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Sunday, June 29, 2003

Can Anyone Really Believe the US is Facing an Inflation Bonfire??

Now I don't usually have much truck with the kind of arguments to be found in places like the New Repulic, probably because I take the view that giving this type of ideological argument coverage is to give it more importance than it deserves. However the coincidence of two factors, a readers suggestion (thanks Mark) and the recent exchange with Brad about Milton Friedman, has lead me to make an exception. The linked article has no more importance than to serve as an example of how you might not want to approach the problem of deflation. Needless to say the question of demography, and population ageing, doesn't get a look in, either in the US case, or, more surprisingly (if you were innocent enough to imagine that this was a real attempt to examine the question, rather than an excuse to rerun some worn-out ideas) in the case of Japan. These extracts have been chosen, since I think they illustrate the core of the argument (if you can call it that!!).

The problem is that the measures the Fed uses to fight deflation--lowering short-term interest rates, for example--are the same ones that, sooner or later, lead to inflation. The assumption underlying the recent commentary from Fed officials and the point laid out in the "Preventing Deflation" paper is that deflation is much, much costlier than inflation, which would make this trade-off acceptable.............

And yet, when you look closer at the analogies to Japan and the Depression, as well as the other deflationary episodes throughout history, all of a sudden the risks don't seem so great after all. Depression-style deflationary spirals should indeed be avoided. But the mere fact that average prices are falling does not a deflationary spiral make. In fact, throughout much of history, falling prices have happily co-existed with economic growth. On the other hand, the mirror image of deflation--a period of persistent inflation, which the Fed would be forced to combat with higher interest rates--can be very damaging to the economy itself.................By demonizing the risks of deflation while downplaying those of inflation, our policymakers may be setting us up for just the economic stagnation they so desperately hope to avoid.

..............economics giants such as Ludwig von Mises and John Maynard Keynes understood deflation as a condition brought about by a scarcity of money and credit in the financial system. If, for example, there was too little money relative to the amount people needed to transact their day-to-day business, then people might start rationing and even hoarding it, which would cripple economic activity. True, prices would fall under these circumstances, since fewer dollars makes each one worth more. But those falling prices would only be a symptom of the real problem, which was a collapse in the money supply.

There are two key reasons the prices of certain goods are falling, neither of which has to do with the money supply. First, all the equipment and information technology that companies invested in during the last 20 years--particularly during the late '90s--has dramatically increased productivity, enabling companies to produce the same amount of goods more cheaply than ever before. Second, that investment has led to excess capacity, meaning companies are able to produce more goods than the market can absorb. According to The Wall Street Journal, for example, the global-production capacity for automobiles stands at about 80 million per year, while global demand is about 60 million. Companies that overproduce tend to cut prices to move all their extra goods.

Despite scholarly debate about what precipitated the slowdown, there is widespread agreement that the contraction of the money supply, caused by a series of bank failures (more than 25 percent of the banks in operation in August 1929 either failed or merged with other banks in the ensuing four years) and the Fed's inability to offset the contraction (in one view, Fed officials were relying on incorrect measures of the money supply), deserves much of the blame for its depth and duration.

The main reason Japan has been caught in a deflationary funk for the better part of a decade is that its banking system is an absolute basket case. Banks in a normally functioning financial system would have responded to the popping of Japan's "twin bubbles"--which left them holding scads of worthless land and stocks from businesses with no source of profit--by cutting their losses, foreclosing on the businesses they'd been lending money to, and trying to divert those loans to more productive enterprises. But, because of various bureaucratic imperatives, the banks were rarely allowed to cut off well-connected businesses and force them into bankruptcy.

According to Meltzer, as long as the money supply remains stable, the only thing falling prices do is increase purchasing power...................All of which assumes, of course, that falling prices are, in fact, a horrible alternative. As we've established, they're not--unless the falling prices reflect a contraction of the supply of money and credit.

In fact, not only is deflation not a serious risk today, but its mirror image, inflation--and the rising interest rates that accompany it--is. Thanks primarily to a recent orgy of tax-cutting, the projected ten-year federal deficit now stands somewhere in the neighborhood of $4 trillion. Even more alarming, according to a report ordered by former Treasury Secretary Paul O'Neill but subsequently suppressed by the Bush administration, is that the current value of the gap between all of the government's future liabilities and its future revenue is $44 trillion. Shortfalls like this are highly inflationary since they stimulate demand for goods and services in the short run, which raises prices, and because they often get paid for in the long run by printing money. Likewise, the dollar's recent decline--it has fallen by over 20 percent against the euro and almost 10 percent against the yen in roughly the past year--is also inflationary, since a weaker dollar raises the prices of imports.

"We perceive [deflation] as a low probability, ... but the cost of addressing it is very small indeed," Greenspan told his colleagues, before comparing the Fed's decision to overcompensate against deflation risk to a "fire break," in which firefighters clear land as a buffer for more valuable property. But the Fed is the one starting the fires. And pretty soon that could send America's economy up in smoke.
Source: New Republic

Now I don't think it's stretching the argument at all here to say that this writers view is that deflation is not necessarily a problem unless it is accompanied by a contraction of the supply of money and credit. This, of course, is what is implied by the idea of the 'neutrality of money'. A general decline in nominal prices is not necessarily a problem, on this view, provided all the real relations remain unchanged. Actually to be consistent, we would probably have to imagine that a certain proportional reduction in monetary aggregate targets would be in order, just to leave everything in its place.

In other words, the danger only comes from a sudden and excessive contraction in monetary aggregates. Well this brings us back to where we were at the end of last week (and here ). The key question is not the ability of the monetary authorities to control the quantity of high powered money, but their ability, through the exercise of such control, to control the movement of monetary aggregates and in particular the supply of and demand for credit. The question here is between an exogenous, monetary policy based account of the money supply, and an endogenous one, where the values of monetary aggregates reflect changes in output and the real economy, and where these process are in the main determined by factors like 'business conditions' and the way these are interpreted by the key actors in the process, the financial intermediaries (read bank employees) and their clients, both on the deposit and the lending side. Monetary agregates are based on the day to day activities of a myriad of economic agents and modelling the process requires micro-foundations which are based on the expectations and actions of these agents (and in part, heaven forbid, that implies letting the sociologists go to work on economic processes). In many ways I am staggered by the apparent absence of qualitatative investigation of these issues. Really this is probably the result of a 'constant velocity of money' prejudice on the part of many monetary theorists.

So, returning to the tnr argument, what grounds are we offered for anticipating that such a contraction of credit might not occur. Well, look for yourselves, but I can't find any. Now I have advanced one possible ground for imagining that, even when the Fisher type debt deflation purging of the equity bubble has worked its course, we might observe a contraction in the demand for credit: the changing age structure of the population. You see whether you go for the permanent income hypothesis, or the life cycle one, one thing stands out, people in different age groups have different demands for credit. My hypothesis for the 70's type inflation was that this was a reflection of the fact that these 'credit rich' age groups had a high specific weight in the population. Now these 'heavy' generations are getting nearer to retirement, and the impact of this on the demand for credit is bound to make itself felt.

True some societies, the UK, the US, Spain, are currently experiencing the highest credit to GDP ratios in their history, but this is what makes the imminent intimate impact of deflation all the more problematic. This high indebtedness, if followed say, by a significant deflation in housing values, could leave the already numerically depleted younger generations mired in debt for years to come. (If anyone is interested Paul does make a first attempt at modelling all of this:

Moving outside the formal model, the prospects for a liquidity trap also depend on investment demand. Here demography again comes into play: the prospective decline in the labor force reduces the expected return on investments. And institutional problems, such as the troubles of the banking system, may also lead to some credit rationing that deters investment. And to the extent that firms are financially constrained by the debt run up in the past, they may be unable to invest as much as they otherwise would.

On the whole, while it is quite easy to make the case that Japan really is in a liquidity trap, it is much harder to give a convincing explanation of why. Demography seems to be the leading candidate; other "structural" reasons that are widely cited, while they do amount to an impressive litany of sins, do not necessarily explain why demand should be inadequate, as opposed to simply causing garden-variety microeconomic inefficiency. This lack of a clear link between the structural issues and the proximate problem has some important policy implications, as we will soon see.

What is certain, however, is that Japan's long-run growth, even at full employment, must slow because of demographics. Through the 1980s Japanese employment expanded at x.x percent annually. However, the working-age population has now peaked: it will decline at x.x percent annually over the next xx years (OECD 1997), and - if demographers' projections about fertility are correct - at a remarkable x.x percent for the xx years thereafter. As suggested by the discussion of investment and q in the first half of this paper, such prospective demographic decline should, other things equal, depress expectations of future q and hence also depress current investment. Of course, the looming shortage of working-age Japanese has been visible for a long time...........

Nor is Japan, important as it is, the sole issue. Nobody thought that a liquidity trap could happen in Japan; now that it has, we should wonder whether it could happen elsewhere. Germany and France currently have short-term interest rates of only 3.5 percent, and Europe faces Japan style demographics; could a liquidity trap happen to EMU? We now know that the liquidity trap is not a historical myth: it can and does really happen sometimes, and we had better try to understand it.

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