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Wednesday, September 03, 2003

Escaping From Global Deflation

There is nothing especially fresh in the link you will find below. In fact I'm looking around for material on deflation and I came across this piece from Rogoff back in July. However it does have the virtue that he tries to address the problem of general deflation, recognises that collective devaluation won't work, and suggests a strategy of collaboration between the three principal central banks to implement generalised monetary easing. He also notes the balance sheet consequences for the government of the central bank buying treasury bonds, stating that focussing on the consolidated government balance sheet (rather than taking each part separately) " explains why it is nonsense for the public to worry excessively when the Bank of Japan suffers capital losses on its holdings of long-term government bonds. The Bank's loss is the Ministry of Finance's gain, and both are ultimately owned in full by the Japanese taxpayer".

He does however rather let the cat out of the bag when he deals with the dangers of precipitating major inflation: "inflation might temporarily spike, but as soon as it does, interest rates will shoot up above zero, the BOJ will be out of its liquidity trap, and will once again be able to use standard monetary policy tools". This assumption that the central bank will rapidly adjust rates once the economy emerges from deflation is precisely what makes it difficult to convince market participants of the reliability - working backwards from looking forwards - of central bank 'irresponsibility', and hence what makes it so hard to get out of the liquidity trap right now in Japan.

So how to get out of global deflation in the unlikely scenario that it happens? For Japan—where despite recent developments, the IMF reports warning that deflation could easily still worsen remain valid—many observers believe that only way out of its deflation is through yen depreciation. At some level this must be right. Whatever route the Bank of Japan ultimately takes to conquer deflationary expectations—whether it be buying stocks, JGBs, or foreign exchange—the yen will likely fall sharply. Such action may be seen as manipulating the exchange rate in beggar-thy-neighbor fashion. After five years of deflation, however, the rest of the world—and certainly the IMF—should not complain too much about such a policy.

But if all the major regions were mired in deflation, they cannot all simultaneously depreciate their exchange rates, so this door out is closed. Would this be fatal? No, it should not be. A clear communication strategy that all three major central banks are deeply committed to restoring positive inflation, would go a long ways towards putting a floor under deflation expectations. It is not necessary to adopt any narrowly-construed version of inflation targeting—indeed escaping from deflation is sufficiently tricky it would be very hard to deliver on a target. But central banks can and should specify their long-term (five- to ten-year) inflation objectives. Aggressive quantitative easing worked in the 1930s, when those countries that abandoned the shackles of the gold standard and inflated their economies were largely far more successful than those that clung to gold. If all three major central banks acted in concert, there would not have to be dramatic exchange rate movements, although admittedly the yen might still depreciate since Japan is now in the deepest hole.

I admit that the central banks of the world would have a hard time calibrating their escape from deflation. Quantitative easing does eventually lead to inflation, but the relationship is not nearly as smooth or reliable as economists such as Milton Friedman once believed. Modern central banks rightly prefer to work with interest rates. Of course, as interest rates approach zero, this method begins to fail. Printing piles of currency will surely end deflation: the problem is how to avoid overshooting and ending up locked in high inflation. Should people in Japan worry that an overly aggressive exit from deflation will lead to the kind of horrific inflation levels that Japan suffered after the War? I don't see it, especially given the large output gap. Inflation might temporarily spike, but as soon as it does, interest rates will shoot up above zero, the BOJ will be out of its liquidity trap, and will once again be able to use standard monetary policy tools. Any inflation overshoot should be fairly temporary and relatively manageable. One has to acknowledge there are many risks to this strategy. However, there may be even greater risks to trying to live with deflation indefinitely.

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