HIGH-NOON TAKENAKA

Some interesting behind-the-scenes political analysis fro Time of Asia:

Japan's Prime Minister Junichiro Koizumi is used to making other politicians unhappy. But even he seemed shaken when his longtime supporter Mikio Aoki took the floor of the Diet last Tuesday and added his voice to the growing dissension over the Prime Minister's latest round of banking reform proposals. In a withering attack, he accused Koizumi's new finance chief Heizo Takenaka of being a loose cannon, an unelected and unaccountable radical operating outside the system. And he finished with a direct salvo against the man he used to defend, telling Koizumi, "What is lacking most is leadership in coping with economic issues." When the barrage was over, the Prime Minister smiled wanly and thanked Aoki for his "encouragement."

On Tuesday morning, Liberal Democratic Party (LDP) heavyweights Mitsuo Horiuchi, Taro Aso and Taku Yamasaki vowed to intervene. While Koizumi briefed the emperor at the Imperial Palace that evening, the three leaders and other LDP bosses confronted Takenaka behind closed doors in the Diet building. Takenaka left the meeting looking visibly pale. "This was poor leadership from Koizumi," says Mamoru Yamazaki, chief economist at Barclays Capital Management. "Takenaka was accused by the leading politicians of the Diet, and the Prime Minister wasn't protecting him." That evening, Takenaka said the publication of his plan was postponed till the end of October, though he later insisted that he wouldn't temper his proposals.

Koizumi's opponents are worried about a host of factors, including what they deem a "Takenaka Recession." Under the finance chief's plan, the easy pipeline of money from complacent banks to profitless companies would be cut off, giving these companies no choice but to shut down and throw their workers out on the street. "Companies are going to go under and Japan offers no support for the unemployed," frets Minoru Morita, a prominent political analyst. Already, LDP politicians and Tokyo bankers are circulating a list of 51 companies presumed likely to meet with peril under the plan—including retailer Mitsukoshi, video gamemaker Sega and trading outfit Nissho Iwai, plus a slew of construction, heavy machinery and real estate companies. Goldman Sachs estimates that if all 51 companies on the list were to close, Japan's unemployment rate would jump from 5.4% to 6.1%. And that tally doesn't include thousands of small and medium-sized businesses also likely to go belly-up. Indeed, bleaker estimates suggest that unemployment could spike to 10%. In Japan, that grim prospect is less palatable than trillions of yen in bad debt—not just to politicians but to the majority of Japanese citizens who vote for them.
Source: Time Asia Magazine
LINK

CHANGING DYNAMICS IN MUSIC AND CINEMA

This is a strange item for me to blog, as I don't especially like rap, and I don't claim to know too much about the contemporary music scene of young Americans. Reading the piece I have the impression that Emminem drives on a mixture of populism and raw energy, and what's wrong with that as they say. No, my interest isn't musical, I can't help noticing and thinking about how the heavy migration into the US dince the early eighties is having an impact on the entertainment industry production targeting.

The Bronx River Houses are hallowed ground in the hip-hop world, one of the neighborhoods where young African-Americans and Hispanics helped create a new art form in the 1970's. The housing project in the South Bronx takes its heritage seriously. From there emerged a founder of hip-hop, Afrika Bambaataa, and the loose-knit group of D.J.'s, dancers, graffiti artists and rappers called Zulu Nation.Three decades later, the No. 1 selling rapper in the country is a 30-year-old white man, Eminem, born Marshall Bruce Mathers III. Only three years ago, he was derided as "the Elvis of hip-hop," or a raw version of the 1980's flattopped performer Vanilla Ice (no comparison could be worse on these streets). But these days at "the Bricks," as the Bronx River Houses are called, there is no resentment, there are no complaints about Eminem's racial identity.

"8 Mile," starring Eminem, is released on Nov. 8. The film, loosely based on Eminem's life, is the latest test of the rapper's crossover appeal. The film's title refers to the rough-and-tumble neighborhood that is Detroit's racial and economic divide. While it is well known among music industry executives that hip-hop consumers are more than 75 percent nonblack (Eminem's core audience is suburban white teenagers), Universal Pictures will need to reach into minority audiences to make "8 Mile" a hit.Hip-hop artists are a proven box-office draw. "Barbershop," an urban comedy starring Ice Cube, grossed an estimated $69.5 million by Saturday since its release on Sept. 13. "Brown Sugar," a hip-hop love story starring Taye Diggs, grossed $22.4 million since its release on Oct. 11. Last year, "Exit Wounds," starring DMX, grossed $52 million. The main artists in these movies have been black. But no one expects Eminem's race will keep blacks and Hispanics from going to the box office.
Source: New York Times
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MODIGLIANI ON DEFLATION

Stephen Roach has interviewed Franco Modigliani.

There are always great imponderables in the macro outlook. But today the questions seem to loom larger than ever. At the top of my list are two burning issues -- the prognosis for the American consumer and the risk of a US deflation. Nobel laureate Franco Modigliani has long been noted for his path-breaking work on these very issues. He was in town in couple of weeks ago, and we had the chance to sit down for a most engaging discussion. An edited version of our conversation follows.
Source: Morgan Stanley Global Economic Forum
LINK

Below are my comments on the interview.

"I must confess to being surprised about the resilience of consumption after the stock market bubble popped."

Well I think actually people like Stephen Roach and Paul Krugman have been telling a reasonably plausible version of things here. The so-called wealth effect, however, is much more likely to show itself, in my view, not in the direct impact of the stock market ride down, but on the preparedness-to-accept-indebtedness effect based on the value of the whole asset basket, and here it seems property is paramount.

"I have my doubts. I am suspicious of those studies that find the wealth effect is larger from real estate than equities. Theory tells me it should actually be the opposite. That’s because the house in part, produces a consumer good -- housing services, which we consume. When the value of the house I inhabit goes up, its implied rental value increases. But that does not significantly improve my spending power, because my imputed rent has gone up as much. Any wealth effect on individually-owned property must net out the consumption of the service we derive from living in our homes."

Well, yes and no. In a time of high asset price volatility housing is perceived as the savings harbour of last resort. especially when people are conditioned to expect inflation. In addition the rents argument doesn't seem to me to be of the best, since - following one reading of the life-cycle hypothesis - people tend to trade down as they get older. Again it doesn't fit with the situation here in Spain were many members of the middle class now have two, or even three properties as a form of saving.

In addition I think he is looking at it too theoretically, from the point of view of drawing up the pertinent equations, assigning shadow vales, opportunity costs, etc.

But the individual/consumer isn't looking it in this way at all (remember Kahneman/Tversky just got a Nobel). The consumer/individual is simply looking to find a 'rule of thumb' solution to the savers problem: where to park money in a time of low interest rates (never mind that in part this is money illusion), and equity market collapse. The 'rule of thumb' answer is property. Especially with the built-in inflation expectations that easy money and growing deficits must produce. The 'safe harbour' appears to be property. But I say 'safe' advisedly, because it isn't safe at all.

Of course when I’m talking about the saver’s problem, I’m only talking about roughly 49% of the consuming population, since the bottom 50% do virtually no saving. While you need to strip out the top 1% (following Krugman) since they probably give freak readings and simply distort the picture.

‘Neither a Lender nor a Borrower be’
(Old English Ditty)

All this has finally allowed me to make some sense of that optimal control stuff we economists are forced to learn, since I can now see that in a situation of volatile inflation/deflation switchovers, and financial crashes the optimal saddle-path trajectory for the consumer/worker is to operate a continuous stream of expenditure-stream of earnings adjustment in order to pass smoothly through the middle, nicely avoiding all those savers/debtors problems.

My favourite after-dinner trick of late is to pull-out a nice clean 20 Euro note over coffee, grab a saltcellar, sugar bowl, a saucer, etc, and then ask my wide-eyed audience, if the saltcellar was a flat, the sugar bowl a basket of equities, the saucer some bars of gold, and the 20 Euros the equivalent in cash to the dollar value of each one of the other three (which all have the same) then which would they buy with the dollars I offer to give them to play the game (this thought experiment takes place in Barcelona). The answer - without exception - is the flat. Regardless of whether the person in question needs somewhere to live or not. Wrong I say, take the money, at the moment it's the best investment available for the individual saver given the high risk element attached to all the others and the imminent arrival of deflation when the value of money will rise.

"Sadly, the large cohort of aging baby boomers is not adequately prepared for old age."

You bet, we are also not prepared for the fact that there are not enough young people coming up behind to maintain growth and living standards. The so-called 'demography' effect. More on this another day, but it's smack in line with the deflation hypothesis.

"Are you saying that creditors gain because deflation effectively expands their purchasing power?"

This is true, as Modigliani notes, only if the deflation doesn't get serious. But if we get the collapse of financial institutions then the creditors obviously lose since the debtors can't pay. But of course he's right about the initial positive effect for savers, and that must be why all those old people in Japan don't vote for the 'inflation driven' solution to deflation.

"it probably would be offset by a devaluation of the dollar"

This is really Svennson's 'foolproof path' argument. The problem is how the dollar can come down when there's no-one to go up. Or, on the 'foolproof path' more generally, it simply isn't foolproof if all the 'fools' try to go down at the same time, ie if the deflation is global.

I

"The answer to that question depends on the causes of the supposed deflation, a subject on which you have not dwelt extensively. I can think of two major causes: The most obvious would be a deep cyclical decline, but this version is most unlikely because of the availability of well known stabilization policies, and because in this century, as a result of wage rigidity, no contraction has ever produced deflation in developed countries, since the Great Depression. The other possibility is dogged foreign competition from countries like China. This type of deflation, within limits, would be good for the consumers and would compensate for any resulting downward pressure on nominal wages.

If it’s just a temporary blip down in the price level, it wouldn’t worry me....The answer to that question depends on the causes of the supposed deflation....Historically the floor for increases in wages is defined by productivity. So as long as productivity growth is maintained, nominal wages are unlikely to fall."

Here is the problem, if deflation isn't just a temporary blip, then the theory side of why not needs a lot of building up. I have a strong feeling that it won't be just a blip, but the explanation is going to need time. On a more contingent point, Modigliani doesn't seem to consider the output gap mechanism seriously, clearly once prices drop below zero-increases, if the gap continues then the problem only exacerbates, there is no blip. Secondly, the rigid wages argument (like the low productivity services) argument is a strange one in the context of deflation since many argue that in the 1930's wage-rigidities were not an advantage, but in fact helped to prolong the problems, which could be equally true today for the margin-pressured corporate sector. Alternately, in the epoch of outsourcing and short term contracts, perhaps wages are not as 'sticky' as they were. A big chunk of 'greying' America is about to retire, what's the betting that the wages of their replacements won't turn out to be so sticky.

I think what I'm saying is here is that the good and grand old man is just that, and unfortunately a little out of his times.

DUISENBERG HITS BACK

Without specifically referring to Romano Prodi as 'stupid' the ECB issued a press release last Friday which might as well have done so:

The principle of budgetary discipline enshrined in the Treaty and the Stability and Growth Pact are indispensable for Economic and Monetary Union (EMU)
EMU, with a single monetary policy and 12 governments responsible for budgetary policies, needs a fiscal institutional framework. The framework must be simple and enforceable and ensure that fiscal policies in Member States are sound and sustainable. Such a framework of fiscal policies fosters sustainable growth and employment, is conducive to economic stability and is a necessary complement of a monetary policy geared to price stability.........

The main commitment of Member States under the Stability and Growth Pact is that the fiscal policies should result in medium-term budgetary positions which are "close to balance or in surplus". This, in conjunction with the Maastricht Treaty obligation to avoid excessive deficits and to apply appropriate implementation procedures, secures the sustainability of public finances and provides scope for dealing with the expected fiscal challenges caused by population ageing. Moreover, and contrary to the claims of its critics, the Stability and Growth Pact also provides sufficient flexibility after "close to balance or in surplus" positions have been reached, as automatic stabilisers can then operate fully. Problems have arisen not because the rules are inflexible, but as a result of some countries' unwillingness to honour their commitment to respect the rules. The results of fiscal policy in several countries are very disappointing. In this context it is important to recall that the main reason why countries are in budgetary difficulties at present is because they have not used the situation of higher growth to substantially improve their fiscal position.
Source: ECB Press Release
LINK

In saying "contrary to the claims of its critics, the Stability and Growth Pact also provides sufficient flexibility", the ECB doesn't directly mention Prodi, but they might as well have done so. This means the two leading institutions of the Euro zone have effectively gone to war with each other. As Morgan Stanley's Eric Chaney has it:

The debate on fiscal policy in EMU-land has suddenly jumped several degrees on the Richter scale. A lapidary communiqué from the European Central Bank created a sensation on trading floors and government circles. In short, the ECB entered the fray with a strict interpretation of the Stability and Growth Pact (SGP) that leaves little ambiguity on its intention: the ECB is throwing its full weight toward avoid a watering down of the EMU code of good conduct.

The explanation given in yesterday's communiqué will sound rhetorical and hollow to most readers: "By ensuring sustainable public finances and by providing enough flexibility for the full operation of automatic stabilisers in periods of economic weakness as well as strength, the SGP also has a favourable effect on macroeconomic stability. This facilitates achieving price stability and fosters confidence in the euro area's economic prospects." Reading between the lines, I understand that fiscal stability is crucial for the ECB because its opposite might eventually imply its own extinction. In plain English, fiscal instability -- read spiraling government debt -- might lead to a serious political crisis and, in the end, a break-up of the EMU. Hence, it makes sense that central bankers do their best to secure a strong initial bargaining position.
Source: Morgan Stanley Global Economic Forum
LINK

The situation of having the two leading institutions of the Euro zone at loggerheads is a new development for financial architecture theory to chew on, it is also, for a Spanish resident like me, rather preoccupying.

Paul Krugman has recently raised the question of using backward induction points (which I don't claim to fully understand) as a means of analysing current strategy options for key players. Well, one possible scenario could look like this:

Firstly, think about the impact of this rather chaotic situation on an already Euro-skeptic British public. The balance of pro's and con's of the Euro just took a dramatic hit in favour of the latter. (Many commentators try to be positive by emphasising the teething troubles line, but others may be surprised that so-many problems are arising so-quickly). Then look at the impact of the entry of ten new members into the EU, and the consequent impact on agricultural policy and structural fund distribution. The first idea which comes to mind is that these new members will not be entering the Euro any time soon. The problems of coordinating the existing members are just too big. So we've got a two tier Europe, a customs union and a core currency union block (I suspect that this was always Margaret Thatcher's spanner-in-the-works strategy). Then think about the budgetary impact of the new entrants, Spain, Portugal and Greece will all be net losers, less aid/more contributions and more competition from low-wage, currency flexible customs union states. Add to this the inflationary tendencies of the latter three, and the fact that if they were not in the Euro and the UK was, then interest rates could come down and help Germany with its difficult situation since the average inflation would then be well below the 2% target (nice thought that the UK being able for once to help Germany).

Bottom line: medium term the three above mentioned countries (suffering from a mixed metaphor of 'cost push'/'demand pull') could well as we say in Spanish 'salir disparados' from the Euro group. Oh, what a mess, and why didn't anyone think of this sooner! Of course this is just one scenario. But it is a real possibility, and if the financial community finally get round to projecting forwards and then calculating backwards to factor it in, then the chances of it happening shoot up significantly.