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Sunday, October 27, 2002


Stephen Roach has interviewed Franco Modigliani.

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

Below are my comments on the interview.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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