely; but its more flexible markets and institutions should now help it to adjust. For now, both countries remain in danger.
Source: The Economist
LINK

MODIGLIANI ON DEFLATION

Stephen Roach has interviewed Franco Modigliani.

There are always great imponderables in the macro outlook. But today the questions seem to loom larger than ever. At the top of my list are two burning issues -- the prognosis for the American consumer and the risk of a US deflation. Nobel laureate Franco Modigliani has long been noted for his path-breaking work on these very issues. He was in town in couple of weeks ago, and we had the chance to sit down for a most engaging discussion. An edited version of our conversation follows.
Source: Morgan Stanley Global Economic Forum
LINK

Below are my comments on the interview.

"I must confess to being surprised about the resilience of consumption after the stock market bubble popped."

Well I think actually people like Stephen Roach and Paul Krugman have been telling a reasonably plausible version of things here. The so-called wealth effect, however, is much more likely to show itself, in my view, not in the direct impact of the stock market ride down, but on the preparedness-to-accept-indebtedness effect based on the value of the whole asset basket, and here it seems property is paramount.

"I have my doubts. I am suspicious of those studies that find the wealth effect is larger from real estate than equities. Theory tells me it should actually be the opposite. That’s because the house in part, produces a consumer good -- housing services, which we consume. When the value of the house I inhabit goes up, its implied rental value increases. But that does not significantly improve my spending power, because my imputed rent has gone up as much. Any wealth effect on individually-owned property must net out the consumption of the service we derive from living in our homes."

Well, yes and no. In a time of high asset price volatility housing is perceived as the savings harbour of last resort. especially when people are conditioned to expect inflation. In addition the rents argument doesn't seem to me to be of the best, since - following one reading of the life-cycle hypothesis - people tend to trade down as they get older. Again it doesn't fit with the situation here in Spain were many members of the middle class now have two, or even three properties as a form of saving.

In addition I think he is looking at it too theoretically, from the point of view of drawing up the pertinent equations, assigning shadow vales, opportunity costs, etc.

But the individual/consumer isn't looking it in this way at all (remember Kahneman/Tversky just got a Nobel). The consumer/individual is simply looking to find a 'rule of thumb' solution to the savers problem: where to park money in a time of low interest rates (never mind that in part this is money illusion), and equity market collapse. The 'rule of thumb' answer is property. Especially with the built-in inflation expectations that easy money and growing deficits must produce. The 'safe harbour' appears to be property. But I say 'safe' advisedly, because it isn't safe at all.

Of course when I’m talking about the saver’s problem, I’m only talking about roughly 49% of the consuming population, since the bottom 50% do virtually no saving. While you need to strip out the top 1% (following Krugman) since they probably give freak readings and simply distort the picture.

‘Neither a Lender nor a Borrower be’
(Old English Ditty)

All this has finally allowed me to make some sense of that optimal control stuff we economists are forced to learn, since I can now see that in a situation of volatile inflation/deflation switchovers, and financial crashes the optimal saddle-path trajectory for the consumer/worker is to operate a continuous stream of expenditure-stream of earnings adjustment in order to pass smoothly through the middle, nicely avoiding all those savers/debtors problems.

My favourite after-dinner trick of late is to pull-out a nice clean 20 Euro note over coffee, grab a saltcellar, sugar bowl, a saucer, etc, and then ask my wide-eyed audience, if the saltcellar was a flat, the sugar bowl a basket of equities, the saucer some bars of gold, and the 20 Euros the equivalent in cash to the dollar value of each one of the other three (which all have the same) then which would they buy with the dollars I offer to give them to play the game (this thought experiment takes place in Barcelona). The answer - without exception - is the flat. Regardless of whether the person in question needs somewhere to live or not. Wrong I say, take the money, at the moment it's the best investment available for the individual saver given the high risk element attached to all the others and the imminent arrival of deflation when the value of money will rise.

"Sadly, the large cohort of aging baby boomers is not adequately prepared for old age."

You bet, we are also not prepared for the fact that there are not enough young people coming up behind to maintain growth and living standards. The so-called 'demography' effect. More on this another day, but it's smack in line with the deflation hypothesis.

"Are you saying that creditors gain because deflation effectively expands their purchasing power?"

This is true, as Modigliani notes, only if the deflation doesn't get serious. But if we get the collapse of financial institutions then the creditors obviously lose since the debtors can't pay. But of course he's right about the initial positive effect for savers, and that must be why all those old people in Japan don't vote for the 'inflation driven' solution to deflation.

"it probably would be offset by a devaluation of the dollar"

This is really Svennson's 'foolproof path' argument. The problem is how the dollar can come down when there's no-one to go up. Or, on the 'foolproof path' more generally, it simply isn't foolproof if all the 'fools' try to go down at the same time, ie if the deflation is global.

I

"The answer to that question depends on the causes of the supposed deflation, a subject on which you have not dwelt extensively. I can think of two major causes: The most obvious would be a deep cyclical decline, but this version is most unlikely because of the availability of well known stabilization policies, and because in this century, as a result of wage rigidity, no contraction has ever produced deflation in developed countries, since the Great Depression. The other possibility is dogged foreign competition from countries like China. This type of deflation, within limits, would be good for the consumers and would compensate for any resulting downward pressure on nominal wages.

If it’s just a temporary blip down in the price level, it wouldn’t worry me....The answer to that question depends on the causes of the supposed deflation....Historically the floor for increases in wages is defined by productivity. So as long as productivity growth is maintained, nominal wages are unlikely to fall."

Here is the problem, if deflation isn't just a temporary blip, then the theory side of why not needs a lot of building up. I have a strong feeling that it won't be just a blip, but the explanation is going to need time. On a more contingent point, Modigliani doesn't seem to consider the output gap mechanism seriously, clearly once prices drop below zero-increases, if the gap continues then the problem only exacerbates, there is no blip. Secondly, the rigid wages argument (like the low productivity services) argument is a strange one in the context of deflation since many argue that in the 1930's wage-rigidities were not an advantage, but in fact helped to prolong the problems, which could be equally true today for the margin-pressured corporate sector. Alternately, in the epoch of outsourcing and short term contracts, perhaps wages are not as 'sticky' as they were. A big chunk of 'greying' America is about to retire, what's the betting that the wages of their replacements won't turn out to be so sticky.

I think what I'm saying is here is that the good and grand old man is just that, and unfortunately a little out of his times.

Further to Glenn Hubbard:

In his FT article the Chairman of the US Presidents Council of Economic advisers says:

"Private forecasters expect the overall rate of consumer inflation to rise to about 2.4 per cent in 2003 as the recovery takes hold"

Don't the US government have their own forecasters any more? This, of course, is a silly quibble, but still the argument is a bit unpresentable. Which private forecasters, those who thought the economy would be booming come last March? He also asserts:

"Moreover, the inflation rate for consumer services has stabilised at little more than 3 per cent a year."

This is the really dodgy part of his argument, since this increase in costs comes from a lack of productivity, not from an excess of it. In particular, once we take out housing (which is a case apart in many ways), the majority of this inflation probably comes from education and health (incidentally these belong to Griliches poorly measured sectors - deriving a price index for health when you control for quality has to be a nightmare, what you can clearly say is that the costs per employed worker of providing health for the entire US population is going to rise significantly), ie the immediate consumers are not salary-earners, the consequences of this for GDP per capita, and hence growth, remain unclear. I wish we had a model here.

Stephen Roach tackles this from another angle in this morning's FT, suggesting that global forces will drive down prices in this sector. In part he has a point, but if he's wrong and they don't, then, as I say, these sectors should be a drag on growth, not a plus point. It's all very complicated, and obviously a bit too complicated for poor Glenn Hubbard. He'll be telling US next that strong speeches by George W are good for the economy since they drive up petrol prices and prevent deflation.

I'm trying to work through a model somehow. It started off something like, consider an economy with three sectors. Sector one trades in the international arena, and is subjected to globally falling prices. Sector two produces high tech products and has just had a technology revolution that is producing a continuous fall in prices and systematic excess capacity. Sector three is home directed, inefficient and with low productivity growth, it thus suffers from upward cost push. (This is meant to be fairly serious, but I can't help going back to the begining and starting with imagine an economy with FOUR sectors: the fourth one would manufacture pieces of paper, with I promise to pay written on them, and would be directed to the international market, but this is stealing from Stephen Roach).

OK, this takes care of the supply side. On the demand side the savings ratio has a lot to say, and that's were the demography comes in, Modigliani life-cycle or Ricardian equivalence, or whatever.

DEFLATION DENIAL

Glenn Hubbard, the chairman of Bush's Council of Economic Advisers makes it official, deflation is greatly over-rated because the US Economy is going just fine:

This modern deflation scenario seems to make a lot of sense - until you get out your calculator. When you do, the basic features of the US economy look quite good and deflation appears unlikely. To start with, analy sis of the productivity data over the past six quarters confirms some of the best news that economists have delivered in a generation - the acceleration in productivity growth that began in 1995 continues unabated. Thanks to this, today's consumers can look forward to real incomes that grow much more quickly than they have during the past 30 years - a good omen for current consumption.

Of course, one can point to the strength of the housing market as a factor keeping consumption strong. House values have risen and low mortgage rates have encouraged homeowners to take out some of the equity in their homes through refinancing. But while this process has been a part of healthy consumption growth, it has been only a part..............The question of why house prices have risen so much in the past few years is interesting. The surge in immigration during the 1990s and the lack of land suitable for new housing in some cities with tight zoning restrictions are probably part of the answer. But fears that the US housing market is in the midst of a bubble are unwarranted. Behind any bubble is the hope that an investor can purchase an asset for one price and sell it quickly for a higher price. This is hard to achieve with houses, because of the high transaction costs in housing markets. And without a rapid and nationwide decline in housing wealth, it is hard to see how deflation can occur.

While in the long run deflation - like inflation - is a monetary phenomenon, low aggregate demand is not likely to push the US toward deflation any time soon. It is a pretty boring story, compared with those told by the deflationists. But it does pretty well when confronted with the facts.
Source: Financial Times
LINK.

Now perhaps this article would be eminently forgetable, were it not for the fact that Paul Krugman has seen fit to enter the fray. I post the Krugman piece in full.

JOBS, JOBS, JOBS (10/10/02)
Of all the things to be upset about right now, a silly fallacy in Glenn Hubbard's FT article today doesn't rate very high. But it's a fallacy I hear a lot, so let me take a minute to bash it.

Hubbard, like so many people, asserts that one reason for optimism about economic recovery is our continuing high rate of productivity growth. At first this sounds right: higher productivity growth means, other things equal, faster income growth, which means more spending, which means faster demand growth. So all that is good for recovery, right?

No, not really. What most people mean by recovery is job growth - an economy that is growing, but in which employment grows more slowly than the labor force, may be in recovery by some measures, but it will feel like it's still in recession.

Now what does productivity growth do? It raises incomes and hence demand. But it also raises the growth rate the economy needs to achieve to create jobs, and to a first approximation it does so by exactly the same amount. That is, an economy with 3 percent productivity growth will, other things equal, have 2 percent faster demand growth than an economy with 1 percent productivity growth; but it will also need a growth rate 2 percent higher to keep unemployment from rising.

In fact, the "productivity growth helps jobs" story, if that's what it is, is just the flip side of the lump-of-labor fallacy, which says that productivity growth reduces employment - and equally wrong. (There's a different argument, about how productivity growth reduces the NAIRU - but that's about the supply side, not the demand side).

You might say that I'm being too abstract; what about the lessons of history? But they all confirm this point. Terrific productivity performance in the 1920s didn't protect us against the Depression; all through the 70s and 80s Europe had higher productivity growth than the U.S., but worse job growth; you can multiply the examples.

I'm not surprised that Hubbard would make a silly argument; he is not, after all, a free man. But it's a sign of desperation, I think, that so many people have bought into this fallacy.
LINK

Hubbard clearly has it wrong. Rising productivity can be accompanied by either rising incomes, or falling prices, it depends. And it's this 'depends' that really is at the issue here. Hubbard clearly believes that the current increasing LABOUR productivity will lead to increasing real incomes, increased consumption, and thus, presumably increased investment (although this is my deduced mechanism since it isn't presented explicity), because he says so.

"the acceleration in productivity growth that began in 1995 continues unabated. Thanks to this, today's consumers can look forward to real incomes that grow much more quickly than they have during the past 30 years - a good omen for current consumption."

The deflationist argument is that the other possibility exists, that the increased productivity leads to falling prices as firms compete to sell. This is the role of the output gap argument. This argument is also backed by the idea that current consumption has been maintained by borrowing. It's not the wealth loss caused by the drop in the financial markets that's the problem, but the increased debt encouraged by the false sense of security provided by rising assett, and subsequently rising property, values.


One of the problems here is that productivity is a poorly understood phenomenon - by all of us. The majority of the numbers being bandied-about at the moment seem to be numbers for 'labour productivity' from the BLS. And this is where the argument starts, because the 'jobless recovery' is a product of another process, the relentless drive by corporate America to cut costs, ergo increase output while not contracting new labour, or hiring young workers on short term contracts etc. It's very early to start making conjectures about these numbers because the serious analysis isn't through yet. But it is entirely consistent with the deflation/output-gap argument. US workers are trapped in a kind of modern version of the olive press, and at some stage all that can be will have been squeezed.

"Now what does productivity growth do?" Perhaps this is an unfortunate way to present the story, since maybe productivity growth doesn't 'do' anything. In the present context this productivity growth is an effect of something, and it's understanding this 'something' that is the problem.

Paul Krugman himself in another piece on the related topic of the output gap clarifies what he is saying: "Brad DeLong is quite right that there's no such thing as excess capacity for the economy as a whole. I've been vociferous about that myself in the past. What I meant to say was over-investment in short-lived business capital, mainly tech, relative to other resources...."

However it is in this last point, rather than the conjuctural productivity/output-gap argument, where the real problem lies. You see, I think it's just not credible to say that "over-investment in short-lived business capital" is pushing the global economy into a period of secular deflation (I take it as read that Hubbard just doesn't understand what's going on here). The normal expectation would be that this excess capacity would be worked-off, and on we would go again. But it's all too evident that this just isn't happening.

I've already indicated in this column (ad infinitum) some possible candidates: the continuing fall in ICT and biotech prices, the structure of world trade (especially China, but my guess is India won't be too long making its presence felt), and demographic processes in the G3 countries.

If demography is going to be important in the story then the deflation problem should be more acute in the EU countries (Italy and Spain in particular, but also Germany) than in the US, but obviously with Japan and Europe going downwards the US is bound to be sucked in.

Put this another way: if demography is not important, then why, in Stephen Roach's words is the world lacking an alternative global growth engine right now. Surely using conventional growth theory the 'convergence factor' should be offering plenty of catching-up momentum elsewhere.

Perhaps demography will turn out to be the modern economists 'pons assinorum'.

Incidentally, while the Glen Hubbard piece may be eminently forgetable, the ever-to-be-recommended Economist has a very nice (Krugman influenced?) piece on deflation (see below), and especially the dangers for Germany right now - going 'naked into the conference chamber' - thanks to the voluntary Euro disarmament. (It's hard to remember that it was only 10 months ago that the world was cheering on this single currency 'experiment' - so why, oh why, have all the evangelists suddenly gone silent?).
Now as far as the liklehood of deflation goes, either you believe the deflationist story or you don't. But Hubbard is wrong. There are TWO possible outcomes, and this time next year we'll have a better idea which one of the two it is going to be.

THE ECONOMIST RAISES THE DEFLATION ALERT

An extremely comprehensive and well argued piece in this weeks economist - entitled interestingly enough of debt, deflation and denial - draws attention to the growing unease at a possible global drift towards deflation. In particular it points out the highly preoccupying situation of the German economy and the danger that, lacking any domestic policy instruments of her own - thanks to her Euro membership, she may fall defenceless.

The article also draws attention to the ongoing difference of opinion between the ECB and the Federal Reserve. Greenspan obviously takes the threat more seriously than Duisenberg. Time will show who is right

The world is still awash with excess capacity, in industries from telecoms and cars to airlines and banking. Until this is eliminated, downward pressure on inflation will persist. A good measure is the output gap, the level of actual minus potential GDP. Historically there has been a close relationship in most countries between the size of the output gap and changes in the inflation rate (see chart). When the output gap is negative (ie, actual output is below potential), inflation usually declines. The OECD estimates that America's GDP is about 1% below its potential. If growth remains at or below its trend rate of around 3% over the next two years, the negative output gap will persist into 2004, pushing inflation even lower. It would not take much to tip into deflation.

The Fed is at least aware of the risks. However, not all central banks may be either willing or able to learn from Japan's mistakes. Germany probably faces a higher risk of deflation than America. The ECB's interest rate of 3.25% is broadly appropriate for the euro area as a whole, given its inflation rate (2.2%), the size of the output gap, and the bank's chosen inflation target of “less than 2%”. But the ECB seems unlikely to cut interest rates until inflation dips below 2%. And its inflation target is arguably too low.

Even then, however, rates would still be too high for Germany. Since it is the highest-cost producer within the euro area, a fixed exchange rate tends to cause price convergence by forcing inflation to be lower in Germany than in the rest of the euro area. Germany's core rate of inflation (excluding food and energy) has averaged 0.6 percentage points below the euro-area average over the past three years; it is now a full point lower, at 1.1%.

Since interest rates are the same across the whole of the euro area, this implies that real rates will be higher in Germany and growth consequently slower. Germany's output gap, at an estimated 2.5% of GDP, is the second biggest after Japan among the G7 countries, and it is likely to widen. Deutsche Bank recently cut its growth forecast for Germany to only 0.1% for this year and 0.6% in 2003.

Back-of-the-envelope calculations suggest that, if the old Bundesbank were setting interest rates to suit Germany alone, they would now be below 2%. Worse still, not only is Germany unable to cut interest rates, but the EU's stability and growth pact also obstructs any fiscal easing. Nor can it devalue its currency. Stripped of all its macroeconomic policy weapons, Germany now runs a serious risk of following Japan into deflation.
Source: The Economist
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JAPANS CONTINUING DEFLATION

Japans core consumer price index fell for the 35th consecutive month in August, down 0.9 per cent year-on-year. Unemployment in August was just below post-war highs at 5.4 per cent. The number of jobless increased by 250,000 year-on-year to 3.6m. To cap this extremely depressing batch of economic data household spending fell 2 per cent in August month-on-month. This seems to indicate that Japan is as much in the grip of deflation as ever and should give the G7 leaders assembled for the Washington summit plenty to muse over. Meanwhile, in an attempt to deflect criticism, Japan's leaders are suggesting that they may be prepared to act more agressively on the bad loans problem that plagues the banking system:

Japan will tell fellow members of the Group of Seven industrialised nations in Washington this weekend that it is prepared to use public money to bail out its debt laden banks, Masajuro Shiokawa, finance minister, said yesterday.

But the veteran politician offered no details of how the potential injections would take place and insisted the bailout would only proceed "if necessary", offering policymakers a range of options to avoid having to abide by this strategically timed pledge. Members of the G7 have been calling for a meaningful resolution of Japan's bad debt problem for many years and Mr Shiokawa's statement is likely to mollify them. But it could backfire if not backed by action. "At the meeting I will stress the importance of banks' liquidation of corporate borrowers in serious trouble. As a result we may inject public funds into banks, if necessary," Mr Shiokawa said yesterday.

Despite the rumours of his demise, Mr Yanagisawa - Japan's Financial Services Minister -was in unrepentant form yesterday, insisting an injection of funds is not needed but making his first public commitment to a scheme that would help the banks by expanding the role of the Resolution and Collection Corporation (RCC).Mr Yanagisawa said yesterday he would accept the use of public funds only if they were used to cover losses incurred by the RCC when it offloaded the loans it had purchased from the banks.The minister's comments neatly capture the core of the debate over how to deal with the bad loan problem. One view - the true bailout scenario - involves public funds being injected directly into the banks, wholesale management changes, a short-term rise in bankruptcies, rising unemployment and potential political and social unrest.The other view - the quasi bailout scenario - involves the bad loans being transferred to the RCC, which will offer a better price for them than previously. This will restore the banks to health but leaves borrowers just as bankrupt as before, but able to struggle on.
Source: Financial Times
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FEDERAL RESERVE CLUES IN ON JAPANS PROBLEMS

The following article by a group of Federal Reserve economists attempts to come to grips with any connection there may be between Japan's burst bubble and the creeping deflation they are experiencing.

Abstract: This paper examines Japan’s experience in the first half of the 1990s to shed some light on several issues that arise as inflation declines toward zero. Is it possible to recognize when an economy is moving into a phase of sustained deflation? How quickly should monetary policy respond to sharp declines in inflation? Are there factors that inhibit the monetary transmission mechanism as interest rates approach zero? What is the role for fiscal policy in warding off a deflationary episode? We conclude that Japan’s sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities’ failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan’s experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.
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A NOTE FOR MY READERS

This blog is currently under construction. It will bring together material I produce, and links I discover to interesting material, relating to what I consider to be one of the characteristic phenomena of the coming decade: deflation.