BoE Paper Gives Thumbs Down to British Deflation

According to the latest paper to come out of the Bank of England, deflation is unlikely to be a major problem in the UK. Unless, of course, there's a housing crash. We'll see.

A general price deflation in which interest rates fall to zero is 'highly unlikely' to hit Britain, according to a paper published by the Bank of England today. Interest rates at historically low levels around the world and a troubled economic outlook have prompted central banks to start worrying about deflation. Japan, where prices are falling and the economy is stagnating even though the Bank of Japan has, in effect, cut rates to zero, is an example nobody wants to follow. But an article by one of the Bank of England's economists in its latest quarterly bulletin says economic models suggest that for an economy such as Britain's, which is aiming for an inflation target of 2.5 per cent, the risk of a deflationary spiral is "very small indeed". In part that is because if the Bank saw a risk of deflation it could, and would, cut interest rates aggressively to head off the threat.

However, the article also argues that central banks should in normal times try to move interest rates only gradually, to reassure the markets that any change was likely to stick. If the preventive policy fails and deflation does persist, and interest rates have been cut to zero, the Bank paper considers possible policies for breaking out of the trap. Such policies would include tax and spending decisions, buying shares or bonds, devaluing the exchange rate and printing money to pay for a tax cut. But it concludes that many of these policies are "untried and untested", and prevention is likely to be better than cure. With underlying inflation at 3 per cent, and expected to go higher, deflation seems like the least of the Bank's problems. A house price crash, likely to be accompanied by a slump in consumer demand, could resurrect deflation as a significant threat.
Source: Financial Times
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When Money is No Longer Liquid

I have spent part of this morning reading the latest Bank of England 'deflation watch' piece published in the latest edition of the quarterly review. In the midst of a relatively serious summary of the recent debate I find the following quote which really has set me thinking: "when we say that cash is more liquid than other assets we mean that it can, for example, be more readily transformed into something else that the owner wants". This seems innocuous enough doesn't it? It is probably after all a central tenet of all known monetary theory. But what happens when there is nothing else that the owner of a liquid asset wants than to hold the asset? Here I think we have the heart of the current debate and widespread misunderstanding about what is happening in Japan. There is in fact no charge for holding money. Now when interest rates are zero and deflation is running at two per cent, holding cash also attracts a positive real rate of some two percent, and apparently with no risk. In times of deep financial crisis (like the one which currently afflicts the Japanese banking system) the asset may even be considered by some to be safer under the bed than in a current account deposit where certain kinds of transaction may even attract charges. So the most liquid of assets ceases to be as liquid as it was (viscous perhaps, sticky money, etc, etc?), and herein lies the problem: everyone will accept cash, but not everyone is so willing to part with it. Oh, and just one more thing, printing money to acquire assets whose value may decline without provoking inflation (ie failing to provoke inflation) could be considered a cure worse than the problem if it only served to detriorate an already serious debt liability situation.

Goodfriend has suggested that the central bank could stimulate the economy by buying assets less similar to cash than normal: illiquid assets like infrequently traded bonds, or even claims on the private sector like shares or corporate bonds. An exchange like this would involve the private sector giving up an illiquid asset and taking a more liquid one, cash, in return. When we say that cash is more liquid than other assets we mean that it can, for example, be more readily transformed into something else that the owner wants. Money can be swapped for goods directly: other assets generally cannot. Having something that is more readily (more cheaply) turned into a good that can be consumed is valuable. Following an exchange of cash for illiquid bonds or shares the private sector would have more ‘liquidity’ and would therefore be better off. This would stimulate spending. By announcing that the central bank is prepared to engage in operations in formerly illiquid assets, these assets would themselves become more liquid. That would cause their prices to rise, make private sector holders of those assets better off, and increase demand. Higher levels of spending would raise expected inflation and lower real rates, stimulating demand further, and so on, until a point was reached when normal interest rate policy could be effective again.
Source: Bank of England Quarterly Review
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What Type of Deflation in Japan?


Morgan Stanley's Takehiro Sato draws our attention to a debate in Japan that is not without importance. The debate became public through the delcarations of BoJ Policy Board member Kazuo Ueda in an opinion article that appeared in the Nikkei Shimbun on March 17. In the piece he questions the Bank’s official stance toward the Non Performing Loan (NPL) problem. He draws a clear distinction between asset price deflation (particularly that of land and property, which has fallen some 70-80% since its peak) and the consumer price index, which has fallen rather moderately. The asset price decline is what bears comparison to the 1903's deflation problem, but the slow-burn chronic deflation reflected in the CPI is, in my book, something new and decidedly modern. This argument remains unchanged even if poor measurement practices mean the decline in the CPI has been slightly larger than estimated. The property angle is worthy of much deeper investigation for it's importance in the spectacular growth of the Japanese economy, and because with an ageing and shrinking population pressure on Japan property values are likely to decline and not increase. Again how to resolve the structural problem of the major outstanding policy problems facing Japan. All in all, the argument is an important one since it relates to whether or not monetary solutions can work in the absence of a complete restructuring of the banking system.

According to Ueda, asset price deflation, not general price deflation, is linked closely to the Japanese economy’s current stagnation and macro policies that work against general price deflation are unlikely to lead to a sustained recovery. Reasons given to support this view are (1) no indication of a rise in real debtor burden caused by higher real interest rates, as occurred in the 1930s, given the mild 3% cumulative decline in the CPI from its peak, (2) no evidence of general price deflation leading to asset price deflation with almost no correlation between asset price and general price trends, considering the 70-80% cumulative decline in the urban land price index from its peak, tantamount to asset deflation during the Great Depression, and (3), conversely, some downward pressure on general prices from the inability to resolve quickly setbacks to the financial intermediation function caused by asset price deflation.

Based on these assumptions, efforts to boost general prices using macro policy would not provide a solution for asset price deflation. This position blunts the arguments of those calling for inflation targets through the purchase of risk assets. Ueda also projects a continuation of negative pressure on asset prices until the Japanese economy succeeds with structural transformation and asserts that this is a necessary adjustment. It is hence necessary to revitalize the financial intermediation function along with macro policies to stop general price deflation in order to limit adverse repercussions from a debt-deflation-adjustment process comparable to the 1930s. There must be a restructuring of both borrowers and lenders and a rebuilding of the financial system using public capital where appropriate. However, Ueda’s view puts asset price deflation at the center of the NPL problem and differs in nuance from the Bank’s official stance presented last October in the areas cited below.
Source: Morgan Stanley Global Economic Forum
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Deflation Alive and Well in the Czech Republic

Many observers seem to treat deflation as if it were a problem which was exclusively focused on Japan. In fact the problem is much more generalised, and seems to be spreading rather like that horrible pneumonia problem. Today some news from the Czech Republic. The seasoned deflation observer will note that the principle pillars of policy are increasing the government debt (which rose by a staggering 18% of GDP last year, provoking sharp criticism from the IMF) and lowering the value of the currency. Neither of these lines of attack would be open to the Czechs were they, at some future date, to enter the euro.

Czech consumer prices grew 0.2 % month/month and fell 0.4 % yr/yr in February, reports the Czech Statistical Office (CSU). In February, prices of food, clothing and household equipment fell, while other items in the CPI basket rose in month/month comparison. The main factors behind the month/month price increase in February were increased prices for recreation and culture (1.0 %) and transport (up 0.5 % due to a 2.3 % rise in fuel prices). Housing prices rose 0.3 %, while telecommunications added 0.9 %. On the other hand, food prices fell 0.3 % and clothing and footwear prices went down 1.0 % in February. As in January, the yr/yr fall in prices was influenced by decreases in consumer prices of food and non-alcoholic beverages (down 6.0 %), clothing and footwear (down 4.8 %), natural gas (down 11.4 %), electricity (down 4.7 %), says the CSU. "In the next months, prices of fuel and transport will continue to grow," predicts Komercni banka (KB) chief analyst Kamil Janacek. "Also there will be a reversal in the declining trend of food prices." He expects inflation to be just under 2 % at the end of 2003. Prices in 2Q 2003 will be compared to the relatively low base created in the second quarter of 2002, says Radomir Jac of Commerzbank Capital Markets, adding to the factors driving annual CPI inflation higher. Analysts believe deflation could continue until March or April. At the end of January, the Czech National Bank (CNB) reduced its rates by 0.25 bps, bringing the key two-week repo rate to 2.50 %, or 0.25 points below eurozone levels. Low inflation was the main argument for the cut. If the low inflation continues, Miroslav Brabec of Raiffeisenbank expects another 25 bp rate cut in anticipation of further monetary easing by the European Central Bank (ECB). The Czech crown firmed to below CZK 31.80/EUR Monday morning following the release of inflation data.
Source: Interfax Czech Republic
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The Conventions of Unconventional Policy


With the 'soft patch' getting softer and pressure once more rising on the Fed to lower rates, Stephen Cecchetti again asks the dreaded 'D' question: what should we do if and when we hit zero. His answer is not to panic, since, he tells us, policymakers have studied and prepared a set of unconventional options and are convinced that they will work. Now both these points should worry us a little: that the options are unconventional, and that they are 'guaranteed' to work. In the first place we need to exercise a little prudence. The dollar-peso peg was 'guaranteed' to work in Argentina, the euro was a 'guaranteed' good thing for the EU, and ........ These 'options' exist on paper, they are not in any sense tried and tested, and when we are offered 'foolproof' policies which are guaranteed to work to solve a problem which has been steadily growing for three years (this month is the third anniversary of the NASDAQ break), we have the right, nay the duty, to remain a little skeptical. I can see three major problems that deserve our attention.

Firstly while I am in no sense a 'rational expectations' fan, I think we need to remember Churchill's point about not being able to fool all of the people all of the time (because of course it is the citizens who are presumed to be the 'fools' here, or is it the politicians, I am never quite sure). Deflation is in part about expectations, not the sophistocated kind which are assumed to work in, for example, the Ricardian equivalence argument. No, a more basic and primitive set of expectations, possibly motivated by that most basic of emotions fear. Keynes 'animal spirits' comes to mind here. If the expectation sets in that deflation is here, and that it has come to stay for a time, then this will alter people's attitude to cash. Interest rates may reach zero, but if prices are declining at, say, 2% per annum, and are expected to continue to do so, then holding cash carries a positive interest rate. Much of what follows then depends on the stability of other prices.

If, as in Japan, this slow-burn deflation is accompanied by a more general decline in asset values, then cash can become extremely attractive, people can hold more of it, and the velocity of circulation can decline. If this happens to any significant extent then the central bank intervention is effectively sterilised. This, and not simply Ahearne style 'cut early and cut often', is the true lesson from Japan. If, with interest rates tending to zero, fixed operating costs and low margins, and an increase in non-performing loans, the banking sector becomes per se weaker, then this turns itself into yet another argument for holding cash. (Actually I have a feeling that if we wanted to be really 'smart' and look to really new ways to deal with a new situation, we would be thinking about e-money and its possible role and use, but this is for another day). I mean, at the end of the day, people aren't fools, and it is extremely hard to convince them you are going to be irresponsible long term, and that once the irresponsibility stops you won't fall back into the whole again, only this time deeper. The 'man on the clapham omnibus' is far more likely to use this type of rule of thumb guidance than the professional economist is. This is doubly true since 'responsible' central bankers have spent years convincing us that 'fine tuning' inflation is a difficult art, now they want to convince that they can fire it up to 3% and hold it there, no problem.

Secondly, the coming defation seems generalised and sustained. This seems to set it apart from being a mere business cycle phenomenon ( at least in the normal 'short cycle' sense, and with all due respect to Brad: I will have more to say on this on another occasion). In this case, what might work in an isolated case of localised and short-term deflationary pressure, seems from the start to be more problematic. The most effective and convincing part of the fire-fighting programme is the one relating to currency value. In fact I am pretty convinced that the recent 'permissive' fall in the value of the dollar forms part of the Bernanke strategy. But such currency devaluations, by their very nature, cannot be generalised. The dollar has fallen, at what price? Japan's export lead expansion has faltered, and Germany stands on the brink of deflation.

My third objection relates to the causes of the problem. I'm afraid I don't buy the view that all of this is simply a business cycle blip. There is, after all, a real economy out there somewhere. There is a globalisation process, the relative fortunes of countries can rise and fall. There is a something called Moore's law, it is still operative. We do live on an ageing planet, this must have consequences. I don't think I have all the answers, far from it. What worries me is that so many people are not even asking the pertinent questions. When Cecchetti tells us that 'these policies are bound to be effective, driving up prices and eliminating any deflation', we have the right to doubt. Remember, only last November he was informing us that "while there are some things that I think about late into the night, deflation and the ineffectiveness of monetary policy are not among them".

Overnight interest rates have fallen to their lowest levels in decades. With the US Federal Reserve's federal funds rate at 1.25 per cent, the European Central Bank's main refinancing rate at 2.5 per cent and the Bank of England's repo rate at 3.75 per cent, we are approaching a very clear limit. And since nominal interest rates cannot go below zero, what will policymakers do if they reach that limit? Importantly, what will they do if nominal interest rates are zero and the economy is experiencing deflation?


These questions have been on the minds of central bankers since before the Bank of Japan, in response to a mild but persistent deflation, moved its policy rate to zero in early 1999. Policymakers have studied a set of unconventional options thoroughly and are convinced that they will work. What are these unorthodox policies? How do they work and what do they mean for policy both now and in the future?

The mechanics of unconventional monetary policy is straightforward and based on the fact that the central bank controls the size of its balance sheet. It is through changes in its assets and liabilities that it influences the economy. During normal times, policymakers operate by controlling the supply of their liabilities to meet an interest rate target. The details vary with each central bank, but the thrust is always the same. All monetary policy, conventional or not, is the result of balance sheet manipulation...........

This line of reasoning leads to two important conclusions for policy today. First, the mere prospect of hitting zero means acting earlier and faster. What looks like caution in moving slowly, can turn out to be very risky. This was one element that led the Fed to lower interest rates 4.75 percentage points over a period of 11 months in 2001. While there is every reason to believe that tomorrow's meeting will not produce another cut, Open Market Committee members are surely ready to pull the trigger should conditions worsen perceptibly between now and their next meeting in early May. And, with the main refinancing rate at 2.5 per cent the ECB should be giving serious consideration to the same sort of pre-emptive action.

The second conclusion is that, in order to avoid having to use unconventional policies of uncertain effect, policymakers are willing to tolerate a bit more inflation. A year ago, the Federal Reserve would probably have been comfortable with consumer price inflation of 1-2 per cent. Today I am not so sure. My guess is that Fed officials are nervous enough that they are going to aim for inflation in the 2-3 per cent range in the hope that unconventional policies remain unnecessary. At least, I hope so.
Source: Financial Times
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US Life Expectancy on the Rise


Nothing particulary surprising or shocking in the latest US CDC report. American life expectancy rose in 2001 to 77.2 years from the 77.0 years reported in 2000. This is good news all round. Except that is, for the actuaries. You may be surprised to learn that most pensions related calculations assume a tapering-off and not a continuation (much less an acceleration) in life-expectancy trends. better start getting your calculators out!!

Americans’ life expectancy hit an all-time high in 2001, while age-adjusted deaths hit an all-time low, according to a new report released today by HHS Secretary Tommy G. Thompson.The report from HHS’ Centers for Disease Control and Prevention (CDC) documents that the national age-adjusted death rate decreased slightly from 869 deaths per 100,000 population in 2000 to 855 deaths per 100,000 in 2001. There were declines in mortality among most racial, ethnic, and gender groups.

Meanwhile, life expectancy hit a new high of 77.2 years in 2001, up from 77 in 2000, and increased for both men and women as well as whites and blacks. For men, life expectancy increased from 74.3 years in 2000 to 74.4 years in 2001; for women, life expectancy increased from 79.7 years to 79.8 years. Record high life expectancies were observed for white men and for both black men and women.“This report highlights some encouraging progress, including a continued reduction in death rates from the Nation’s three leading killers -– heart disease, cancer, and stroke,” Secretary Thompson said. “At the same time, it reminds us that we need to do more to reduce the health disparities that disproportionately affect certain racial and ethnic groups.”
Source: US National Centre for Health Statistics
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These kind of numbers seem to confirm what they've been saying over at the Commission on Global Aging for some time:

Our findings confirm that the population forecasts used to calculate unfunded benefit liabilities in every G-7 country assume that the demographic trends of the past half-century will moderate in ways that improve the actuarial soundness of old age benefit programmes. In general, official forecasts assume that:

• life expectancy will increase much more slowly than in the past;
• recent low birth rates will rebound rapidly toward replacement-rate levels;
• immigration will likely persist at historical rates, or possibly decline somewhat over coming decades.

Forecasts of the size and composition of the populations of all G-7 countries for the period 2000 to 2050 were prepared by Shripad Tuljapurkar, Nan Li, and Michael Anderson of Mountain View Research. The findings on longevity that underlie these forecasts were featured in an article by Tuljapurkar and colleagues in the June 19, 2000 issue of Nature. The forecasts employ a probabilistic methodology that translates historical trends in population into dynamic projections.An important feature is that they incorporate variability around past trends, and project this into the future.

The findings of this study suggest that most of the G-7 countries continue to significantly underestimate increases in longevity, while the low-fertility countries overestimate the prospects for a recovery in birth rates. Significantly, actuarial optimism is greatest among countries that have the highest per capital public debt burdens, are ageing the fastest, and face the greatest social security funding shortfalls.
Source: Commission on Global Ageing
LINK to MORE DETAILS

Unless We Slide into Japan Style Deflation....


I'm afraid my thoughts coudn't be more distant from those expressed by Paul Krugman this week. Of course I find the way the US deficit is ballooning scary, and of course I think the Bush administration isn't thinking clearly about the future, but I can't buy the 'inflation scare' argument. Of course, Paul is intelligent and he adds the 'caveat emptor' get-out clause, "unless we slide into a Japan style deflation". But that's just the point, that seems to be exactly where we are heading. And, unless I got something badly wrong, isn't he suggesting inflation targeting as a protection from Japan's malaise? And Paul is far too good an economist not to know that if you stoke up 4% inflation, then you don't know where this will take you. Our 'fine tuning' isn't that fine you know.

Running out of base points is not the same thing as running out of ideas. One swallow doesn't make a summer, and one Fed paper - even a good one - doesn't mean we've understood Japan. The real lesson from Japan is that thinking economics exclusively in terms of monetary/fiscal mix, like love in a time of cholera, simply isn't enough. Fortunately we do have science, but only if we are willing to climb out of the box, learn to think critically and try to understand what is happening. My feeling is that institutional and structural factors need more attention than they are getting. We could also put some historical time (rather than abstract state space) back into economics. Be that as it may, this is neither the time nor the place to develop such points.

Unfortunately fiscal bankruptcy does not necessarily imply inflation. Recourse to text books doesn't help here, since they all carry those 'ceteris paribus', 'buyer beware' stickers. Because if other things are not equal.........

And they aren't. For the trillionth time, when were we last looking at these demographics? National Income it will be remembered is commonly assumed to be a function of capital and labour, and capital formation stands in some relation to the saving habits of those who are working. So if the proportion of people working in any society goes down (and of course the proportion of those who are dependent goes up), shouldn't we expect that fact in itself to produce changes in things like national productivity and national income. Lets put this another way: isn't it probable that there will be some unpleasant consequences associated with the unwinding of that most beneficial of beneficial phenomena, the ninetees 'participation squeeze'. How far this goes all depends on what kind of vicious circle we manage to get ourselves backed into.

For what it's worth my hunch is that inflation has something to do with forward-looking growth expectations and liquidity constraints. What does this mean? Take growth in Japan and the US 1960 to 1985. GDP went up at the rates of 5.2% and 2.5% per annum respectively. Under these conditions a 25 year old Japanese citizen could expect to be 12.5 times richer (in terms of lifetime earnings) than his or her 75 year old grandparent, while a 25 year old American would only expect to be 2.8 times richer than the grandparent. Small differences in growth expectations create big differences in lifetime earnings expectations. Obviously these differences can then be reflected in differing capacities for bringing forward future earnings for consumption now (read borrowing, read liquidity constraints). Our societies are evidently facing a future where the screws of liquidity constraints are definately going to be turned. On the most optimistic expectations growth will slow. But this reduction in growth can then feed back into diminished borrowing and hence even slower consumption (this is one part of what I mean by vicious circle). Then look at the age demographics of consumption. A society with a lot of young people is 'front loaded' in the sense of having many people whose future earnings are multiples higher than their current income stream. An aging society does not have that priviledge, future earnings for a growing part of the population are pretty near to what they are now, or less. Conclusion: where's the inflation push? ( This may seem hopelessly simplistic right now, but just give me time.....)

On the other hand the US and Japan are not Argentina (and even there inflation has been remarkably restrained of late, given everything). In fact Japan's enormous saving's surplus means that the government can benefit from remarkably low interest rates into the indefinite future (the 30 year yield curve is, in fact, flattening out). It would be a rise in interest rates which would precipitate national bankrupcy, that's why no-one in Japan expects inflation any time soon. I don't see in principle why it should be any different in the US. When push comes to shove interest rates are, after all, determined by the supply-of and demand-for savings.

My feeling is that Paul Krugman might well live to regret his fixed interest mortgage decision. (A better decision, as the economist seemed to be recommending, might have been to sell now, pocket the money and rent, but it's just a thought. If deflation really sets in the only asset with a rising value might just be: cash. Certainly the uncertainty level suggests that the smart money now is liquid, but of course isn't that why so many people are meticulously going in the opposite direction and evacuating their bank accounts to sink their hard earned savings in concrete. This puts me in mind of another Paul Krugman, the one sitting in the cheap Pizza diner, watching all those truckers busily following CNN Money). Still, this all goes to show that even the best of economists can make the same mistakes as everyone else. Meanwhile developing a bit of theory to help explain what's going on could prove to be the most useful investment of all.

With war looming, it's time to be prepared. So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I'm terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits.

From a fiscal point of view the impending war is a lose-lose proposition. If it goes badly, the resulting mess will be a disaster for the budget. If it goes well, administration officials have made it clear that they will use any bump in the polls to ram through more big tax cuts, which will also be a disaster for the budget. Either way, the tide of red ink will keep on rising.
How will the train wreck play itself out? Maybe a future administration will use butterfly ballots to disenfranchise retirees, making it possible to slash Social Security and Medicare. Or maybe a repentant Rush Limbaugh will lead the drive to raise taxes on the rich. But my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt.

And as that temptation becomes obvious, interest rates will soar. It won't happen right away. With the economy stalling and the stock market plunging, short-term rates are probably headed down, not up, in the next few months, and mortgage rates may not have hit bottom yet. But unless we slide into Japanese-style deflation, there are much higher interest rates in our future.

I think that the main thing keeping long-term interest rates low right now is cognitive dissonance. Even though the business community is starting to get scared — the ultra-establishment Committee for Economic Development now warns that "a fiscal crisis threatens our future standard of living" — investors still can't believe that the leaders of the United States are acting like the rulers of a banana republic. But I've done the math, and reached my own conclusions — and I've locked in my rate.
Source: New York Times
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Why All the Fuss About Deflation

Deflation is a generalised and sustained fall in prices, with the emphasis on generalised and sustained. At any given time, especially in a low-inflation economy like that of our recent times, prices of some goods and services will be falling. Price declines in a specific sector may occur because productivity is rising and costs are falling more quickly in that sector than elsewhere or because the demand for the output of that sector is weak relative to the demand for other goods and services. Sector-specific price declines, uncomfortable as they may be for producers in that sector, are generally not a problem for the economy as a whole and do not constitute deflation. Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.


The above more-or-less is the now commonly accepted definition of deflation. However worrying about deflation is one thing (all thinking economists are now worried about it). Knowing why it is happening, and having something useful to say about what to do about it is another. We can all get interest rates down to the zero limit, and then start dropping our currencies 1930's style - but will it work, or will we only succeed in going round in circles?

Even while there is a growing consensus that the problem of deflation is real, my feeling is we are quite short on analysis. This was also my initial impression when I read the writings of two deflation stalwarts: Paul Krugman and Steven Roach . Importantissimo as their work is in drawing attention to the problem, too much weight in my view has been placed on the debt deflationary dynamics of the burst bubble, and not enough attention has been paid to getting to grips with why this impact has been so deep, and why it is happening now?


Why, for example, is Japan so ill? Certainly we have the boom-bust cycle story (and thanks a lot to Stephen Roach and Larry Summers for this), but are things really so unstable that you cross over a little white line and bingo, you're stuck. This, incidentally, cuts across all those arguments to the effect that we've actually got better at handling economic and financial problems.And why is today's Japan deflation of the chronic, slow-burn variety, which is very different from the dramatic and acute deflation of the 1930's. Again what is the significance for policy of this difference?


My question then is, is there something more important going off? I personally think so: I tend to use the expression 'phase transition' - or regime switch - to describe this move from an inflationary to a deflationary environment, but it's only a metaphor.


So far, I've come up with three candidates:


Firstly the secular decline in the unit price of INFORMATION (ie not just IT equipment, but eg human genome string etc, for more on this see Kurzweil's exponential over exponential, or law of accelerating returns - another thing some people just don't seem to get).


Secondly the changing demography of the developed countries: aging, changing support ratios, changing patterns of saving and consumption etc. Jeffrey Williamson and Angus Deaton, for example, have some interesting material on the growth of the so called Asian tigers that makes very interesting reading here.


Thirdly the changing structure of international production through globalisation, and in particular the entry of China into the WTO. Again Williamson and O'Rourke show how the opening of the New World changed structurally the European economies and facilitated industrial growth. It is only reasonable to expect that the take-off of China and then India will have similarly dramatic consequences in the twenty first century. These three pointers are only a start, my point of departure for an ongoing investigation. I have set up a page on my website and it is my attention to use this page to take this analysis further, and to continue digging until in Wittgenstein's famous phrase, my spade is turned. Anyone else who's interested is welcome to join me there, and mail me if you have anything interesting to contribute.
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Housing: On Bubble Business Bound


Does the current housing market constitute another case of bubbleitis. This week it's the turn of the Economist to worry. They look at all sides of the argument, and as usual these days stay firmly on the fence. Certainly the evidence for the existence of a bubble is unclear. Three cases, however, do stand out: the UK, Spain and Australia. Others like the US, Italy, Sweden and France are less obvious, really we will only know with hindsight. But the connection with the peak in stock market values is evident. With the equity collapse and low interest rates all round, second homes or more expensive first homes have become for many a safe haven source of saving or investment. True in the past house prices have not fallen subsequently as much as equity prices. But in the past housing was not converted so feverishly into a financial instrument. It's important to note that it's a lot quicker to get your money quickly out of the bank than it is out of concrete.

Many argue that the increased values only reflect the reduced repayments. This is also true, but a lot depends on the future direction of general prices. If we are making a transition from an inflationary to a deflationary envirnoment then this will have importance for the way these increased repayments may or may not be sweat off. If there is no inflation to reduce the real capital value of the debt, and wages and prices are sticky but downward bound, then those increased premium payments are going to weigh heavy on all those newly indebted young people, who will it should be remembered be paying for all those extra pensions coming on line. A sticky situation all round.

America's boom is already slowing: the average price of a home rose by 7% in the year to December, compared with an 11% gain during 2001. In the fourth quarter prices rose at an annual rate of only 3.3%, the slowest since 1997. However, according to The Economist's global house-price indicators, markets in many other countries continue to bubble merrily. (We launched these indices a year ago, and plan to update them every six months.)

Australia, Britain, Ireland and Spain all saw double-digit increases in house prices in 2002. House-price inflation rose in eight of the 13 countries covered in the year to the fourth quarter, but fell in five. Prices fell in Germany and Japan, which have yet to recover from the bursting of property bubbles in the 1990s. In both countries prices are lower than in 1995.

Britain, Ireland and the Netherlands have seen average annual price rises of more than 10% since 1995 (chart 2). But the Dutch bubble is now bursting: prices fell late last year. House prices are also falling in London, if not yet in the rest of Britain. The Irish housing market, which saw a brief fall in prices in 2001, has taken off again. The average Irish home now costs three times as much as in 1995.

The commonest argument for why house prices are not overvalued is that low interest rates allow people to borrow more, so they are willing to pay more for their homes. But is it possible to work out some sort of fundamental value of a home? Edward Leamer, an economist at the University of California in Los Angeles, argues that the price of a house, like that of any other asset, should reflect its future income stream. Just as analysts and investors seemed to believe during the dotcom boom that the link between share prices and profits was irrelevant, people today may have forgotten the link between house prices and the rental income that can be earned if homes are let.
Mr Leamer argues that a price/earnings (p/e) ratio can be calculated for houses, as for shares, by dividing average house prices by average rents. John Krainer, an economist at the Federal Reserve Bank of San Francisco, has calculated this ratio for America's housing market, covering the past two decades. He uses an index of average house prices and the imputed rent paid by owner-occupiers that goes into the consumer-price index. As home prices have outpaced rents, the p/e ratio has soared

Mr Krainer estimates that house prices would have to fall by 11% to bring the ratio back to its long-run average. In contrast, the p/e ratio for America's S&P 500 stockmarket index suggested in early 2000 that share prices needed to fall by more than 50%. Alternatively, if house prices instead remain constant and rents grow at their average pace of 4% a year, the ratio would revert to its long-term average by the end of 2005, with no need for a price decline. Mr Krainer concludes that, nationally, American house prices are not dramatically out of line with rental values. But there are two caveats. First, after a boom the housing p/e ratio usually undershoots. That implies either a bigger fall in prices or a longer period of stagnation. Second, it may be too optimistic to assume that rents will rise by 4% a year.
Source: The Economist
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To Monetise or Not to Monetise, That is not the Question


Curious how almost everyone who's anyone in New York or Washington thinks that the Japanese problem has a monetary solution, while almost everyone who's anyone in Tokyo disagrees. This time it's the turn of Morgan Stanley's Robert Alan Feldman.

Is it too late for Japan? The monetization is now complete along the yield curve. European investors ....worry that Germany might be the next Japan, or that somewhere else might be the next Japan. In particular, criticism has been targeted at the Fed and ECB for not moving aggressively enough in the face of deflation potential. Japan is cited as the example of what not to do, for example, in a paper by the Federal Reserve (“Preventing Deflation: Lessons from Japan’s Experience in the 1990s,” by Ahearne et al., June 2002). Although I agree that Japan has provided some examples of what other countries should not do (just as have European and North American economies at times), the contention that monetary policy was the key failure is, in my view, absurd. Rather, the key omission was an aggressive approach to structural reform in both financial and industrial sectors.

So we get back to the debate on what monetary policy should do. For those who think that ending deflation simply means lowering rates a lot and/or printing a lot of money, Japan’s experience should toll a warning bell. Base money is up by 80% since 1997, while deflation has continued. Even monetarists in Japan now agree that the collapse of money velocity cannot stop without structural reform. Moreover, the Weimar experience suggests that rapid money printing will not end the troubles of the Japanese economy. Even in less dramatic contexts, no one has ever argued that high inflation improves resource allocation -- even if it removes bank debt at the expense of creditors. On the contrary, capital flight is the natural result of such an approach, in the wake of which both confidence and real investment collapse.

I agree with my colleagues that it is necessary for the ECB and the Fed to move aggressively, in order to prevent deflation. Where my approach differs is on the question of whether monetary aggressiveness is sufficient. Easy money was NOT sufficient for Japan to avoid deflation. Structural policies were necessary too. In my view, the real lesson from Japan will be learned only when both Europe and the United States focus on the heavy, political issues of dealing with structural impediments to resource re-allocation in their own economies.
Source: Morgan Stanley Global Economic Forum
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The Durably Deflationary World

Now Morgan Stanley's Eric Chaney argues the point: Europe is risking a very close call with generalised deflation. Top of the 'at risk' list: Germany. Gee, their boss, Stephen Roach, is really getting through to them.

From 1973 to the late-1990s, a popular macro game between industrialised economies was to export inflationist pressures. The strong-dollar policy in the Reagan period and also during the Rubin one, and the strong Deutsche Mark policy in the boom years that accompanied the German unification were textbook examples of this not really zero-sum game. Nowadays, in a durably deflationary world, the game is different. Its name is "exporting deflation" and I am afraid that Europe could be on the wrong side, this time. The analytical case is three-folded. First, the euro is already non-competitive, on a unit labour cost basis. This is particularly flagrant for Germany. Second, three years of sub-par growth have widened and continue to widen considerably the output gap. Third, the euro might rise even higher, if the US economy does not recover convincingly and oil prices stay high.

In other terms, even at 95 cents, the euro was slightly overvalued, from a pure productivity-adjusted costs standpoint. Euroland manufacturers could have lived with that. For a region where restructuring is a compelling necessity, a 10% over-valuation of the currency is not that bad, in our view. But at today's rate, 107, Euroland relative labour costs (ULCs) stand at 123. A 20% to 25% over-evaluation of the currency is clearly excessive for a sector already in recession. Put simply, it is deflationary for Europe. Note that, for Germany alone, things are much worse: on the same estimates, German ULCs are now 38% higher than US ones.

As the decline of the US dollar carries on — the US currency is only half-way on its way down, according to my colleague Stephen Jen — the situation will get even worse if the euro is the only counterpart to bear the burden of the rebalancing of the US economy. Well, it seems that this is the case, since most Asian currencies are practically linked to the USD. Using the weights used by the Fed for its own currency basket, it appears that a 10% effective depreciation of the USD would require a 50% rise of the EUR/USD rate. If only half of this is behind us, there is more pain coming for Europe. In addition, it seems that the well-established correlation between oil prices and the USD exchange rate is now inverted and that, practically, the euro has now taken the status of "petro-currency." Just imagine what would happen if crude oil prices stayed around $40 for some time. As the US and Asia export their own internal deflation risks, Europe seems to be the main recipient of this poisoned calice. Has Europe the means to absorb deflation? The answer is clearly negative, given the still very high rigidities most regional labour markets suffer from.
Source: Morgan Stanley Global Economic Forum
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Rinban Revaluation No Solution For Japan's Deflation

Once more Andy Xie argues the point, and once more I feel he is right: fixing deflation in Japan is not about making things worse in China:

Japan is obsessed with China for the wrong reason, in our view. Its leaders are increasingly looking at China’s economic growth and Japan’s economic decline as a fairness issue, i.e., “the renminbi is too cheap”. Japan’s Ministry of Finance has tried repeatedly to internationalize its concern by presenting the renminbi’s value as an issue at G-7 meetings. The rallying cry is, “China is exporting deflation”. Is blaming China fair or helpful to Japan? We think not. China’s economy is growing just as Japan’s was three decades ago. Growth is rapid because of the low base. Wages are low because Chinese workers have little wealth and, hence, put a low value on leisure. This is quite consistent with what Solow’s growth model tells us. Poor people cannot be blamed for working long hours. Would raising the value of the renminbi against the dollar make a significant difference to Japan? It would make a sustainable difference only if the Japanese investment that is now shifting to China were to stay in Japan. But the cost difference between China and Japan is so huge that no conceivable change in the renminbi’s value could reverse the investment flow. The yen/dollar rate has fluctuated between ¥100 and ¥130 with no visible impact on Japanese investment in China.


Economic theory tells us that, if one economy has an undervalued currency, it will suffer increased inflation. The inflationary process of revaluing a currency causes real interest rates to stay low, which may trigger an investment bubble. This is what happened in East Asia before the 1998 crisis. This is why economists usually advise against fixed exchange rate policies. Advising another country to abandon a currency peg makes sense when that country is suffering from high inflation and rising foreign exchange reserves at the same time. But inflation is the last thing that we are likely to find in China. Its price level has been declining for five years. One factor was China’s adjustment to the devaluations in other Asian economies in 1998 through a decline in domestic prices. Its current deflationary problem mostly originates from its labor market. Its effective labor force is growing rapidly, with the quality of new entrants into the labor market also improving. The economy is not growing fast enough to offset this pressure. As a result, wages are rising only slowly, causing deflationary pressure.On the basis of Japan’s prescription for China – raising the value of the currency – the economy would grow more slowly and labor market conditions would worsen. Why should China commit to such a hara-kiri currency policy? Further, a renminbi appreciation could not stick in real terms, as discussed above. The adjustment in 1998 demonstrates that wages in China can fall and large numbers of workers can be laid off. If the renminbi appreciates, China’s deflation would worsen and restore its competitiveness. The exchange rate does not determine competitiveness for an economy with a flexible labor market.
Source: Andy Xie, Morgan Stanley Global Economic Forum
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Japanese Reality-Check

Whatever the merits or otherwise of recent economics and finance appointments, whether in the US or Japan, a reality check reveals one thing: things ain't gettin better, and fast.

The pernicious deflation that has plagued the Japanese economy showed no signs of alleviating in January while unemployment hit a postwar high, underlining the challenges facing Toshihiko Fukui, the newly-appointed Bank of Japan governor. Japan's jobless rate rose to 5.5 per cent in January while the core consumer price index tumbled 0.8 per cent from a year ago, its fortieth straight month of decline. Economists said deflation was likely to get worse before it got better, a result of the strengthening yen and "anaemic monetary stimulus". The yen recently rose to a six-month high against the dollar at Y117.Chris Walker, economist at Credit Suisse First Boston in Tokyo, said: "For the next few months, the most likely direction for CPI inflation is down, towards the record rate of minus 1 per cent, year-on-year.
Source: Financial Times
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No Let Up in China's Deflation


Arguing that, in the case of deflation in China, its not over till its over, Andy Xie explains that massive surplus labour and capital supplies in China mean that deflation can be expected to continue, with the global PPI being driven from China. I agree with him.

China’s CPI possibly rose in January from a year ago. This would be the first positive year-on-year change since the fall of 2001. Some may interpret this as a sign that deflation is ending in China. This would be a mistake, in our view. China’s CPI is a lagging indicator to export performance. The CPI stayed positive for six quarters in the last export recovery. A rise in the CPI reflects higher commodity prices during a trade upturn. China’s CPI functions as the producer price index for the global economy.China’s economic development is a deflationary process. This is the nature of industrialization of a large economy with surplus labor and capital. The United States also experienced deflationary industrialization, as immigration created a horizontal labor supply curve, and high domestic savings and capital inflow led to ample supply of capital. Rapid productivity growth in a large economy with no constraints on labor and capital supply is passed on to consumers in lower prices.

Raw material cost is the most important and, probably, the only meaningful, parameter for China’s inflation since the mid-1990s. Labor and capital supplies have exceeded demand and their prices do not respond to demand. Raw material cost has become the only independent variable in inflation. It is a race between productivity and raw material cost. When demand rises fast enough, material cost will rise faster than productivity and, thus, trigger an increase in the finished product price. The purchasing price index for raw materials was up 1.3% in December 2002 from a year ago compared with a 4.8% decline in January 2002. The rise in raw material prices in China in December was much less than in the international market. The CRB index was up 26.4% in December 2002 from a year ago. The raw material component of the US Purchasing Price Index was also up 26% during the same period.China’s raw material price has fluctuated by one third as much as the international market price. This may partly be due to the index composition. However, China’s data may have understated the fluctuation. Recent anecdotal evidence points to a quite dramatic rise in raw material prices. Chinese statistics have a tendency to smooth trends. China’s raw material prices tend to lag international prices. This may be a statistics collection issue rather than any substantial disconnect between China’s and the international market.If the past pattern prevails, China’s raw material price index is likely to accelerate to an 8% increase six months from now. This is similar to the peak in 2000. It should be interpreted as statistics catching up with reality. The CPI should be able to stay in positive territory for four quarters.
Source: Morgan Stanley Global Economic Forum
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Taiwans Deflation Continues


While the world continues to pore over the tealeaves and debate the future of the German economy, most commentators continue to treat deflation as a purely Japanese phenomenon. Deflation also exists in other Asain economies, notably China, and........Taiwan. (NB Also, and with reference to yesterdays Joanthan Anderson post, don't miss the China factor here).

Taiwan’s economy grew by 4.2% YoY in real terms in 4Q02, above our and market expectations of around 3.6% but a slowdown from 4.8% in 3Q02. Full-year 2002 growth came to 3.5%, versus our forecast of 3.3%. A closer look at the numbers reveals that Taiwan is becoming ever more dependent on exports as its engine of growth, while a weak currency policy remains crucial in guarding against deflation and the loss in nominal income amid structurally weak domestic demand. Nominal GDP expanded only 2.4% in 2002 to NT$9.73 trillion, implying a negative YoY change in the GDP deflator of 1.1%, which reflected deflationary pressure and the loss in terms of trade. The situation worsened in the last quarter, when the GDP deflator fell 1.9% YoY. In US dollar terms, nominal GDP remained stagnant at US$281.6 billion (+0.1%) in 2002, still 9% below that in 2000. Currency weakness remains crucial for Taiwan to maintain its size in the global economy.

Taiwan is undergoing immense structural change (“Positioning HK and Taiwan Against the China Shock”, January 27, 2003). Its economic development over the medium term is likely to be shaped by further integration with the increasingly open economy of Mainland China. We estimate that cross-strait trade (whether re-exported or transshipped through Hong Kong) totaled US$43.6 billion in 2002, growing at 35.4% (“Understanding Cross-Strait Trade”, February 13, 2003). This represented 18% of Taiwan’s total merchandise trade, compared with 10% in 1994. As the manufacturing operations become even more integrated, we believe that the strong trend in cross-strait shipments will persist. China absorbed 28% of Taiwan’s exports in 2002, replacing the US (20% of total) as the top market. Nevertheless, the surge in intraregional trade masks the structural pressure on Taiwan from a hollowing-out effect. While refined specialization in manufacturing processes amid China’s development boosts exports of upstream IT components and machinery to the China-based Taiwan factories, we should keep in mind that Taiwan remains under threat of its role as a manufacturing producer in the global economy shrinking over the medium term.
Source: Morgan Stanley Global Economic Forum
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One Recession Away


Well the weekend's finally come round again, and with it another Friday post from Stephen Roach. This week it's deflation he's worried about, and in his view the US is just one recession away from deflation. As he argues, many see the recent spike in producer prices as evidence of a receding deflation danger - others (such as yours truly), however, argue that it provides what threatens to be only a temporary respite, and one which at the same time complicates the picture for Greenspan by putting pressure on him to think about raising rates. Far from offering us any hope of an 'all clear', Roach is surely right to argue that the US, absent any other major engine for global growth, is still trapped in the relegation zone, in danger of being sucked down by the backdraft emanating from Japan, and now, as looks increasingly probable, from Germany. We also need to watch and wait to see what will happen in the UK when the housing bubble finally burns itself out. And if the 'geopolicital uncertainty' produced by the threat or reality of an Iraq war should push us all back into recession, then clearly that could be all that is needed to heave us over the edge. So far from stand easy, it seems more like a case of get ready to man the pumps.

And if I seem even more decided in this than Stephen Roach, the reason is to be found in one detail where I take my difference from him. Stephen's deflation case rests on three premises: post bubble excess global supply, globalised supply networks, and forces associated with the business cycle. On the first two of these we would I am sure, and theoretical niceties apart, be in fairly broad agreement - in place of simply excess supply I would probably develop a story based more on a Moore's Law type process of falling prices in several key technology areas, and in place of global supply chains I would spell out more directly China and India, but let's be reasonable, we're on the same wavelength. It's the third point that bothers me. To introduce the business cycle at this stage as an explanatory variable seems to me to duck the question. Again, leaving to one side all the tricky problems about business cycle analysis, the point it seems to me is that it is precisely the form that the present cycle, or stage of the cycle, is taking that needs to be explained. In fairness Stephen has his get-out: it's the oil shock. And this is fair game, since the portrait he paints concerning the dangers for an already weakened global economy of a sutained rise in oil prices are real enough. The point is why is global demand so weak. Why is it that this recovery, coming as it does after one of the most sustained periods of growth in the history of the world economy, and with all its attendant productivity miracles, is so damned weak, why the dickens is this 'soft patch' we've hit proving to be so difficult to shake off.

Well to understand this I think you have to understand the specific weight in the global economy of a limited number of high income countries, call it G6 or G23, the difference isn't especially important. The fact of the matter is that a relatively small proportion of the world's population is responsible for a relatively high part of it's wealth creation and it's wealth consumption (something which in itself is potentially unstable in any even). Now this population is rapidly becoming old, and this is happening at a time of accelerating technological change which is in itself devaluing the net worth of all that accumulated and aging experience. Hence, ever so subtly patterns of consumption are changing. Look at clothing. It's a world phenomenon, people are looking for cheaper, more buy-and-throw-away apparel. Cultural transition or aging process, you tell me. Then look at Japan, and look at the retail industry which seems to be more and more dominated by cheap outlets selling cheap Chinese imports. The future belongs to Wal-Mart. And now tell me again that the subtle downward shift we're seeing in consumption habits, the one that's causing all the fuss about the output gap, tell me it's got nothing to do with the changing age composition of our populations.

The case for deflation rests on three key premises: First is the post-bubble legacy of excess supply -- especially the overhang of redundant IT capacity that was put in place in the United States and Asia in the latter half of the 1990s. While America’s IT correction was fast and furious over the 2001-02 interval, the rest of the world has not been as quick to follow. Europe’s telecom carnage is an obvious exception but non-Japan Asia’s ongoing appetite for new IT capacity -- especially China -- has been an important offset. Against the backdrop of a post-bubble compression of aggregate demand, the world remains awash in excess supply. That’s a classic deflationary condition.

Globalization is a second force behind the deflation story. Courtesy of accelerating growth in world trade, the globalization of supply chains changes the balance between aggregate supply and demand. That is not only the case in tradable goods -- the so-called China factor comes to mind -- but is also evident in the “non-tradable” services sector. With service sector deregulation now a global phenomenon, surging cross-border M&A activity creating huge multi-national service behemoths that span the globe, and the Internet spawning the advent of IT-enabled service exports from countries such as India, service-sector supply curves have gone from being national to global. That magnifies the overhang of aggregate supply -- yet another reason for global pricing to adjust downward.

But the latest twist can be found in the business cycle, the third piece to the deflation puzzle. Recessions are, by definition, deflationary events. Since the world economy entered its last recession in 2001 at a very low inflation rate -- a 1.3% increase in the advanced world GDP deflator in 2000, according to the IMF -- a close brush with outright deflation can hardly be judged a shock. In the parlance of macro, this recession opened up a positive “output gap” as a deficiency in aggregate demand and, in the context of excessive aggregate supply, virtually destroyed any semblance of pricing leverage for most global businesses. Normally, cyclical recoveries promptly close the gap between supply and demand, thereby restoring pricing leverage. That has not been the case in the decidedly subpar recovery that has occurred in the aftermath of the 2001 global recession. By our estimates, a 2.6% increase in world GDP in 2002 -- versus a longer-term trend of 3.6% -- actually led to a further widening of the global output gap and a concomitant increase in deflationary pressures. Against this backdrop, it would now take a fairly vigorous recovery in the global economy -- several years of world GDP increasing in excess of 4% -- to tilt the business cycle away from deflation.

Yet precisely the opposite now seems to be in the cards. Courtesy of a full-blown oil shock, the world is now flirting with yet another recession. Crude oil prices (as measured on a West Texas Intermediate basis) are now around $37 per barrel. Not only does that represent an 87% increase from levels prevailing at the start of 2002 (an average of $19.69 in January 2002), but today’s prices ($36.79 as of the close on 20 February) are nearly identical with the highs hit on 20 September 2000 ($37.20) that played a key role in triggering the recession of 2001. Unfortunately, oil shocks and recessions go hand in hand. That was not just the case in 2001 but also the outcome in the aftermath of the first OPEC shock of late 1973, as well as the result of the spike associated with the Iranian Revolution in 1979. And, of course, the same was the case following the sharp run-up in oil prices leading up to the Gulf War. In other words, show me an oil shock and I’ll show you a recession. It’s hard to believe that the current oil shock will be the one exception.

Another recession at this juncture could well reinforce the cyclical piece of the case for global deflation. Our global forecast is currently “under review” as we assess the twin impacts of looming war and higher oil prices. Our baseline scenario for 2003 world GDP growth currently stands at 2.9%. While I do not want to prejudge the outcome of our deliberations, I would place the ultimate downside somewhere in the 2.0% to 2.5% range. With global recession widely viewed as anything below the 2.5% world GDP growth threshold, there can be no mistaking the potential consequences of this oil shock -- a second worldwide downturn in two years. But the key insofar as the macro-analytics of deflation are concerned is the implications for the global output gap -- the discrepancy between aggregate supply and demand. When judged against the world economy’s 3.6% long-term trend line -- a good proxy for potential growth, or global supply -- a sharp downward revision to our 2003 baseline forecast has critical implications for the global output gap. Taking the midpoint of the 2.0% to 2.5% world GDP growth range noted above as an illustration, that would represent a 1.4-percentage-point shortfall from trend. Such a further widening of the global output gap would come on the heels of a 2.4 percentage point shortfall that opened up over the 2001-02 interval. That would bring the cumulative shortfall from trend to nearly four percentage points since 2000 -- large by any standards of the past.

Therein lies the risk. In my view, it was the widening of the global output gap in 2001-02 for a low-inflation world economy that led to the subsequent lack of pricing leverage and the close brush with deflation. And now -- courtesy of another oil shock -- that global output gap is set for a sharp further widening. As I see it, that can only intensify the lack of pricing leverage, taking the world all the closer to the brink of outright deflation. In other words, the current oil shock should not be interpreted as an inflationary event along the lines of the outcomes of the 1970s. It is, by contrast, very much a deflationary shock. Prior to this oil shock, I would have depicted the world economy as being only one recession away from deflation. To the extent that recession may now be in the offing, the case for deflation actually looks more compelling than ever.
Source: Morgan Stanley Global Economic Forum
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Play It Again Alan


After a second look, and a few hours reflection, it seems to me there is plenty of meat to chew on in the Greenspan speech, and that after the Iraq problem has found its place in history the problems of the budget deficit may return time-and-time again to haunt the American presidency. Particularly worthy of note is his advocacy of an accrual based accounting system - one which would take into account accumulated liabilities (like pensions and Medicare) - and his indication (the first I have seen from a 'responsible' figure) of the importance immigration will play in determining the level of US pensions and growth. I quote: "short of an outsized acceleration of productivity to well beyond the average pace of the past seven years or a major expansion of immigration the aging of the population now in train will end this state of relative budget tranquility in about a decade's time". Well an increase in productivity over and above the average for the last seven years seems a non-starter with an older workforce, and China approaching fast in the rear view mirror, so that leaves immigration. In fact, just to ram the point home he reiterates it: "short of a major increase in immigration, economic growth cannot be safely counted upon to eliminate deficits and the difficult choices that will be required to restore fiscal discipline". Well done Alan, I know you've been criticised in the past on many counts (and probably with good reason), but in my party its never too late for someone who's seen the light to climb on board. Now lets get to work.

If instead, contrary to our expectations, we find that, despite the removal of the Iraq-related uncertainties, constraints to expansion remain, various initiatives for conventional monetary and fiscal stimulus will doubtless move higher on the policy agenda...........


One notable feature of the budget landscape over the past half century has been the limited movement in the ratio of unified budget outlays to nominal GDP. Over the past five years, that ratio has averaged a bit less than 19 percent, about where it was in the 1960s before it moved up during the 1970s and 1980s. But that pattern of relative stability over the longer term has masked a pronounced rise in the share of spending committed to retirement, medical, and other entitlement programs. Conversely, the share of spending that is subject to the annual appropriations process, and thus that comes under regular review by the Congress, has been shrinking. Such so-called discretionary spending has fallen from two-thirds of total outlays in the 1960s to one-third last year, with defense outlays accounting for almost all of the decline........


Estimating the liabilities implicit in social security is relatively straightforward because that program has many of the characteristics of a private defined-benefit retirement program. Projections of Medicare outlays, however, are far more uncertain even though the rise in the beneficiary populations is expected to be similar. The likelihood of continued dramatic innovations in medical technology and procedures combined with largely inelastic demand and a subsidized third-party payment system engenders virtually open-ended potential federal outlays unless constrained by law. Liabilities for Medicare are probably about the same order of magnitude as those for social security, and as is the case for social security, the date is rapidly approaching when those liabilities will be converted into cash outlays.

Accrual-based accounts would lay out more clearly the true costs and benefits of changes to various taxes and outlay programs and facilitate the development of a broad budget strategy. In doing so, these accounts should help shift the national dialogue and consensus toward a more realistic view of the limits of our national resources as we approach the next decade and focus attention on the necessity to make difficult choices from among programs that, on a stand-alone basis, appear very attractive.

Because the baby boomers have not yet started to retire in force and accordingly the ratio of retirees to workers is still relatively low, we are in the midst of a demographic lull. But short of an outsized acceleration of productivity to well beyond the average pace of the past seven years or a major expansion of immigration, the aging of the population now in train will end this state of relative budget tranquility in about a decade's time. It would be wise to address this significant pending adjustment sooner rather than later. As the President's just-released budget put it, "The longer the delay in enacting reforms, the greater the danger, and the more drastic the remedies will have to be."

Faster economic growth, doubtless, would make deficits far easier to contain. But faster economic growth alone is not likely to be the full solution to currently projected long-term deficits. To be sure, underlying productivity has accelerated considerably in recent years. Nevertheless, to assume that productivity can continue to accelerate to rates well above the current underlying pace would be a stretch, even for our very dynamic economy. So, short of a major increase in immigration, economic growth cannot be safely counted upon to eliminate deficits and the difficult choices that will be required to restore fiscal discipline.
Source: Federal Reserve Board
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Japan Back in Reverse Gear


More bad, bad news from Japan.The economy has begun, once again, to contract. You could call it the incredible shrinking economy, were it not for the fact that humour seems to be out of place here, and that these results may give us a pointer to what's in store for the rest of us if I'm even halfway right about the root cause. Apart from the downturn, also worthy of note is the continuing decline in bank lending and the slow rate of growth in monetary supply.

Figures to be released on Friday are likely to show that the Japanese economy contracted in the December quarter, bringing to an end the shortest recovery in Japan's post-war history, a senior economic adviser to the prime minister conceded on Monday. "I am afraid that the economy is already contracting," said Haruo Shimada, professor of economics at Keio University and senior economic adviser to Junichiro Koizumi, prime minister. He said there was no sign of improvement in domestic consumption, with the only increase in demand coming from the external sector. The concession that the economy has stuttered to a halt came as figures showed last year's mini-export boom beginning to slow. Data for bank lending, also released on Monday, showed the 61st straight month of decline as financial institutions continued to shrink their lending base in an effort to shore up capital adequacy and prevent more loans from turning sour. Bank lending for January fell 4.7 per cent.

"Japan is never going to be driven too much by exports because they account for only 10 per cent of the economy," said Peter Tasker, head of Arcus Investment, a Tokyo-based hedge fund. "There's only so much you can do if the other 90 per cent of the economy is going in reverse." The current account surplus for 2002 rose 34 per cent from the previous year to Y14,248bn ($120bn, €112bn, £74bn), about 3 per cent of gross domestic product. Exports for the year rose 6 per cent thanks largely to a 13.7 per cent increase in shipments to Asia, of which almost a third were electronics goods. "Exports to Asia climbed very steeply in the first half of 2002 and have now levelled out," said Chris Walker, economist at Credit Suisse First Boston in Tokyo. Exports to the US rose just 1 per cent during the year.

Signs that the export-led recovery may be petering out came with figures for December, which showed the current account surplus shrinking 1.4 per cent year-on-year. Economists said an improvement in Japan's external performance tended to strengthen the yen, which then choked off further growth. "You had quite a sharp recovery in industrial production driven entirely by the export sector, but momentum peaked in summer and has been easing off since then," said Mr Tasker. He said there had been no collapse in economic activity since growth had never properly got going in the first place. "It's hard to collapse when you're already sprawling on the ground." The Bank of Japan also said on Monday that monetary supply in January grew at 2 per cent year-on-year, its slowest rate of increase since the end of 2000. The central bank's policy board meets on Thursday, but is unlikely to contemplate a radical change of policy before March, when a new governor is due to be appointed.
Source: Financial Times
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