The Problem of Excess Dollars and the Current Account Deficit

An interesting argument here from Richard Duncan, about the role of excess dollars in asset booms in Asia, and the subsequent surplus capacity and deflationary tendencies:

During the 30 years since the breakdown of the Bretton Woods International Monetary System, the global economy has been flooded with dollar liquidity. International reserves are one of the best measures of that liquidity. During the quasi-gold standard Bretton Woods era, international reserves expanded only slowly. For example, total international reserves increased by only 55% during the 20 years between 1949 and 1969, the year Bretton Woods began to come under strain. Since 1969, total international reserves have surged by more than 2000%. This explosion of reserve assets has been one of the most significant economic events of the last 50 years.

Today, Asian central banks hold approximately $1.5 trillion in US dollar-denominated reserve assets. Most of the world's international reserves come into existence as a result of the United States current account deficit. That deficit is now $1 million a minute. Last year, it amounted to $503 billion or roughly 2% of global GDP. The combined international reserves of the countries with a current account surplus increase by more or less the same amount as the US current account deficit each year. So central bankers must worry not only about their existing stockpile of dollar reserves, but also about the flow of new US dollar reserves they will continue to accumulate each year so long as their countries continue to achieve a surplus on their overall balance of payments.

With the depreciation of the dollar rapidly gaining momentum, Asian central bankers are scrambling to find alternative, non-dollar denominated investment vehicles in which to hold their countries' reserves. Consequently, this is a topic that is attracting considerable attention in the press.

First, it is clear that countries which built up large stockpiles of international reserves through current account or financial account surpluses have experienced severe economic overheating and hyper-inflation in asset prices that ultimately resulted in economic collapse. Japan and the Asia crisis countries are the most obvious examples of countries that suffered from that process. Those countries were able to avoid complete economic depression only because their governments went deeply into debt to bailout the depositors of their bankrupt banks. Second, flaws in the current international monetary system have also resulted in economic overheating and hyper-inflation in asset prices in the United States as that country's trading partners have reinvested their dollar surpluses (i.e. their reserve assets) in dollar-denominated assets. Their acquisitions of stocks, corporate bonds, and US agency debt have helped fuel the stock market bubble, facilitated the extraordinary misallocation of corporate capital, and helped drive US property prices to unsustainable levels.Third, the credit creation The Dollar Standard made possible has resulted in overinvestment on a grand scale across almost every industry worldwide. Overinvestment has produced excess capacity and deflationary pressures that are undermining corporate profitability around the world.


The affect on the economy is just the same as if the central bank of that country had injected high powered money into the banking system: as those export earnings are deposited into commercial banks, they sparked off an explosion of credit creation. That is because when new deposits enter a banking system they are lent and re-lent multiple times given that commercial banks need only set aside a fraction of the credit they extend as reserves.

Take Thailand as an example. Beginning in 1986, loan growth expanded by 25% to 30% a year for the next 10 years. Had Thailand been a closed economy without a large balance of payments surplus, such rapid loan growth would have been impossible. The banks would have very quickly run out of deposits to lend, and the economy would have slowed down very much sooner.In the event, however, so much foreign capital came into Thailand and was deposited in the Thai banks that the deposits never ran out, and the lending spree went on for more than a decade. By 1990 an asset bubble in property had developed. Every inch of Thailand had gone up in value from 4 to 10 times. Higher property prices provided more collateral backing for yet more loans.

An incredible building boom began. A thousand high rise buildings were added to the skyline. All the building material industries quadrupled their capacity. Corporate profits surged and the stock market shot higher. Every industry had access to cheap credit; and every industry dramatically expanded capacity. The economy rocketed into double digit annual growth.And, so it was in all the countries that rapidly built up large foreign exchange reserves: credit expansion surged, investment and economic growth accelerated at an extraordinary pace, and asset price bubbles began to form. That was the case in Japan in the 1980s and in Thailand and the other Asia cisis cuntries in the 1990s. It is also true of China today. Wherever reserve assets ballooned in a short space of time, economic bubbles formed. Unfortunately, economic bubbles always pop. And when they pop, they leave behind two serious problems.

First, they cause systemic banking crises that require governments to go deeply in debt to bailout the depositors of the failed banks. Economic bubbles always end in excess industrial capacity and/or unsustainably high asset prices. Banks fail because deflating asset prices and falling product prices make it impossible for over-stretched borrowers to repay their loans. The second problem economic bubbles leave behind when they pop is excess industrial capacity caused by the extraordinary expansion of credit during the boom years. The problem with excess capacity is that it causes deflation. Japan is suffering from deflation. Hong Kong and Taiwan have deflation. Even China, where an economic bubble is still inflating, has been experiencing deflation since 1998. The rest of the Asia crisis countries only avoided deflation by drastically devaluing their currencies and exporting deflation abroad. Think of the impact that the over expansion of Korea's semiconductor industry has had on global chip prices.
Source: Finance Asia
LINK

Navigating Unfamiliar Terrain

Useful and timely piece from the FT. Not really an analysis of deflation, but full of timely advice. Of particular note is the suggestion that "he best way to ride out a deflationary meltdown involves liquidating an investment portfolio and burying the cash in the garden".

Forget inflation. A greater risk to the US economy and investors' portfolios, Federal Reserve policymakers declare, is "the probability of an unwelcome substantial fall in inflation". The Fed did not even mention deflation, but investors translated the "Fed speak" with ease. Now some, at least, are pondering how best to position their portfolios for an economy where prices and asset values spiral lower.


That is not an easy task. It is unfamiliar terrain: Americans have not experienced deflation since the Depression of the 1930s, and only a few years ago inflation was the big threat. But 12 interest rate cuts since 2001 have failed to jumpstart the US economy. Factoring out the impact of the war in Iraq on energy costs, consumer prices in March rose only 1.7 per cent from year-earlier levels, putting inflation at a 37-year low. Until recently, John Forelli, a portfolio manager at Independence Investment, calculated there was, at most, a 5 per cent chance the US economy would spiral into deflation. The Fed's decision to put deflation front and centre in its statement on interest rate policy last week has prompted Mr Forelli to raise that to 10 to 15 per cent.

When true deflation takes hold, the value of assets, ranging from stocks and commodities to a new car, deflates along with the economy. The only havens are cash and Treasury bonds, whose value is backed by the US government. "Cash becomes king," says Cliff Gladson, senior vice-president of fixed income investments at USAA, a mutual funds company. Mr Gladson grew up listening to his grandfather's story of buying a house built for $35,000 for only $8,000 in cash in the depths of the 1930s Depression. The best way to ride out a deflationary meltdown involves liquidating an investment portfolio and burying the cash in the garden. But that melodramatic solution is far too drastic even if it were clear that inflation is inevitable. Paul O'Brien, fixed income economist at Morgan Stanley, notes that in Japan it took two years for the economic growth rate to fall to zero from 1.5 per cent - and another four years before deflation took hold. "Deflation is not something that will happen tomorrow," he says.

Investors who believe there is a high probability of deflation should build a portfolio full of Treasury bonds and income-yielding securities - high-grade bonds or stocks - issued by companies that can maintain pricing power in a sluggish economy. "Until you get to where interest rates are zero, Treasuries would reward you richly in that initial deflationary period," says Stephen Peterson, vice-president at Sand Hill Road Advisors. The US economy retains pockets of pricing power and strong demand that stock market investors can tap into. A starting point might be the insurance industry. As most consumers who have received bills for car or health insurance premiums know, these sectors appear to have plenty of pricing power. Regional banks with strong loan portfolios are attractive, since the dollars earned through those loans become more valuable in a deflationary environment.

The allure of cash in deflationary times makes dividends more attractive, especially when they are paid by companies whose products remain in demand. "You'd look at a company like ConAgra, a food-processing company, which yields about 4.5 per cent," says Neil Hokanson, a financial adviser. Pharmaceuticals company Bristol-Myers, and even Altria (formerly Phillip Morris), might be other candidates, he suggests. Investors with a higher risk tolerance could look at companies such as Starbucks, which Mr Hokanson says might defy deflation because consumers will still be willing to pay a few dollars for a latte. As college tuition fees surge, companies specialising in adult education such as Apollo Group might also be a good bet, he notes.

The biggest problem with these strategies is that most of these assets, including Treasury bonds, are already priced at a premium as investors have flocked to havens over the past two years. "It's like buying flood insurance after it's started raining," Mr O'Brien says. "The market is already very pessimistic about growth prospects, so for investors to profit things have to turn out even worse." Treasury prices, for instance, reflect investors' conviction that economic growth will average 1.5 per cent a year over the next five years. Then there is the risk of being in the wrong place if or when the economy comes roaring back to life. Treasury investors could face big losses, and those without exposure to commodities or companies that benefit from a growing economy could forfeit big gains. There are ways for investors to hedge their deflationary bets. They could buy inflation-protected bonds, or TIPs. "If inflation falls, (an ordinary Treasury) will do better than a TIP, but a TIP will still benefit," Mr O'Brien says. "If inflation rises, you'll get the yield plus the increase in the price level."

Putting more money into overseas markets, particularly emerging ones, is another strategy. These economies are at a different stage in their development and in their growth cycle, notes Mr Peterson, who urges his clients to keep as much as a third of their stock allocation overseas. Those fearing deflation can also take smaller steps to protect themselves. Cutting debt is a good idea, Mr Peterson says, since future payments on that debt would be made with increasingly valuable dollars. "But the best approach these days is to hope for the best and plan for the worst," Mr Peterson says. "That way you won't be caught off-guard by either deflation or inflation."
Source: Financial Times
LINK

Japan's Deflation Gathering Speed

David Pilling from Tokyo, on how the rate of deflation in Japan is accelerating. Not good news.And just as I was getting used to talking about the 'slow burn' deflation.The rise in the yen isn't going to help any, either.

Japanese deflation gathered pace in the first quarter with year-on-year prices falling 3.5 per cent - their fastest drop on record. The fall may fuel fears that Japan, which has managed to co-exist with relatively mild deflation since the mid-1990s, could be sliding into a deflationary spiral. Japanese prices - as measured by the gross domestic product deflator, considered a more accurate measure than the consumer price index - have been falling more or less continuously since 1995. Annual price falls have averaged between 1 and 2 per cent for most of that time. Friday's figures showed deflation accelerating in fiscal 2002, a year in which Japan was growing out of recession, to minus 2.2 per cent, a record for a full year.

The figures were released along with GDP data showing that growth in the first quarter fell to almost zero, leading some economists to conclude that the economy was on the brink of yet another recession. Nominal growth fell 0.6 per cent in the March quarter, or minus 2.5 per cent on an annualised basis. Paul Sheard, economist at Lehman Brothers, said: "If you look at the chart it looks horrible. It looks as though deflation is going through the floor." However, the headline figure exaggerated the picture, he said, because the GDP deflator in the first quarter of 2002, when Japan began to pull out of recession, was positive. "It's something of a statistical fluke, though deflation is deflation and it is not a good sign."Shuji Shirota, economist at Dresdner Kleinwort Wasserstein, said "unprecedented deflationary pressure" had been stoked by a big cut in the winter bonuses of government employees, as well as by a fall in the price of PCs and other electrical machinery.

The issue of deflation has split the government, with officials disputing its causes and disagreeing over its effects. Heizo Takenaka, economy and financial services minister, on Friday said falling prices posed a threat. "Deflation remains severe. While pursuing structural reform we must also press on with efforts to end deflation." This week, Eisuke Sakakibara, former vice-finance minister, said Japan could live with mild deflation so long as it prevented the economy tipping into a destructive spiral of falling prices. He said deflation was the structural result of global productivity gains and would likely spread from Japan to the US and Europe. Mr Takenaka drew some comfort from the fact that real growth for fiscal 2002 was 1.6 per cent, above the 0.9 per cent the government had predicted. Much of that was based on exports, which have begun to slow, and on surprisingly robust consumer spending. In the first quarter of this year, consumer spending, which accounts for 60 per cent of GDP, rose 0.3 per cent quarter on quarter. Mr Sheard said real growth of about 1 per cent a year over the past decade was welcome, but he pointed out that the economy was shrinking in nominal terms. Nominal GDP for fiscal 2002 fell to ¥499,000bn, the first time it has dipped below ¥500,000bn in eight years.
Source: Financial Times
LINK

(N)either the Fiscal Side (N)or the Monetary Side Sould Be Effective.

I grew up on Xmas re-runs of a film called 'the longest day', I have a feeling that as this year's solstice approaches this title may ring through my head on more than one occassion. This week has been a worrying one for Brad . It started on Wednesday after a hard day at the chalk-face struggling with thinking about liquidity traps . As he reflects

Paul Krugman has just made me much more pessimistic about the likely success of "unconventional monetary policy" measures to fight deflation and liquidity traps. It's not that I hadn't heard the argument before--this is the third time I've read Paul's stuff on liquidity traps, after all. But when you are teaching something, you focus on it in a way that you almost never do otherwise...
LINK

Then yesterday he started reading the economist and noted:

Economists vary in their beliefs about what needs to be done to fight deflation: large devaluations followed by pegged exchange rates, inflation targeting, or the two-handed approach of large government deficits financed by printing money: either the fiscal side or the monetary side should be effective (even if we are not sure which).
LINK

Things, however are not so simple. Firstly, the problem with large devaluations, as we're seeing with the dollar now, is that one man's meat is another's poison. Solving the US problem by sending Germany to a dark and horrible place is no solution, and this needs to be said clearly. In this sense this weekend's G7 finance meeting is critically important. It's here that the whole Bush strategic vision needs to be reversed, in a global world there is no go-it-alone solution available. But here also is the danger: my fear is that the very shock which Stephen Roach so fears could come from a realisation that money has no safe haven, that a frantic chase from dollar to euro to yen and back again serves no known purpose. In a world swimming in money, this could be very grave indeed. Inflation targeting: this is all about 'expectations', and convincing people you can do it, I mean, I'm not convinced and I fear there may be others. Looking at Japan, what we may well be in is a 'credibility trap'. On the deficit, this is back to Gauti Eggerston, and 'commiting to being irresponsible'. Isn't that just what the Bush set are doing. Is this convincing people? Not if I read Brad's column aright it isn't. Pumping up the deficit as Japan and Europe already know, and the US is discovering, only pushes you closer up against the hard rock of the underlying demographic reality. Bottom line: things are more complicated than 'most economists' tends to assume, and for starters we need to take a view which looks well beyond short run business cycle dynamics.

The Liquidity Trap: A Sticky Problem

Brad has a number of posts this week on the liquidity trap problem (and here and here . Two points occur to me: firstly, is it more than a merely semantic point whether we are 'fast approaching' or "already caught in the orbit" of one; and secondly whether (as Joerg asks me) the name is not a misnomer, wouldn't 'viscosity trap' be a better description? Meantime, John Irons recent post is as good a start for the 'unintitiated' (we still await the 'guide for the perplexed') as any you will find:

The recent FOMC statement by the Federal Reserve (Fed) included the line that "... the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level" (emphasis added.) It occurred to me that this statement might be a little confusing - isn't inflation supposed to be bad? Why would a fall in inflation be "unwelcome"? The answer has to do with what economists call a "liquidity trap." (Note: the full analysis of a liquidity trap is considerably more complicated than below, but this should convey the basic idea.)

The basic argument is that the interest elasticity of money demand increases, and monetary policy becomes less effective, when the nominal interest rate approaches zero. Ok, here's the English version...........
Source: ArgMax
LINK

Currencies and Deflation: The Debate Continues

If things continue like this, my guess is that both the intenational currency markets, and the international equity markets are going to get extremely nervous. Having a rising euro which pushes Germany (and Italy!!) into deflation just doesn't make sense as a long term strategy. Nor is a rising yen going to help an already deflation-bound Japan. The US won the war in Iraq, and now has the 'clout' to impose its will. But what purpose does it serve saving the US scalp by sinking the rest. Contrary to what some say, there is no 'foolproof path' available here. Where does the money go? This is the problem, and this in its way could be the 'shock' that Stephen Roach most fears, the realisation that there may be nowhere to hide, no safe-haven left. After all it can't all go to China. If my memory serves me right, it was in the fear economy that Krugman argued that the biggest problem of all was not the deflation itself, but the shift in expectations towards a horizon of self-perpetuating deflation. One anecdotal detail, visits to my deflation blog have grown by a multiple of ten over the last week, my feeling is that our expectations may be shifting, right now as I am writing this. Whoever 'Mr Yen' is, he's not entirely on the wrong path, deflation is not a monetary phenomenon, it all depends, however, on what you mean by 'structural'.

International tension over exchange rates, accompanied by news of a widening US trade deficit, compounded the uncertainty in currency markets on Tuesday. John Snow, US Treasury secretary, warned that actively managing currencies was no route to prosperity and that Europe and Japan should not blame the falling dollar for their economic troubles. The dollar fluctuated heavily in the wake of his comments, ending New York trading higher despite the release of figures showing the monthly US trade deficit widening sharply in March to its second highest recorded level. In an interview with Reuters conducted last week but released on Tuesday, Mr Snow said: "As I have said on various occasions, devaluation strategies are not well calculated to breed long-run domestic prosperity." Although his comments largely reflected US policy, they came at a time when Japanese and some European policymakers have been signalling rising concern about the fall in the dollar.

Mr Snow's comments came as the US Commerce Department said the monthly deficit in goods and services rose by 7.7 per cent in March, the biggest increase this year, to $43.46bn, well above most economists' expectations. The figures could mean that US economic growth was even slower than reported in the first quarter. Much of the import surge reflected the oil price rise that preceded the war in Iraq and the dollar's fall over the past year. But a sharp increase in oil volume also played a significant role, and the rise in imports was broad-based. Eisuke Sakakibara, the former Japanese vice-finance minister known as "Mr Yen", warned yesterday that attempts at competitive devaluation by any of the three large currency areas could be dangerous. Mr Sakakibara, now a professor at Keio University, said Japan was the forerunner in a global shift from an era of structural inflation to one of structural deflation. "Even if we do not yet have [global] deflation, you have to concede that we have disinflation," he said, attributing falling prices to rapid productivity gains in manufacturing, particularly in China. "Deflation is a structural, not a monetary phenomenon."
Source: Financial Times
LINK

Why Japan's Slump Matters

Despite the fact that John Snow was cheerfully informing us earlier this week that 'deflation is a monetary phenomenon', some inveterate doubters remain unconvinced. Yours truly for one: I think this view is nonesense. Fortunately from time to time more signs of intelligent life appear on the planet's surface. The author of this piece is a Straits Times columnist columnist who goes by the name of Eddie Lee. Now I have no idea who Eddie Lee is, or what he thinks about most matters that affect our civilization. But one thing I do know, he has learnt something from what is currently going off in Japan. And another thing I know is that he must have read something from me somewhere along the line. On the credit-driven expansions, I fear he may have got only part of the full force of the point. There is a double hit. In the first place there are proportionately less people to borrow, but in the second since the growth outlook is reduced (or even negative on the deflation scenario) the future income stream on which they might borrow is also down, so bringing down the whole 'equilibrium' path, and so bringing down expectations in a way which may mean that it's more than just the circle that gets vicious. Here the non-linearities are everything. In any event, from one 'Eddie' to another, thanks mate.

The Japanese government is widely expected to propose an array of measures to bolster the country's stock market soon. Japanese banks' massive stockholdings leave them extremely vulnerable to stock price falls. The price support operation is viewed as a necessary step to prevent a collapse. Yet, hardly anybody is raising an eyebrow. As a regional policy adviser declared recently: 'I don't think the rest of Asia cares much about Japan any more, does it?' It's a sentiment shared by many in Asia.Who can blame this display of apathy? The country has failed to be an engine of growth for so long that nobody's holding his breath. But for anyone thinking about what the future may look like, you can't ignore Japan. The loss of the Japanese engine of growth has had a deeper impact on the rest of Asia than generally appreciated - not just what might have been, but what can be. And it's the future that is the concern, for Japan may be a foretaste of something that might become a more universal problem.

Japan is the first case of a modern economy afflicted by deflation. The typical response to this situation is to say that Japan is unique; the rest of the world 'is not Japan'. How the Japanese state of affairs came to pass is explained by an unusual combination - protected markets, gross inefficiency and a paralytic government that led to a dysfunctional banking system. These factors strangled the production processes and sank the economy. In one of the first books to predict the downfall of the Japanese economy back in 1992, Japan: The Coming Collapse, Brian Reading described the Japanese economic system not as 'capitalist with warts' but 'communist with beauty spots'. It was doomed to fail because the keiretsu model was designed to eliminate competition for the benefit of powerful corporate interests.

The solution? Most analysts call for reforms to deregulate the economy, as this is cited as the main cause of the malaise. But this argument is not entirely convincing. An economy suffering from inefficiency should be punished by a low rate of growth rather than the protracted recession Japan suffered for much of the past decade. And inflation, rather than deflation, should be the symptom. It isn't that the banks are unable to lend either. Mr Mitsuru Machida, managing director of the Mizuho Financial Group, says the problem is a lack of borrowers: 'Deposit levels have fallen, but our loan assets have fallen even more, especially among corporate clients - we have more cash at hand.'

Increasingly, economists believe that the more pressing problem lies with a lack of demand. Private consumption expenditure in Japan has been falling every year since 1997. It is, indeed, an unusual situation. What makes this problem particularly disturbing is you'd think getting spending going again in an economy is not a difficult task. But Japan hasn't been able to do this. A possible reason lies in the fact that Japan has the oldest population on Earth, with a median age of 41.3. The government estimates that in three years, the population size will actually start to decline. Japan could be the chilling example of what happens when an ageing society meets an economic recession: You can't shake off the slump.

Take the typical case of the median Japanese man. He's probably still paying a mortgage on his apartment whose value has fallen by 40 per cent in the past decade. However, as he had to accept pay cuts to keep his job - the average monthly salary for the Japanese employee fell during the past two years - his mortgage burden has increased. He has one child who is about to go to college, but for the past decade, his savings in the bank earned next to nothing in interest. Given this prospect, he has to save heavily to make provisions for the future. Even retirees like Mr Tomiya Isshiki, 67, won't dare splurge. He's relatively prosperous with a house in the Tokyo suburbs. He's paid off his mortgage and receives a monthly pension. But he says, as quoted in the Asian Wall Street Journal: 'We are all worried about the future, so we have to save.' Economist Edward Hugh points out that reviving demand in an ageing society is an uphill task. For while young societies can face credit-driven expansions, old societies obviously cannot. If Japan is providing a foretaste of the future, then Europe could be next in line. In particular, Italy, Switzerland and Germany have populations with a median age of around 40 years. In the past two years, these three countries averaged just 0.5 per cent growth with rapidly falling inflation rates. So far, little attention has been paid to this predicament because few think it's a problem. That may be slowly changing. Mr Naohiro Yashiro, president of the Japan Centre for Economic Research, is a man concerned about his country's ageing population. He notes: 'The ageing society is not only a matter of the future, but a matter of the present.'
Source: The Straits Times
LINK

On the So-Called Sars Paradox

Here's a really good example of a really bad argument. SARS, apparently, is good for you, economically speaking. Why? Because if SARS means that the supply lines to China are cut, then this will be inflationary as supply fails to live up to the needs of demand. You see, every cloud has a silver lining.

Or does it? Let's think about this for a moment. On this argument the Iraq war, and the rise in petrol prices, was a plus. But it wasn't was it. I mean if the problem was to create inflation however, well we could all pick up spanners, go out and unbolt some of those precious petro-ducts, and bingo, the true technical solution......... Now why wouldn't this work. It wouldn't work because productivity isn't a bad thing, it's a good thing. The problem is not too much productivity, but too little growth. The fix we need involves unblocking the the structural imbalances which are a brake on growth - and in my book the main one of these is having a global population which is too old in the developed countries and too young in the developing ones. Cutting off supplies won't help here. In any event this would only be even more deflationary inside China, and hence even more deflationary for the rest of the planet once the supply resumes.

There is a second bad link in this argument, and that is the idea that it is the growth in China itself which is producing the problem. The extraordinary growth which is taking place in China is a product of US overcapacity and lack of pricing leverage, not the cause of it. Here Stephen Roach is undoubtedly right. China is growing because global corporations are franically looking for ways to cut costs in order to maintain momentum. Without China thinks would only be even worse. If you're climibing Everest and feeling scared, it's best not to look down. The only way forward is up............

Call it the SARS paradox: while the killer disease is set to depress prices across Asia, it could have the opposite effect globally and so help allay growing fears of deflation in the United States and Europe. Anecdotal evidence suggests the spread of SARS has so far had little impact on the Asian factories that form the critical links in global supply chains. But as long as the outbreak goes unchecked in China, the point of final assembly for a plethora of manufactured goods, economists see a risk of output disruptions that would push up prices worldwide of everything from toys to televisions. "If you really do have low-cost China no longer being a major supplier, even for a temporary period, that may actually have a positive ripple effect on inflation in the rest of the world," said William Lee, the International Monetary Fund's representative in Hong Kong.Apart from Motorola Inc's closure of its main office in Beijing, the impact of Severe Acute Respiratory Syndrome on multinational corporations has been conspicuous by its absence.

Economists worry, though, that exports will start tailing off if foreign engineers are unable to travel to China to rejig production lines. A failure to prevent SARS spreading to the Chinese countryside is another fear. "Disruption to China-based factories could cripple some Western companies and trigger surging prices for certain products, particularly PCs and related IT equipment," Richard Martin, managing director of International Market Assessment Asia, said in a report. Such an effect, though not the cause, would probably be welcomed in industrial countries worried about following Japan into a deflationary spiral. China's role as price-setter for a growing array of goods in a world glutted with supply is sure to be on the agenda when Chinese President Hu Jintao attends a forum on development issues with the Group of Eight leading nations in France next month. SARS was not detected until mid-March, so it is too early to deliver a verdict on the disease's economic impact on Asia.Beyond decimated sectors such as tourism and restaurants, though, data paint a picture of resilience. Singapore's purchasing managers' index, for instance, edged up in April even though it remained below the no-growth threshold.

Still, economists remain cautious. "The signal we got from the Singapore PMI, though encouraging, is simply not enough to relieve the global anxiety over the potential for the production chain to be disrupted," said David Fernandez of JP Morgan Chase. Whereas a supply-side SARS shock remains only a possibility, the impact on Asian demand and thus on inflation is all too real. Deutsche Bank expects consumer prices in China to rise 0.6 percent in 2003 assuming SARS is contained in three months. But an outbreak lasting nine months would result in deflation of 0.4 percent. Prior to SARS, Citigroup economist Joe Lo expected prices in Hong Kong to fall 1.5 percent this year. His forecast now is two percent. Although the tumbling U.S. dollar should push up prices because of Hong Kong's peg to the U.S. currency, Lo said demand is so weak that retailers cannot pass on higher costs. "The SARS shock will extend and deepen Hong Kong's deflation trend," Lo said.
Source: Forbes
LINK

Beware the Bogeyman Cometh


Nothing especially outstanding about this piece: except that it's being written that is. The Yahoo economists are up to the mark again!! (This is only meant as a scarcely veiled hint to those at the Economist to get their act together, and to those taking the decisions at the ECB to start reading Yahoo News - of course, I forgot, we Europeans tend to laff at Yahoo for their 'failed business model, and 'inability to make money', ha, ha ,ha). But don't miss the Ari Fleischer comment: the WH is 'studying Federal Reserve thinking'. Now you can read into this what you want, but since they're also saying the strong dollar policy is still in place, you have to imagine that they may be playing some of their cards extremely close to their chest (remember my responsible 'irresponsibility' argument, if you watch carefully you'll see the bit where they switch horses under the cowboy).

The fear of falling prices -- the boogeyman that has crippled Japan since the early 1990s -- has come to haunt the U.S. Federal Reserve. After months of worry about sluggish growth and mounting job losses, the uncertainty of war and tepid business spending, the central bankers who steer the nation's monetary policy admitted concern about deflation. The Fed signaled after its policysetting meeting on Tuesday in a brief but unusually complex statement that it stood ready to cut interest rates, if needed, to prevent an "unwelcome substantial fall in inflation." It was the second such warning, but the first to appear in an FOMC statement. Fed Chairman Alan Greenspan last week flagged the problem of slowing price rises when he testified before the House Financial Services Committee.

Few analysts believe the risk of falling prices in America is anywhere near that facing Japan, which has struggled for a decade with the self-reinforcing horror. The Fed on Tuesday said low interest rates, falling oil prices, strong consumer confidence and strengthened debt and equity markets should foster improved growth "over time." However, analysts cheered the Fed's shift in focus to -- and saber rattling against -- falling prices. They said these warnings were not designed to frighten American investors but to reassure them the Fed is on the case and interest rates will stay low, allowing investors the lowest possible borrowing costs for long enough to get the recovery rolling properly. "They're just saying that inflation is too low now, rather than too high," said Goldman Sachs chief economist Bill Dudley. "And that means we want growth, and we want growth to be strong enough to push inflation up and we're not tightening monetary policy for quite a long time."

The White House on Wednesday joined the chorus of concern, saying it, too, would be watching prices. "Administration officials are studying the Federal Reserve thinking on this matter," White House spokesman Ari Fleischer said. "This is one of many areas in the economy that get reviewed on a regular basis." According to the Fed's preferred measure of price rises, inflation rose at an annual rate of just 0.9 percent in the first three months of 2003, a sharp slowdown from the 1.5 percent increase in the fourth quarter of last year. Prices have not increased so anemically since the third quarter of 2001, when the attacks of Sept. 11 brought economic activity to a near standstill. While lower prices may please shoppers, slowing price increases, or disinflation, can quickly turn to deflation -- when falling prices drive manufacturers to bankruptcy.


For the last year, factory owners and retailers have seen the prices they can charge for goods like clothing and cars sink steadily, while the cost of making them continues to rise. With their profits under increasing pressure, businesses have laid off workers and curbed investment in plants and equipment -- the very sort of business spending central bankers have been hoping will boost overall economic growth. "It's a vicious circle," said Sal Guatieri, senior economist at Bank of Montreal/Harris Bank. "People keep deferring their spending, which contributes to further economic weakness and further downward pressure on prices, and price expectations continue to fall. And when you believe that prices will continue to fall, you defer spending."
Source: Yahoo News
LINK

Is There a Way Out?

War, uncertainty, and disease are a tough combination for any economy. But for a stalling and vulnerable global economy, this confluence of shocks hurts even more. The result could well be a weak recovery or the world's second synchronous recession in three years. This could be a critical tipping point for a low-inflation world that is already on the brink of outright deflation. Is there a way out?

Such is the question that Stephen Roach asks us today. The problem is now on the table for all to see. The global economy is not growing fast enough to keep pace with all that increased capacity. This means only one thing: deflation. So what is the remedy. For Stephen this is clear enough, forced by the pressures of a high currency the 'ancien regimes' of the planet will reform. As I keep indicating, this is unlikely (see last post below). Is there a way out: there has to be. Can we see it clearly yet: I'm sorry my answer has to be no. I think we are all going to have to live through a period of more or less complicated re-adjustment. I would say that this is my most important difference of opinion with Krugman and Roach (Brad has really still to pronounce!!). Paul says 'push this button', I say maybe, but if that's all you do you won't fix it. These are uncertain times, and the uncertainty isn't only in the forecasting, we have strategic uncertainty in a more profound sense. Remember we haven't been here before, history and theory can only take us so far. As I keep saying, I personally refuse to speculate much farther forward than 2005, the degree of uncertainty is just too big. Is this a weakness: I don't think so. As someone once said, the first step for getting from here to where we want to be is coming clean on what we don't know. After all if I was claiming to tell you everything that was going to happen, now life would be boring, wouldn't it.

Finally Roach allows his mind to wander over what might happen if the 'cure-all cure' doesn't work. Fissures in the globalisation process. Here he may have more of a point, but I'm not totally convinced, perhaps the degree of global 'connectivity' has already gone one link to far this time. After all, what would happen to the first one out?

A weaker dollar could save the world from deflation. For the United States, a shift in the “currency translation” effect would transform imported deflation into imported inflation. For Japan and Europe, stronger currencies would initially be painful. The appreciation of the yen and the euro would undermine external demand, the only source of sustainable growth in these economies in recent years. That would leave Japan and Europe with no choice other than finally to bite the bullet on reforms in order to stimulate domestic demand. The gain would be worth the pain. It would eventually result in a more balanced mix of global growth -- less domestic consumption from a saving-short US economy and more domestic demand from the saving-surplus economies of Japan and Europe.

There is always a chance such a currency realignment might backfire. If the non-US world chooses to deflect the pain of a weaker dollar, the risk of competitive currency devaluations might intensify. That would take the world down a very slippery slope of trade frictions and protectionism. The recent outbreak of China bashing in Japan is particularly worrisome in that regard. The Chinas and Indias of the world are not a threat. To the contrary, they enable high-cost producers and service-providers in the developed world to realize efficiencies through outsourcing. They also enable rich nations to expand their purchasing power by buying cheaper, high quality goods and services. There will also come a day when the supply-led impetus of countries like China and India hits a critical mass in boosting income generation and domestic demand -- completing the virtuous circle of global rebalancing.

A dysfunctional global economy is at a critical juncture. An intensification of deflationary risks is a real threat if an imbalanced world stays its present course. As globalization continues to expand the supply side of the world economy, a deficiency of aggregate demand becomes the real enemy. If concrete actions are taken to boost the demand side of the global economy, the deflationary time bomb will be defused. The heavy lifting of structural reforms and global rebalancing is the only way out.
Source: Morgan Stanley Global Economic Forum
LINK

Deflation is very Difficult to Reverse

The economists over at Yahoo seem, as usual, to have grasped the significance of the situation. The times they are a changin', in every sense.

Despite a recent slew of sluggish data, the economy should pick up as the Iraq war fallout fades, Federal Reserve chairman Alan Greenspan and his fellow policymakers said. But an emerging menace, deflation, loomed. Over the next few quarters, opportunities and risks for sustainable economic growth were "roughly equal," Federal Reserve chairman Alan Greenspan and his colleagues said in a statement. "In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level," they said. It was the first time the committee had issued such a clear warning about the downward pressure on prices, although they carefully avoided using the word deflation. Deflation, or falling prices, deals a double blow to economies by pressuring people to postpone buying until prices fall further, and by raising real interest rates. It is also very difficult to reverse.

Because of the deflation spectre, the balance of risks overall was "weighted towards weakness over the foreseeable future", the bank said, in a signal it was ready to cut rates if needed. "Evidently the Federal Reserve believes that the economic rebound wont be strong enough to allay deflation concerns," said Wells Fargo Banks chief economist Sung Won Sohn. "The probability of another cut in the interest rate on June 24 has increased significantly." Greenspan was sweating over the threat of deflation after concluding that Japan had waited too long to act before plunging into a four-year deflationary spiral, Sohn said. "The Federal Reserve is determined not to repeat the same mistake," he said. Soaring energy costs in March led to a 3.0 percent rise in consumer prices compared to the same period a year earlier. But when volatile energy and food prices were excluded, core prices rose just 1.7 percent.
Source: Yahoo News
LINK

The Fed's Unprecedented Move

As if to confirm my earlier point about the flagging rate of intelligence down at the Economist, the FT comes in with a hit, which, as is becoming habitual with them, is bang on target. Since both parties tend to cite the opinions of unidentified 'economists' one can only assume that those the FT asks have more idea of what is going on than those consulted by the Economist.

In an unprecedented move, which economists said underlined its concerns about deflation, the Fed split its usual assessment of the overall balance of risks to the economy into separate judgments on growth and inflation. The risks to economic growth - one of the Fed's key objectives - were balanced, the Fed said. But the committee said the risks arising from another fall in inflation meant the overall balance of risks to the economy was on the downside.The statement amplified Fed chairman Alan Greenspan's warning about low inflation last week. Mr Greenspan's favoured measure of inflation, the change in the core price index for personal consumption, recently fell to an annualised rate of just 0.9 per cent and the Fed has been anxious to head off any chance of inflation turning negative. Financial markets read the statement as a clear indication that the Fed was prepared if necessary to lower rates later in the year even if growth picked up. Following yesterday's announcement, the futures market priced in close to a 75 per cent chance of the Fed cutting rates at its next meeting in June, and bond yields also fell.........

On Tuesday, the Fed continued to argue that the US economic recovery should gather pace. "The ebbing of geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt and equity markets," it said. But economists have warned that with the sustainable rate of growth of the US economy now estimated at about 3 to 3.5 per cent, it needs a strong recovery in growth towards its potential to stop inflation falling further.
Source: Financial Times
LINK

What the Fed Actually Said

For those with an eye for detail, and for the simply curious, here is the full text of the FOMC declaration:

The Federal Open Market Committee decided to keep its target for the federal funds rate unchanged at 1-1/4 percent.

Recent readings on production and employment, though mostly reflecting decisions made before the conclusion of hostilities, have proven disappointing. However, the ebbing of geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt and equity markets. These developments, along with the accommodative stance of monetary policy and ongoing growth in productivity, should foster an improving economic climate over time.

Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.

Voting for the FOMC monetary policy action were Alan Greenspan, Chairman; William J. McDonough, Vice Chairman; Ben S. Bernanke; Susan S. Bies; J. Alfred Broaddus, Jr.; Roger W. Ferguson, Jr.; Edward M. Gramlich; Jack Guynn; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; and Robert T. Parry.
Source: Federal Reserve Board
LINK

Am I Feeling Responsible or Irresponsible Today


Back to the problem of 'dynamic inconsistency' ( see post from yesterday below) and the deficit. I have been trying in recent days ( here and here ) to provoke some discussion and controversy based on the argument that you shouldn't always take things at fact value. The pretext for this argument is a paper by Gauti Eggerston ( Committing to Being Irresponsible ). Since this is exactly what the Bush administration seems to be trying to convince everyone that it is doing, I thought the arguments in the paper might bear some examination. This argument has even more interest when you consider that Eggerston did his thesis at Princeton (where Ben Bernanke among others is based), and that non other than Paul Krugman was his supervisor (which is hardly surprising as he was among the first to propose the inflation solution for Japan). The weight of the argument revolves around what to do to avoid to avoid the problem of the lower zero bound (limit) to interest rates. How do you lower interest rates more when you reach zero? The argument is complicated and essentially as it is being presented revolves around 'expectations' of future rates and prices. It seems the best strategy to effectively lower real interest rates is to provoke expectations of inflation. There is a difficulty with this due to the 'dynamic inconsistency problem'. No-one would remain convinced that a discretionary independent central bank would maintain the policy for long enough to provoke the inflation, and so the players will not react to the expectation as intended. That is, we're all unlikely to behave like good girls and boys.

Another solution is to try and tie the banks arm behind its back, by imposing a (possibly legal) commitment to maintaining a given rate of inflation for a given period of time, but then again, it seems, we could all 'front run' that one, and again it wouldn't work. So enter Eggerston. His argument is that what is needed is a temporary abandonment of the independence of the central bank, and collusion between bank and government to provoke a big fiscal deficit via a significant tax cut and thus increasing government borrowing requirements. Since no-one (with the honorable exception of Glenn Hubbard, apparently, and maybe this was why he had to go??) has the least difficulty imagining that this will lead to significant and continuing inflation because the government will have an interest in maintaining it to reduce the capital value of its debt, then presumably we all reach for our guns, or rather, our wallets. But what about the politics? Maynard, for example, is not convinced and asks me :

does one believe that the Bush team has America's interests at heart (as opposed to interests of some small fraction of America) and does one believe that the Bush team is competent in figuring out how to translate America's interests into practice?

These kind of assumptions are not necessary. The politicians will always do what they do for whatever reasons occur to them at the time.The key player here is the central bank, and the members of the US Treasury who may be working in tandem with them. In fact the bluff might be that the central bank appears to lose its independence while actually running things. The President might even go so far as to appear before the senators to warn against the inadvisability of the deficit. I mean this is like one of those interactive movies where you can change the script to fit the characters as you like it best. In the end what the reality is is anybody's guess. And I suppose that's just the point, to keep us guessing. In that way we won't be able to front run it.

In conclusion, for Maynard, I have no idea whose interests Bush has at heart, to understand my 'reading' you don't need to know this, nor do you need to make any evaluations of how competent the administration is at doing anything other than giving a tax cut, running a deficit, and then needing inflation to get out of the mess. Finally if things go well, and there's more growth than anyone else can see in their wildest dreams they can claim the credit. On the other hand, if things don't work out that way, and they run up a big bill together with an inflation bonfire they will be remembered as the administration that died saving America from deflation. Either way they can say: see, we always knew what we were doing. Of course in my book neither of these scenarios will happen, we'll get the deficit and we'll get the deflation (ie the worst of both worlds), but then I'm looking at things in an entirely different way. All I am trying to do here is to give an account of what might otherwise appear to be highly perplexing behaviour, and to suggest that if you really want to have a go at them, you look at the situation from all its various angles - simultaneously.

More on the Irresponsibility of Being Responsible

Maynard has again come to the rescue by giving me some (as is usual with him) intelligent feedback on my preposterous suggestion that maybe a superficial reading of the US deficit situation was missing something. Firstly Maynard's response:

When I first saw your comment in Brad's weblog I was confused, and
thinking about it since then has not cleared things up.

Here's my problem. Assuming you are correct, and that this is all an act, I still don't see you expect this to play out. The federal debt increases, sure, and long term interest rates increase (supply and demand and all that); and then what? Long term interest rates in and of themselves will not cause inflation. So what's next? The fed floods money into the system via OMC actions, reducing the fed discount rate, maybe even changes the reserve requirements. Why do these require an irresponsibly large federal debt to work effectively?

I think I understand the large scale idea. A future deeply indebted federal government clearly benefits from unexpected inflation that reduces its debt load. What I don't understand is (a) how the federal government gets from wanting this inflation to actually making it happen and (b) won't this be a fiscal disaster for the federal government after some brief cheering? Won't investors, screwed out of their funds once, demand an interest rate for future fed offerings that not just covers the inflation rate but also compensates them for their past losses and for future uncertainty? That seems pretty much what happened when we went through this last time in the early 80's. And won't the federal government be forced pretty close to a desperate situation by such an increased interest rate burden.

Now certain things need to be said at the outset. In the first place I am thinking very much about this situation in the light of the Japanese experience, and in particular in the light of what many influential American economists have had to say about how to address the problem of deflation were it ever to reach the shores of the US. The key texts to keep in mind in this regard are probably Ben Bernanke's speech Making Sure 'it' Doesn't Happen Here and a highly influential paper by Lars Svennson A Foolproof Way of Escaping From a Liquidity Trap . Various articles by Paul Krugman on the liquidity trap issue (links to which can be found on my Deflation Page are also relevant). The problem that may be thought to be facing the US is not being stuck in a liquidity trap, but to avoid entering one. Three strategies are recommended: monetary easing, purchasing securities by the Federal Reserve, and purchasing of non dollar denominated assets to devalue the currency. All of this is being proposed with the objective of creating inflation, or to be more exact of creating the expectations of inflation. Various ideas have been floated as to how to manage this process without provoking on the one hand excessive inflation, and on the other without market participants internalising the idea that the central bank is only engaging in a limited operation which will not be sustained. In other words how do you avoid market participants 'front running' the central bank?

Now the major criticism of this line of argument from inside Japan turns precisely on this question: how do you convince everyone that a solid institution is suddenly becoming irresponsible, and is going to remain irresponsible for long enough. If the Japanese don't adopt inflation targeting, it isn't because they don't understand (or haven't thought about) the argument. It's because they're understandably scared that all they might do is create another asset bubble and another crash. How do you know when to stop?

Well non of this seems to pre-occupy unduly our inflation targeters. And what they can't succeed in getting the Japanese to try out, they may well be willing to experiment with in the US. Paul Krugman and Brad Delong are undoubtedy right to point out the problem of above trend productivity growth coupled with below trend growth in demand: the logic is continual price disinflation, followed eventually by price deflation. According to reasonable estimates this could be only a year or so away (Krugman's back of the envelope guess). Also bear in mind that the negative upward oil price shock could be followed at some stage by a downward one in a slack global economy with Iraq needing (for whatever reason!!!) to sell oil quickly. This would be the push that tips everybody over, and then you can have it: zero interest rate bound, and liquidity trap. This is not inevitable but it is one distinct possibility.

I am convinced that Stephen Roach is right, the Fed is taking this possibility very seriously. Now despite central bank independence the US Treasury do talk to each other. Greenspan's opinion is valued (and via Greenspan Bernanke's) and Greg Mankiw is not stupid. In fact I think the first clue that something might have been on the cards was Mankiw's appointment (and the ignominious sacking of yes-man Glenn Hubbard, which must in my book count as one sign of intelligent life in the White House). The second clue has been dollar policy since O'Neill's departure. There is now no real attempt to suggest that the US is maintaining a strong dollar policy. A significant devaluation has already taken place, and it is entirely possible that another is in the pipeline. But the US economy is not sufficiently open for this to have a critical impact (although on another occassion I would want to say something about the fact that it's level of openness is highly significant in other contexts). The pass through rate on prices is small, and in addition many of the Asian economies (which in some ways are the ones that matter) are tied to the dollar and so relative prices are unaffected. Indeed if SARS becomes important in China, this will mean even more internal deflation there, and in other Asian economies. So in the end the dollar 'correction' may have more to do with that other US deficit: the current account one.

So we come back to domestic policy. How do you convince market participants that the US is serious about inflation. One solution, which is proposed in the paper I cited, would be to weaken the level of perceived independence of the central bank, and have it constrained to print money for a serious fiscal deficit. Now what better Mick and Montmerency double act here than Alan Greenspan and George W Bush. After all everyone's completely convinced that the White House is determined to cynically manipulate everyone in sight. (Look, although I hate to do this, I think it has to be said: in some ways Paul Krugman could have fallen into the trap (I'm sure a non-liquidity one) of perpetuating the image of Bush that would make this a feasible strategy. Bush, the crazy president who is going through unashamed self-interest to ruin his country by running huge inflation-provoking deficits. Or maybe Paul Krugman is actually a true patriot, who is putting country before private reputation, and given credence to the Bush 'madman' view to help legitimate the trap-proof fool).

Now for the questions. Why the fiscal deficit, not massive quantitive easing. Because looking at Japan, even though no one is ready yet to admit this publicly, I think we can see that this alone doesn't work. It doesn't work for a variety of reasons, and if you want to know what I think about them all you'll have to follow developments on my Japan Page as I try work through all the issues involved. The principal problem however is that monetary policy is inherently more limited than it has been fashionable to imagine of late. In particular, you can carry out all the quantitative easing you want, but if the bank managers aren't willing to lend, because they don't believe the expansion is coming, you can find yourself stuck. Let's just call this for the time being the "credibility trap".

Now 'won't this be a fiscal disaster for the Fed after some brief cheering'? Obviously this is the risk. But remember the plan 'B' probably is: after steering nicely clear of the deflation iceberg (and this is, of course, the part of the theory I can't really swallow) they get to say, whoops, sorry folks, we made a (deliberate) mistake, looks like the critics were right all the time. The part I'm not spelling out is that all this would, naturally, involve abandoning those cherished 'tax cuts' that only lock in as the decade advances, but this may be considered the lesser evil (or maybe they believe all the late 90's Greenspan optimism that above trend sustained growth is possible, in which case all the numbers change). Look, I never said I agreed with this (although it has a lot more possibility of working in the US than it ever would in Japan or Europe), what I'm trying to do is explain some puzzling behaviour in a way which is different from the 'simplistic' theories. I like simple theories (a la Occam and Einstein), not simplistic ones (which doesn't mean the simplistic theories are never right, but we should always probe reality a little more, just in case they aren't). I don't know that this is actually what is going through peoples heads, just that it is quite consistent with a close inspection of the pertinent theories, and some of the known facts. Is it surprising that they are not explaining this: well obviously no. For this game-play to work it is important that the other players aren't aware of it. What I do think is that before arriving at strong conclusions we should at least consider all the arguments: I am simply presenting one story, a story which might account for what would otherwise appear to be some highly irrational behaviour. Are they up to it? I haven't a clue.

A Commitment to Higher Inflation

I'm not getting much feedback on my Bush the actor pretending to deficit spend irresponsibly argument (hint, hint!). Today there are two US professional economists areguing the case for an open comittment to inflation. Of course they're using a fairly orthodox inflation targeting argument of the kind I don't really swallow (not in its simplistic monetarist for anyway) but still, if you take this argument seriously, wouldn't they be doing what they are doing over at the US Treasury? Or what is it I'm missing?

The Federal Reserve has won its long war against inflation. And, with victory, go the spoils - evident in President George W. Bush's decision to reappoint Alan Greenspan for another term as chairman. But to ensure an enduring legacy, Mr Greenspan now needs to solve a different problem: inflation is too low, rather than too high. How so? The economy needs a buffer of inflation above price stability to ensure that monetary policy has room to work effectively in the event of shocks to aggregate demand. The inflation rate should be high enough to allow the economy to take a shock without falling into deflation.

During its anti-inflation campaign, the Fed opportunistically accepted recessions when they inevitably occurred because they generate disinflationary dividends. Then, in subsequent recoveries, the Fed would pre-emptively increase rates before there was any sign of a rise in inflation.Opportunism and pre-emption made sense when the Fed's goal was to push inflation lower. The mistake of tightening too much or easing too little had the benefit of clipping inflation. Cycle by cycle, the war against inflation was fought, with each recession drawing us closer to victory.

The logic no longer holds, however, now the promised land of price stability has been reached. There would be nothing opportunistic about going lower on inflation. To the contrary, doing so would be a deflationary mistake. Similarly, pre-emptive tightening makes no sense if there is no buffer between the actual inflation rate and price stability, as at present. Without a buffer, the Fed should welcome a modest rise in inflation.Such an outcome would provide the economy with greater room to absorb the inevitable adverse shocks. The deflationary costs would be very high in the present post-bubble world, given the heavy debt burdens of businesses and households. And the Fed has only 1.25 percentage points of interest rate ammunition left, even less if it wants to avoid putting the money market mutual fund industry out of business.

So what should Mr Greenspan and Fed colleagues do? First, they should junk the doctrines of opportunistic disinflation and pre-emptive tightening. Such a declaration would pull down expectations of short-term rates and foster lower longer-term rates.Second, the Fed should commit to keeping its federal funds rate at or below the current 1¼ per cent until core inflation climbs back to, say, 2 per cent or higher on a year-on-year basis. The current reading of about 1½ per cent (on Mr Greenspan's preferred measure, the core PCE deflator) is right in the middle of the 1-2 per cent range that Ben Bernanke, Fed governor, recently suggested as the working definition of price stability.

A commitment to a higher inflation rate would be better than a commitment to eschew tightening for a specific period, as some have suggested.Under the former, if the economy strengthened or if inflation rose, expectations about when the Fed would be released from its commitment would move closer and investors would bring forward their expected date of tightening. Bond yields would rise even before the inflation target was reached, helping to slow the economy and keep inflation from rising. Conversely, if the economy slowed or inflation fell, investors would anticipate a much longer period of low short-term rates. This would pull down bond yields, helping to stimulate the economy. The bond market vigilantes would be enlisted as a posse to help the Fed stimulate or restrain the economy.

In contrast, a time commitment could backfire. If the economy were much stronger than expected and inflation climbed, Fed officials would be stuck with a Hobson's choice - honour the commitment and allow inflation to climb higher than desired or renege on it and lose years of hard-won credibility.A strategy tied to an objective of modestly higher inflation does not require an accurate forecast. The Fed just has to be willing to live with inflation as high as the target. But what about the danger of an economy with a head of steam overshooting the inflation target? After all, given the slow effect of monetary policy, it would take time for the Fed to slow the economy. This is a risk. But we have little doubt that the market would start to raise longer-term interest rates, tightening long before the Fed. Meanwhile, the Fed would restore a buffer of inflation against a deflationary shock.

Such a strategy would require Mr Greenspan to give up some of his cherished flexibility. But flexibility is not always a good thing. It leads to uncertainty, not least over the Fed's vigilance in avoiding deflation. Such uncertainly contributes to higher risk premiums for both corporate equities and bonds. By reducing worries about deflation, the Fed could restore more normal risk premiums, promoting a greater appetite for risk among investors in post-bubble corporate America.Expectations are what drive markets. By shaping expectations - and anchoring inflation expectations in positive territory with a buffer against deflation - the Fed could get the more exuberant economic recovery it desires, with less risk of deflation.
Source: Financial Times
LINK

Ken Rogoff on Inflation Targeting


The Chief Economist at the IMF becomes an inflation targetting evangelist in today's FT. Normally I give an unequivocal welcome to the breath of fresh air Rogoff has brought to IMF economics, but here I can't help feeling he is way off target. He seems to miss the deflation problem entirely and treat the interaction of political and economic objectives as if this was a simple 'technical' question. As everyone knows the US treasury is hell bent on provoking inflation provoking deficits, Bernanke down at the Fed cannot really disagree. What would be 'moderate' inflation? 4%, 5%? So at least noone can complain is that the US authorities are not making their inflation targeting (useful 'double entendre' here) clear. What many less people seem to recognise is that this may be a sophistocated game of poker, where the interaction between the central banker and the politician may be central.In fact 'destructive ambiguity' may be what the game is all about. Or are we to assume that the public at large are a bunch of simpletons?

Even those of us who are not inflation-targeting fanatics are starting to wonder why the G3 central banks (Bank of Japan, the European Central Bank and yes, even the US Federal Reserve) seem so reluctant to speak more openly and concretely about their long-term inflation objectives. What harm would there be in giving broad guidelines for, say, average consumer price inflation over the next five to 10 years? One can think of some concerns but do they really outweigh the potential benefits? Yes, each of these large central banks faces special challenges, but the broad general issues are really the same.


The principal argument in favour of more transparent and specific official long-term inflation objectives is to make it easier for markets to interpret central bank policy. With long-term inflation expectations more firmly anchored, long-term interest rates might jump around a bit less, and businesses and investors might find it easier to draw up long-term contracts.

Admittedly, monetary policy in both the US and the eurozone has vastly improved over the last two decades, and long-term inflation expectations are correspondingly more stable. But could a bit more transparency hurt? Besides, there are other potential benefits to anchoring expectations. For the BoJ, the failure to communicate a clear strategy on inflation over the past five years has helped confound all efforts to escape the country's deflation sand-trap. Surely annual yields on 10-year yen bonds would not be below 1 per cent if people envisaged a clear end to the country's long bout with falling prices. True, there is relatively little danger of seeing broad-based embedded deflation take root in the US or the eurozone, but it is clearly an outside risk. If the Fed, in particular, had in place a framework for anchoring long-term inflation expectations, there might be less need to worry about having to use unorthodox anti-deflation weapons such as purchasing long-term securities.

And then there is the perennial problem of the changing of the guard. This is a much discussed concern in the US, but in some ways no less of an issue for the euro area and Japan. Would not some clarity over long-term inflation objectives help to calm markets?

There is another delicate matter: while much of the world currently enjoys an outstanding group of central bankers, what if some future appointees were less competent and perhaps less committed to controlling inflation? Wouldn't having a long-term inflation guideline help mitigate the problem, at least marginally?

The interesting question is why reject this small non-addictive dose of inflation-targeting? The most compelling argument, perhaps, is the "slippery slope" defence: if one of these central banks were to issue broad guidelines for five- to 10-year average inflation, it would only be a short hop, skip and a jump to far more narrowly construed inflation targeting, say along the lines of the Bank of England. Worse things could happen, although it is important for the largest central banks to retain considerable flexibility and discretion. In today's complex global environment, difficult-to-imagine uncertainties form the exception that proves the rule.

Another concern is the inflation guideline itself. What if a central bank chooses the wrong one? This counter-argument seems pretty feeble. Central banks have implicit guidelines anyway, and if they do seem misguided, then all the more reason to hear the central banks' thinking. What kind of targets make sense: 2, 3, zero per cent? These are technical questions, but suffice it to say that in currency unions that are less well integrated, both in terms of fiscal policy and labour mobility, a higher inflation objective is needed to reduce the odds of localised deflation. And positive and negative deviations from the guidelines ought to be treated symmetrically.

What about the fact that there is a variety of indices of inflation, and none is quite right for everything? True, but as long as the central bank is clear on its aims, markets ought be able to adjust accordingly. In any event, in the universe of macroeconomic concepts, inflation is something we measure relatively precisely, compared, say, to output or unemployment.

What I propose is a small step. I do not regard transparency of long-term inflation objectives as being more important than maintaining central bank independence, or than having conservative central bankers with strong anti-inflation credibility. Indeed, looking over the next 40 years, one has to be concerned about burgeoning fiscal deficits and ballooning old-age transfers in the biggest economies. Monetary institutions must remain strong or the irresistible force of fiscal profligacy will once again overwhelm all inflation resistance. A greater measure of inflation transparency can only help. It is time to end policies of destructive ambiguity.
Source: Financial Times
LINK

On the Comparative Advantage of Being Young

Joerg has written to me raising some interesting points, among them:

"You also have a page with graphs done by Ray Kurzweil which show how fast things get faster, i.e., the degree of acceleration inherent in technological progress. This points to accelerating growth and thus an offsetting effect in terms of overall future growth. In my view, combining an increase in the retirement age with pro-immigration policy and an innovation-friendly incentive structure should do the trick. However, obviously there is no way to ever remove the growth advantage a "younger" society has during the brief period that it stays younger. Why should there? But maybe your thesis is more pessimistic and refers to increasing resistance against technological change in "older" societies?"

The page in question is ( here ).

I think Joerg has understood me, it's not just how fast things get faster, but how much faster they are getting faster. Kurzweil calls it the law of accelerating returns. My gut feeling is that we are talking about an underlying power law type process here: cooking, agricultural revolution, industrial revolution, informationalism....then what? The first point I would make is such change, linked as it is to fundamental uncertainty and absence of visibility (sound familiar??), is by its very nature destabalising, at least for a society which is nicely adapted to a far slower rate of change. Of course I think that economy and society are complex adaptive systems so we will learn eventually, but there is going to be a transition period.

And this transition period occurs when, guess what, our societies are ageing rapidly. Of course whether there is a connection between these two things, or put differently what is ergodic and what is non-ergodic (incidentally I am grateful to Cosma Shalizi for pointing out in his blog that chaotic sytems are generally ergodic, though 'subject to positive destabilising feedback' : ( here )

So this is the first point. We are, in principle, going to have trouble handling all this change, and I think we are already seeing signs of that. Now on the more mundane economic level whether tthis process of technological change produces growth as we conventionally measure is a hard question, as is, as Joerg notes, quatifying what is happening. You mention the comparative advantage of a young society for the 'brief period' it remains younger. May I remind you that in the case of the UK this brief period lasted from the end of the 18th to the end of the 20th century, during which time enormous transformations in relative rankings in the global economy occured. In particular India and China got stuck on the starting block. But now much of this seems to be unwinding, and I think it is worth trying to investigate some of the consequences. Especially since some of the previously young societies haven't yet been convinced of the comparative advantage of younger societies and may be in some sort of denial. Also the brief period may well be much briefer for some newly developing economies, and this tends to suggest a much more roller coaster type ride as we move forward (again I suggest China is going to be a very clear example of this: something like having a Tsunami passing through your front garden).

Getting really mundane, we need some ageing metrics both in age and relative value terms. Theoretically it is possible to have declining labour forces and rising economic values produced. It is also possible to have the contrary case. It depends, and we don't even have tractable models yet. Again it is possible to have rising gross product values and rising per capita incomes, or one without the other. Ditto, it depends and we have no adequate models. One of the key theoretical problems here is what exactly productivity is, and what exactly that nebulous component TFP is. Falling prices are not necessarily bad, this is clear. It all depends on the rate of expansion of the whole economy and the relative elasticities of the different product sectors. You could argue that the rapid productivity advance in the US and the recalcitrant growth rate was an example of bad sector-lead disinflationary pressure, but I am not convinced we have the picture clear enough on this one yet to assert even that.

Committed to Being Irresponsible


Brad Delong has posted the latest information on the US Deficit ( here ) but I'm afraid the smart money says we're all missing something here. Reading the comments there lead me to recommend the following paper by none other than Gauti B. Eggertsson, and appropriately enough entitled "Committing to being Irresponsible"

ABSTRACT

This paper explores the peculiar credibility problem that a zero bound on the short-term nominal interest rate, the liquidity trap, poses to monetary and fiscal policy. We present a rational expectations model in which the zero bound on short-term nominal interest rates is binding due to deflationary shocks. When the zero bound is binding the Central Bank best achieves its objectives by generating inflation expectations to lower the real rate of interest and stimulate aggregate demand. A discretionary Central Bank that is independent from fiscal policy, however, cannot credibly commit to inflation. The result is a liquidity trap that is characterized by excessive deflation and a negative output gap. This deflation bias is the opposite of the inflation bias analyzed by Barro/Gordon (1983) and Kydland/Prescott(1977). Turning to fiscal policy, our model implies that if the Central Bank is independent then Ricardian equivalence holds and deficit spending, i.e. tax cuts and debt accumulation, has no effect. Our proposed solution involves reducing the independence of the Central Bank. If fiscal and monetary policies are coordinated, Ricardian Equivalence fails, and the government can credibly commit to future inflation by deficit spending. As a result it lowers the real rate of return, curbs deflation and increases output. Finally we address what coordination of fiscal and monetary policy might entail in practice. We review the applicability of our model to the current situation in Japan. We then discuss the extent to which the successful policies pursued in Japan during the Great Depression can be rationalized by our model.
LINK

Now remember not everybody working in the White House is completely stupid, there is a real deflation threat, and if they said they were going to create a temporary scare and then announce 'sorry folks only kidding', no-one would believe them, now would they? So if you want to commit to being irresponsible then you have to be credible, and what better actor to convince the world the US government is totally irresponsible than George W. (I never have been able to understand why he didn't get the Oscar for Elmer Gantry).

I have been trying to flag this since Mankiw was appointed. I don't believe the looming inflation story for a minute (my whole ageing population analysis goes out of the window for one. Of course I wouldn't mind being proved wrong since a bit of nice steady inflation would be a lot preferable - there I am a Keynesian at heart - the trouble is I'm not convinced). If I had been Paul Krugman I wouldn't have take a fixed rate mortgage. (Unless, that is, he's also an insider working-up the act. Of course I'm joking but it's a wonder Mickey Kaus and company haven't got round to thinking this one up, probably they're not paranoid enough yet). However once you start along this road you could read Greenspan and Volcker as joining in the act.

Or again, you could read all those internet Iraqui oil/euro conspiracy theories as just Karl Rove inspired spin to keep the Europeans happy with a rising euro while the US Treasury quietly lets the dollar fall.The trouble is, once you start to read economic policy like a game, you just don't know where to stop, now do you?

The government ran up a deficit of $252.6 billion in the first six months of the 2003 budget year, nearly twice the total for the same period a year earlier. The latest figures, released Friday by the Treasury Department, highlighted the government's deteriorating fiscal situation. Record deficits are forecast this year and next. The total deficit so far this fiscal year, from October through March, was higher than the Congressional Budget Office's forecast for a deficit of $248 billion. The shortfall was $131.9 billion in the 2002 first fiscal half. Revenue slipped 6.1% to $825.2 billion from the year-earlier period, reflecting lower tax revenue from the listless economy. Individual income-tax payments dropped 6.8% to $372.1 billion. Corporate tax payments plunged 43% to $44.6 billion, reflecting in part the impact of business tax cuts enacted last year and weaker profits, the CBO said. Federal spending climbed 6.6% to $1.08 trillion from a year earlier. The biggest spending categories were Social Security, at $249.3 billion; programs of the Health and Human Services Department, including Medicare and Medicaid, $246.5 billion; military, $180.9 billion; and interest on the public debt, $160.6 billion. For the entire 2002 budget year, which ended Sept. 30, the government ran up a deficit of $157.8 billion, ending four consecutive years of surpluses...
Source: Associated Press
LINK