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Friday, March 14, 2003

Unless We Slide into Japan Style Deflation....

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

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

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

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

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

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

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

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

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

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

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

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