Is the ECB Rate Drop a Good Decision? It Depends Where You live

As I have been flagging in this column for some weeks now, interest rate policy for the Euro zone is a mess. The most obvious way of indicating this is to say the Duisenberg has no good decision strategy available. Not because he is a good, or bad, banker, but because undecideability is structurally in-built into the problem. The decision is rather whose interests do you favour, the low-inflation or the high-inflation countries. Even if this decision could be seen as mildly helpful from a German, or French point of view, from 'down South' in Portugal, Greece and Spain it looks decidedly risky. For Germany it seems to be a question of far too little, far too late, well behind the curve as they say. Of course, one day the inflation down South will stop. It has to, since they now have no independent currency to devalue in order to recover competitiveness, and, of course, unlike the US they do not have a central bank of their own to start the printing presses rolling. So one day the inflation will turn into deflation as their economies cease to be able to oxygenate and they start to suffer an absence-of-liquidity induced asphyxiation. Meantime we are in a kind of time-void between a decision whose chronicle was already foretold two to three weeks ago (thus there is no real market-shock as it is already priced-in), but whose consequences won't be noticed in any significant sense for six to nine months at least. Bottom line: whatever the long hard winter was which lay in front of Germany as of last Wednesday, well, it still does.

On another front, back in the UK, the consequences for Euro membership of the current interest rate divergence are starting to sink in:

After walking side by side for a while, the European Central Bank and the Bank of England have come to a parting of the ways. It may now be a long time before their paths bring them so close to each other again.In recent years, the gap between the main interest rates of the Bank of England and the ECB has been falling steadily. Last year it closed to just three quarters of a percentage point.Thursday's decisions by the two banks, however, suggested that the impression of convergence between Britain and the eurozone has been illusory......

"The ECB's next move is more likely to be down than up, while the Bank of England's next move is more likely to be up than down," said Robert Barrie of Credit Suisse First Boston. "Inflation is below target in the UK, but potentially going above it, while it is above target in the eurozone but probably going below it." Although both investment and exports have been weaker in Britain than in the eurozone, consumer demand is very much stronger. According to the Organisation for Economic Co-operation and Development, consumption is expected to have risen by 3.6 per cent in Britain this year, supported by a boom in house prices and household borrowing, compared with a mere 0.6 per cent in the eurozone.

The first four years of monetary union have shown that convergence inside it is a slow process. The dispersion of core inflation rates in the eurozone is actually greater now than it was at the euro's birth at the beginning of 1999.For some countries such as Spain and Portugal, real interest rates allowing for inflation are negative. Hence this week's complaint from Rodrigo Rato, Spain's finance minister, that "an interest rate cut is not so great from the inflation point of view". But for Germany, where inflation is low, real rates are still positive although the economy is close to a standstill. "Monetary policy is extremely expansionary in Spain, and extremely restrictive in Germany. It is amplifying the differences between unemployment and growth rates across the eurozone," said Patrick Artus of CDC Ixis in Paris. "If you have a single monetary policy with no significant migration or fiscal transfers, you're in trouble." Whatever the benefits of joining the euro for trade and investment, the risks involved in submitting to the eurozone's single interest rate will make the British government think very hard indeed before joining.
Source: Financial Times
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Is Japan Trying?

This question at first sight may strike one as strange, but it appears to be one which is worth asking since US economists have been lining up one after another recently to suggest just that. One way or another, it seems, the Japanese are simply not trying to find a way of getting out of their dreadful economic mess. Of course this assumes we have a diagnosis which is adequate to the problem, that there is a convenient solution to hand, and that the principle problem is one of having the will. It was Stephen Cecchetti who got the ball rolling in this latest bout of 'Japan fretting' with the following in his Financial Times article on deflation:

"What about the zero nominal interest-rate floor, the point at which central banks supposedly become impotent? Listening to officials from the Bank of Japan, you would think that once they set their interest rate target to zero, there was nothing else they could do about stagnant growth and falling prices. Again, I do not believe it."(see my article here)

Then Ben Bernanke added his tuppence-worth:

"The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation?.......Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States."

In fairness Bernanke does not suggest that the Japanese have failed to use monetary easing. But his analysis of what the Fed might do almost all revolves around the use of monetary and exchange rate policy to produce inflationary expectations, thus the claim that all will be well in the US 'since the US has the tools it needs' might be thought to ring somewhat hollow. If the problem in Japan revolves around political constraints, constraints like an unwillingness to bear the weight of the impact of structural reform, then perhaps he might have done better to address the reasons these political constraints will not be operative in the US. Absent this, the assurance that the US will be different seems to imply that there is a mix of monetary and economic policy (short of collapsing their economy completely by closing half of it down) which the Japanese are NOT using. This however seems doubtful.

On the fiscal front what Bernanke terms 'the heavy overhang of government debt' is cited as making ''Japanese policymakers more reluctant to use aggressive fiscal policies". Now this public debt overhang is a product of Japan's ageing population, so are we really to believe that the US might not face similar dilemnas as we get further up this decade? Further, as Paul Krugman has suggested, Japan has not been exactly backward in coming forward with fiscal policy:

"What about the second line of defense, fiscal policy? Japan has tried that, and it has worked -- sort of. Let me explain. .....If you have visited Japan recently you know that it does not look like a country in the midst of a depression. There are strong similarities between Japan in the 1990's and the United States in the 1930's, but there is also a big difference. America descended rapidly into depression. Japan's crisis has unfolded far more gradually........

The other reason that Japan does not look like a country in the midst of a depression is that the government has found a concrete solution to the problem of mass unemployment. By ''concrete,'' I don't mean serious, hardheaded, substantial. I mean concrete, as in roads, dams and bridges. Think of it as the W.P.A. on steroids. Over the past decade Japan has used enormous public works projects as a way to create jobs and pump money into the economy. The statistics are awesome. In 1996 Japan's public works spending, as a share of G.D.P., was more than four times that of the United States. Japan poured as much concrete as we did, though it has a little less than half our population and 4 percent of our land area. One Japanese worker in 10 was employed in the construction industry, far more than in other advanced countries.

Now for the bad news: deficit spending has slowed the Japanese economy's slide, but it has not reversed it. That is, the public works programs provide only temporary, symptomatic economic relief. The favorable effects last only as long as the spending itself. They don't seem to lay the basis for a permanent turnaround.
The Fear Economy

Well, you might think that the case was far from clear. So why don't the Japanese complain at all this unfair coverage of their economic and financial policy. Well, that's just what two of their politicians do in yesterday's Financial Times. Of course their solution is not particularly unconventional: stop China. Since attack is always the best form of defence, they begin with a scarcely value sideswipe at the ECB:

Monetary policymakers around the world are still fighting the old enemy of inflation, not the new foe of deflation. There is an urgent need to switch to global reflation in order to avoid a deflationary spiral. In order to cope with economic stagnation, there has been aggressive fiscal expansion since the early 1990s. Several years after the collapse of the bubble, the Bank of Japan belatedly shifted to easy monetary policy. Then it gradually guided the short-term money market rate below the discount rate, but without much success in stopping price deflation, let alone reviving economic activity.

Last year, with the short-term rate virtually at zero, the BoJ abandoned the use of interest rates and shifted to a quantitative easing policy by targeting the current account balances of commercial banks held at the bank. Despite the injection of liquidity into the markets, the BoJ has not stopped price deflation. Its ability to conduct an effective monetary policy has also been hampered by a dysfunctional financial sector. Commercial banks, saddled with large non-performing loans and inadequate capital positions, have been unable or unwilling to extend loans even though they have abundant liquidity.The Japanese experience demonstrates that traditional monetary policy can lose potency in a deflationary environment. Since the nominal rate cannot fall below zero, a central bank can lower real interest rates and so provide monetary stimulus only by drastically changing price expectations.
Source: Financial Times
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This attempt to shift the blame for deflation towards China has recently drawn fire from Stephen Roach. In a post on December 13 entitled 'Stop Bashing China' he takes time out to make special comment on this argument from Kuroda:

The Japanese have recently taken their China complaint to a different level, using it as a scapegoat for their deflationary conundrum. That was the unmistakable message from Haruhiko Kuroda, the Japanese MOF vice minister for international affairs, in a recent opinion piece in the Financial Times (see "Time for a Switch to Global Reflation," published on 1 December 2002). Kuroda-san pointed the finger at Japan’s Asian neighbors in general – and China, in particular -- as a major source of deflation. Yet inasmuch as Chinese imports account for less that 2% of Japanese GDP, it’s hard to be too aggressive and blame China for sparking Japan’s own self-created deflation.
Source: Morgan Stanley Global Economic Forum
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One Japanese observer who has some experience of watching how monetary policy evolves as interest rates approximate to zero (ZIRP) is Morgan Stanley's Takehiro Sato. In a post in early November in the Morgan Stanley Global Economic Forum he made the following observation in connection with Greenspan's recent 50bp reduction in the Federal Funds Rate.

The Japanese economy can be viewed as the front runner in a global deflation race with no apparent end. The central banks of other industrialized economies will gradually come to understand the BoJ’s struggle, having completely exhausted traditional policy measures. Central banks fought inflation through the mid-1990s, but the battleground has changed to the uncharted territory of deflation. In some respects, it is positive that overseas policy authorities and academics will begin coming to terms with the tough challenges of fighting deflation in a ZIRP environment, which is something that only Japan has experienced until now. The BoJ should benefit from overseas financial authorities giving serious consideration to the implications of a "purposeless" policy of quantitative easing (basically a zero interest rate with a ¥15-20 trillion reserve floor) should the FRB and ECB move into the ZIRP realm. The unfavorable scenario for the BoJ would be foreign central banks having unexpected success with quantitative easing and such easing ironically spurring a recovery for the global economy. In this case, the BoJ is likely to face criticism for being slow on the draw with policy action.

Japan’s experience thus far suggests slim chances for the latter scenario. Once the policy rate drops into the lower 1% range, the game is already over for monetary policy. While monetary policy can be effective in restricting total demand when necessary, it lacks the wherewithal for demand creation. Since the elasticity of real money demand from nominal rate fluctuations rises to an extreme level with a zero interest rate, the short-term money market endlessly absorbs liquidity supplied by the central bank, just like spraying water in a desert. Liquidity never makes it to the real economy. This can also be understood in terms of zero opportunity costs for reserve deposits. There is no pain from holding an infinite amount of reserves ("no pain, no gain"). Additionally, the BoJ has gradually raised its liquidity provision mechanism of Rinban operations (which is equivalent to coupon pass). However, these operations wind up strengthening flattening bias on the yield curve, and actually contribute to deflation expectations through the financial market’s expectation formation dynamic. ZIRP poses the danger of getting caught in a policy trap that cannot be easily escaped.
Source: Morgan Stanley Global Economic Forum
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In an intriguing and much negelected book published in 1989 - The Enigma of Japanese Power - Karel van Wolferen asks some highly pertinent questions about our 'western' attitudes to change in Japan:

Countless newspaper articles, magazine features and scholarly assessments have asserted over the past quarter-century that Japan had reached a crossroads. Perhaps no other country is so regularly examined by journalists and scholars for signs of impending change: not just the routine kind of change that may be expected in any society, but something basic, a change in the way people see themselves and consequently a change in the attitude of the entire nation towards the world.

Implicit in most reports on the Japan-at-the-crossroads theme is the idea that Japan must change; the things setting Japan apart from the rest of the world are often seen as anomalous and temporary. In the 1970's it was thought that many employees who went abroad for their corporations were going to 'internationalise' Japan upon their return. Later it became fashionable to think that the 'internationalisation' of the Japanese financial markets and other unstoppable economic developments would force Japan to come to terms with the outside world's expectations .....In 1987 there existed a pervasive notion that the pressure of supposed public demand for change, combined with loss of bureaucratic control over businessmen, was begining to transform the Japanese political economy into one more clearly driven by market forces.

Today, Japan is stuck at the same crossroads as twenty five years ago.......No country should be condemned to waiting at the same uncomfortable spot for so long. What the crossroads story appears to reflect more than anything else are myopic western preconceptions about the possible forms that institutions and the organisation of affairs in non-Western nations can take. The march in the direction that many Western observers thought inevitable is just not going to take place.

Karel van Wolferen wrote this fourteen years ago. Japan is still at the same crossroads, with the same need for and possibility of reforms being paraded around in a Western press that appears to understand little and learn nothing about how Japan works.

UK Housing Prices Near the Top?

Is the rate of increase in UK housing prices nearing its ceiling? The latest monthly figures (November) which put the annual rate at nearly 25%, in a generally low inflation environment, only serve to underline how bubble-like the house price explosion has become. Clearly these numbers bear little relation to any any real appreciation in the underlying value of the assetts concerned, and stand in marked contrast to the recent growth estimates revisions from the UK Treasury.

House prices climbed 2.0 per cent in November from October's 1.4 per cent monthly rise, Nationwide said. The average house price rose more than £2,000 last month to reach £115,761. The surging housing market is expected to act as a brake on interest rates cuts when the Bank of England's monetary policy committee announces its rate decision on Thursday, despite new evidence showing manufacturing stagnated last month. House prices have underpinned Britain's consumer boom and fears of the unsustainable rate of growth have led to concerns about the threat of another housing market crash.

John Butler, UK economist at HSBC, said the housing market remained buoyant at a time when global uncertainties had increased. "That makes the UK vulnerable, a vulnerability that has been encouraged by the Bank of England. We believe house prices and consumer spending will slow next year, but the threat of a crash has increased. However, crashes typically need a trigger," he said. "That trigger would tend to come from a rise in rates or rapidly rising unemployment. The former still seems increasingly unlikely. And the latter is well supported by the public sector. It is true to say that at the moment there seems no mechanism for it to self correct."
Source: Financial Times
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UK Treasury Having Second Thoughts on Euro?

The UK Treasury's growing reservations about the wisdom of fixing exchange rates have been revealed in a little-noticed supporting document published with this week's pre-Budget report. Treasury officials have said that the paper has been prepared for the New Delhi meeting of the Group of 20 rich and poor countries a week ago, and was written with developing countries in mind. Nevertheless it probably provides a good test of the temperature of the water being written in what might be called "Treasury-speak" (stealing yet another Roachian expression).

Officially the assessment of the five economic tests for the decision on the euro, due by next June, has not begun, you would however have to be blind not to see some of what is going on in Brussels and Frankfurt, and not, in good British style to raise the proverbial eyebrow. The language in the paper, 'Macroeconomic Frameworks in the New Global Economy, is the strongest yet heard from the Treasury about the potential risks of joining a monetary union. It warns, for example, that if a country wants to establish "a rigidly fixed regime, for example through monetary union", then "the conditions which must be met to minimise the risk of destabilising shocks are specific and demanding". Among those conditions are that "the economy must be very open, with a high share of trade with the country to which it is pegged, the economy and financial system must already extensively rely on its partner's currency, and the shocks it faces must be similar".Much of the evidence continues to raise doubts over whether Britain would or could meet those "demanding" conditions.

The paper also offers an interesting review of thinking behind current UK monetary and fiscal policy. Interestingly enough Britain has become, it seems, the land of the middle way. Contrasting the Schylla and Charybdis of complete discretion (read Greenspan and the US Fed) with fixed rules (read Duisenberg and the ECB) Britain's system is, we are informed, one of constrained discretion (this means that while you may be able to get your hand into the till, you can only take so much out at a time). The first real hint that not everyone is happy with the way things are going in Euroland comes with the following reservations expressed about the problem with fixed rule regimes:

the relationships on which such rules are based tend to break down in the face of financial deregulation, changing technology and widening consumer choice;

rigid rules do not allow any flexibility to respond to economic shocks, leading to substantial costs of adjustment and, at the extreme, irresistible pressure on the rule itself. If a fixed rule becomes too costly to maintain, it will tend to undermine credibility, rather than support it. For example, a rigid fiscal policy rule which requires offsetting adjustments irrespective of an economy’s cyclical position could exacerbate the cycle and undermine public support for the policy.

Obviously someone is thinking about the problems with the stability pact. These problems are not, however, insuperable in principle. This weeks proposals from Pedro Solbes - which would in fact give the UK (but not France, Germany, Italy and Spain) considerable leeway with defecit management - can be seen as going some way towards calming British anxiety here. In another little aside they also indicate that they are not as blind as Frankfurt seems to be to the real problems of the moment:

Shifting the policy focus towards sustainable long-term goals requires governments to set realistic and appropriate objectives for macroeconomic policy which are clearly defined, and against which performance can be judged. For example, the UK has introduced a clear, single, symmetric inflation target. The symmetry of the target means it is clear that inflationary and deflationary pressures will be resisted equally, and there is no dual targeting of inflation and the short-term exchange rate.

In treasury-speak this means that the deflation watch is on. On the subject of monetary union and other forms of fixed-peg system the document contains the following:

The exchange rate can provide an alternative nominal anchor for monetary policy. Countries have put in place a variety of different exchange rate regimes, ranging from a rigidly fixed regime (e.g. through monetary union or a currency board), to regimes that peg the exchange rate to a greater or lesser degree. At the other extreme, a freely floating rate requires domestic monetary policy to provide the nominal anchor.

A fixed exchange rate does not allow any scope for ‘constrained discretion’ in response to shocks. Since it sets a rigid rule, shocks have to be absorbed elsewhere in the
economy, if stability is to be maintained.

If a country wants to establish a fixed exchange rate as part of a longer term policy framework, the conditions which must be met to minimise the risk of destabilising shocks are specific and demanding: the economy must be very open, with a high share of trade with the country to which it is pegged, the economy and financial system must already extensively rely on its partner’s currency, and the shocks it faces must be similar. It must also be willing to give up monetary independence for its partner’s monetary credibility; this means that its fiscal policy must be flexible and sustainable, and it must have flexible labour and product markets to cope with shocks when the exchange rate can’t adjust. The real credibility of any peg thus does not come from the peg itself, but from putting in place the wider institutional arrangements that support the regime and which facilitate adjustment. Experience suggests that a peg in itself cannot be relied upon to be the driver for the essential, wider-ranging reforms.

Some have argued that in a world of international capital mobility, it is not credible for countries which are open to capital flows to run intermediate forms of exchange rate regime in the long-term. This is because they do not have the institutional backing provided by more rigid regimes, such as currency boards, so lack sufficient credibility and strength to withstand speculative attacks. Thus only the extreme ends of the spectrum, (of freely floating or very rigid regimes such as monetary union or a currency board) are feasible. But even with a very rigid fixed exchange rate regime, such as a currency board, the same conditions apply, i.e. monetary and fiscal policy have to operate in a way consistent with it. A fixed exchange rate regime cannot be expected to solve a country’s economic problems if the appropriate macroeconomic framework is not in place. Argentina’s recent experience demonstrates the difficulties of sustaining a fixed exchange rate regime, even where a currency board is used.
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Obviously the force of these comments is directed towards the problems of more fragile economies of the newly developing countries type. It should not however escape our notice that the UK economy has a very different form of 'openness' to that of the main Euro economies, an openness to international finance, and rapid capital movements (remember 1992 and the EMU exit). The UK economy may experience shock whichs differ fundamentally from those to which the other Euro economies are susceptible. It should also be noted that while the weaknesses of the fixed rate regime type are identified (and even Argentina is mentioned) the document is strangely silent on the problems of a free-floating regime (which, of course, are enormous for a developing economy, but seem not to be extreme in the context of the UK's current needs).