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Sunday, May 25, 2003

Deflation: Assymetric Risk and Hedging Your Bets

Paul Krugman has a piece on deflation in The New York Times. The run-round of the problems deflation provokes, and the difficulties of the liquidity trap are fine, but it goes no further. Why are we sinking into a possible global deflation (come to mention it why am I so sure we are: try a solid theory which is panning out OK up to now), here we are offered no explanation. Sometimes it is suggested that the problem is the 700 word limit. I'm not convinced, we still seem too eager to score points with George W for my taste, and too willing to put all our bets on that 'press this button' inflation targeting formula. What we need is to be more imaginative and to hedge our bets. Getting things wrong could be very costly.

Now for some quibbles: "but the central bank's immobility is one main reason why Germany seems set to follow in Japan's footsteps" I'm sorry, here the problem is not 700 words. The euro has been the reason for the immobility. Not sending Greece; Spain and Portugal into inflation hyperspace. The immobility comes from being caught between a rock (monetary policy) and a hard place (lack of fiscal manouvreability) Demography is the MAIN reason Germany is set to follow Japan. There that only needed a paragraph.

How about a reasoning test. Will the relatively higher inflation of the mediterranean 3 save them from future deflation. Answers in less than 700 words....

Well, I'll save you the trouble. The answer is: NO. Argentina went into deflation you will remember.

Next candidate: Bulgaria. Reasons: Lev-Euro peg, loads of IMF money, Corrupt Politicians, and population exodus. How do I know? Because they're coming here to Spain and explaining it to me.

Incidentally, apart from the technological timidity of the inflation targeters, aren't the helicopter money people also a little unimaginative? We know one of the major structural difficulties is the North-South imbalance. Well why not drop this money over some third world countries (tied to the necessary institutional conditions of course)? If the problem of inflation is global, we need to think globally too. This is the real critique of Bush-ism, abandonment of the global perspective. I don't mind if the US wants to play hegemon, just that they should earn the right. Or is the 'big hammer' approach only for Iraq? Or is all this also 'politically unacceptable'. Painful it might be to swallow, but it might be a damn site better than having no pensions.

The preferred solution. Use the moral-harzard strength of the Iraq victory to enforce a drop in the dollar, put a gun to the heads of the Europeans and the Japanese, and tell them: reform or else. Only one snag, IT WON'T WORK. Oh, never mind............

The Fed still has some tricks up its sleeve. Now would be a very good time to announce an inflation target. But it's also clear that the Fed could use some help, at home and abroad. Alas, it's not getting that help. The Fed's European counterpart, the European Central Bank, has been far less aggressive in cutting rates. There are economic, institutional and psychological reasons for this passivity, but the central bank's immobility is one main reason why Germany seems set to follow in Japan's footsteps. European governments aren't much help, either. Bound by the "stability pact," which limits the size of the deficits they are allowed to run, they have been cutting expenditures and raising taxes even as their economies falter. The Bush administration is, of course, notably unconcerned about deficits. Aren't the tax cuts in the pipeline exactly what the economy needs? Alas, no. Despite their huge size — if you ignore the gimmicks, the latest round will cost at least $800 billion over the next decade — they pump relatively little money into the economy now, when it needs it. Moreover, the tax cuts flow mainly to the very, very affluent — the people least likely to spend their windfall. Meanwhile, state and local governments, which are not allowed to run deficits — we have our own version of the stability pact — are slashing spending and raising taxes. And both the spending cuts and the tax increases will fall mainly on the most vulnerable, people who cannot make up the difference by drawing on existing savings. The result is that the economic downdraft from state cutbacks (only slightly alleviated by the paltry aid contained in the new tax bill) will almost certainly be stronger than any boost from federal tax cuts. In short, those of us who worry about a Japanese-style quagmire find the global picture pretty scary. Policymakers are preoccupied with their usual agendas; outside the Fed, none of them seem to understand what may be at stake. Of course, it's possible, maybe even likely, that their nonchalance will be vindicated. Most analysts don't think we'll find ourselves caught in a liquidity trap. And even the Fed believes — or is that hopes? — that a surge in business investment will save the day. But few analysts saw the Japanese quagmire coming either, and there is now a significant risk that we will find ourselves similarly trapped. Even so, we won't have deflation right away. But by the time we do, it will be very hard to reverse.Like the Fed, I hope that doesn't happen. But hope is not a plan.
Source: New York Times

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