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Monday, May 19, 2003

IMF Deflation Revisited

The new IMF publication Deflation: Determinants, Risks and Policy Options is, like many documents of its type, something of a mixed bag. What I think is important is that they're getting the discussion up and running, this should at least be a wake-up call for Brussels and Frankfurt, and the debate can become more 'refined' as we move down the road a little. One BIG complaint is the fact that demographic changes don't seem to get a look in anywhere! Now I may be willing to grant that I'm overstating the case (I'm not convinced that I am, but it's important always to accept the possibility that you may be mistaken), but that it has no part to play in explaining the big picture (in understanding why, for example, Germany is so 'boxed-in' fiscally) this is surely impossible to accept. So why the distinguished absence. Really I am at a loss to understand this. This absence isn't the only major gaffe however, try this one for size. Speaking of economic growth and deflation in the 19th century, it says the following:

Prices declined in large part because of the constraints imposed by the Gold Standard in an environment in which there was a significant excess demand for gold. Increasing demand for money was being driven by technological change and population growth. At the same time, the supply of gold was largely fixed. The constraints imposed by the limited supply of gold manifested in part in the deflationary episodes and relatively weak growth: despite the extraordinary technological revolution, annual U.S. real GDP growth per capita was just above 1½ percent over the entire century; in the U. K. it was just under 1 percent.

Now this argument is really lamentable. By what standard is it possible to talk of overall growth in the 19th century as 'weak'. In comparison with any other known period of human history it was stunning. It is only by looking at the 19th century in comparison with the 20th century that we can look negatively on the 19c, and it only by looking back from the 1990's that we can talk about 20th century growth as 'moderate'. The question is (and it is, as we'll see as our investigations advance, an important one) can this process be sustained. Further, we should try and avoid falling into the trap of assessing all of human history using the yardstick of what just happened, we can gets things seriously out of perspective. Anyway I'll let Brad make the point:

.........the twentieth century is unique. Such rapid growth in standards of living has never been seen before, anywhere, anywhen. The nineteenth century saw perhaps a a tripling or quadrupling real growth und proper account is taken of the impact of new technologies like the railroad and the telegraph, and the expanded range of technological capabilities. And nineteenth century growth was itself fast compared to what had come before: people called it the "industrial revolution" for a reason.

Before the nineteenth century growth was even slower. The standard of living in the Netherlands, probably the richest economy in the world at the end of the eighteenth century, might (or might not) have been some fifty percent higher than it had been three centuries before, at the time of the Renaissance. And before that? Upper classes certainly lived better on the eve of the industrial revolution than they had beforehand, but for the average guy? Was it better to be a slave of the Roman politician Marcus Tullius Cicero or an enserfed peasant under the Han dynasty in the first century B.C., or was it better to be a slave of the American politician Thomas Jefferson or a casual laborer working the Canton docks in the late eighteenth century? As best we can tell, it is very close to being a tossup.
Source: Brad Delong: How Fast is Modern Economic Growth

That having been said the document is, as I've already indicated, interesting. They do, after all, distinguish between deflation in the late 19th century - which if not entirely benign, was at least not lethal - and deflation 1930's style. This contrast is also reflected in the classification of contemporary Chinese (non-disastrous) and Japanese (lethal dose stuff) deflation. From their analysis the economists at the IMF derive four sets of indicators: (i) aggregate prices; (ii) measures of excess capacity, or output gap (iii) asset markets; and (iv) credit market and monetary indicators. In addition, they mention structural characteristics, and the room for maneuver on the policy front as having a role to play in the overall assessment. Clearly I disagree with non of these as pointers to watch, but could it not be that some of them, at least, have demographically related roots: for example the relation between aggregate demand and the supply of savings? And still we are left with no mechanism to explain why all this should be happening now. I think it goes without saying that I do not accept the simple business cycle plus shocks version.

On the German front the document doesn't mince its words:

With broadly stable prices over the past six months, the German economy faces substantial demand driven drag to growth. Credit growth, production, and incomes weakened considerably during 2001 and 2002, and the labor market has been coming under pressure. House prices have been falling; equity markets have adjusted more than in the other advanced economies (Charts 12a and 12b); and corporate balance sheet adjustments still have some way to go. Furthermore, banks and insurance companies are, by their own admission, undergoing the most challenging period since World War II. Thus the near-term outlook for a recovery in investment remains more clouded than in the other advanced economies. The Phillips curve analysis for Germany suggests that for mild deflation to take hold, the output gap would need to rise 1 to 2 percentage points. At the same time, the unemployment gap would have to increase by 2 percentage points. For persistent deflation, the output and employment gaps would have to increase by 2½ to 3½ percentage points. The staff’s central projection sees a widening of the output gap on the order of 1 percentage point this year because real GDP growth would remain around ½ percent. However, the unemployment rate would increase relatively modestly.

Accordingly, the probability of mild deflation taking hold over the next year is considerable. Of course, as prices in Germany decline relative to its trading partners, particularly in the euro area, the improvement in its competitiveness will stimulate exports and investment. This may prevent expectations of falling prices from becoming entrenched. However, this mechanism is likely to operate only slowly, and can do little to remedy difficulties in financial intermediation that could develop rapidly in a deflationary environment. Unlike in other economies, the room for policy maneuver is constrained, if not absent altogether. Fiscal policy is set to become restrictive (cutting the cyclically adjusted deficit by ¾ percent of GDP this year)––in support of Germany’s commitments under the Maastricht Treaty. While monetary conditions have tightened given the euro appreciation, monetary policy may not ease significantly because of greater price pressures in Germany’s euro-area partners.

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