Oh Where Has All the Traction Gone?

This effectively is the question that Morgan Stanley's Stephen Roach keeps asking himself. By policy traction, he means the ability of the authorities to jump-start the global economy with traditional fiscal and monetary stimulus actions. As he points out, in today's world, with the US (and China....?) the only visible engine of global growth, global traction means US traction. But this is just where the problem starts. The US has economy has received an unprecedented reduction in the Federal funds rate, at the same time as fiscal policy has swung violently from small surplus to sustained deficit. Normally, two years into the problem, you should be seeing daylight at the end of the tunnel, so where is it? Could it be that most analysts are missing something? Roach says its the post-bubble hangover resulting from earlier excess. Yours truly suggests that it's a change in global headwinds resulting from yet-to-be-analysed consequences of structural changes in OECD demography, and the imminent arrival of the two incipient Asian giant 'tigers', China and India. Whatever it is, something is crying out for more explanation than its getting.

Policy traction should not be taken for granted. Under normal conditions, all it takes is a dose of fiscal and/or monetary stimulus and the real economy normally responds -- albeit with a lag. However, the key in understanding the concept of policy traction lies in what constitutes "normal conditions." Insofar as my view is concerned, there is very little that is normal about America’s post-bubble workout or about the lopsided nature of this US-centric global economy. Largely for those reasons, I remain highly suspicious of the consensus presumption that policy traction can be counted on to spur a solid recovery in the US and the broader global economy.

To better understand this conclusion, I think it helps to lay out what can be called a model of policy traction -- identifying the conditions under which policy stimulus leads to an acceleration in the pace of real economic activity. In my view, this model has five key ingredients:

* First is the purging of pre-recession excesses. Typical excesses include an overhang of unutilized business capacity, unnecessary construction activity, and unwanted inventories. Of course, there can also be financial excesses, such as too much debt or too little saving. Until these imbalances are eliminated, policy stimulus is unlikely to bite. If, in fact, these excesses endure, the result would be the functional equivalent of economic "headwinds" that would restrain any recovery or subsequent expansion.

* Second is the development of pent-up demand. This involves the deferral of goods and services during a recession -- for example, the cars that aren’t bought, the homes that aren’t built, and the business investment and hiring that is deferred. Once the recession comes to an end, consumers and businesses typically unleash that pent-up demand, thereby providing a spark to the early stages of the typical cyclical recovery.

* Third is the inventory cycle. Recessions are invariably accompanied by sharp production cutbacks outright liquidation of unwanted inventories. Accordingly, it takes an increase in production to bring any such destocking to an end. To the extent that the end of the inventory run-off coincides with a policy-induced improvement in final demand, traction in the real economy is usually reinforced and often magnified.

* Fourth is the nature of the policy stimulus itself. These days, stabilization policies are normally left in the hands of the monetary authorities. Of course, that doesn’t preclude the possibility of a fiscal stimulus. Nor does it rule the possibility of a foreign-exchange-induced stimulus brought about by currency devaluation.

* Fifth are the lags -- the variable and often long response time between policy actions and their impact on the real economy. In most economies, it takes about 12-18 months for the effects of monetary stimulus to begin to show up in the credit sensitive sectors of consumer durables, residential constriction, and business capital spending. Fiscal lags tend to be shorter, depending on the nature of the stimulus.

In my view, the usefulness of this model is that it enables us to frame the debate on policy traction in a reasonably objective and coherent fashion. On that basis, the first point to make is one of global context: In a US-centric world economy, global policy traction is tantamount to US policy traction. Barring the emergence of a new engine of global growth, the rest of the world is beholden to the US for any spark of cyclical revival. And yet just as America has played a disproportionate role in driving the global economy since the mid-1990s, it is now playing an equally important leadership role in applying policy stimulus. Consequently, a US-centric global economy awaits the outcome of America’s policy-traction debate with bated breath.
Source: Morgan Stanley Global Economic Forum
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Germany in 'Make or Break' Tussle

Or at least that's how Wolfgang Clement the country's economics and employment minister sees it. In an interview with the Financial Times, he said 2003 must be a reform year for Germany. "It will also be decisive in determining the competency and strength of this government. It is a decisive year in all aspects." His declaration came as new data show that the German economy grew by only 0.2 per cent last year, its worst performance since 1993, sparking concern over growth prospects this year for Germany and its Euro zone partners.

"We are certainly going through a difficult phase, no question," Mr Clement said. "No one can accept a situation with 0.2 per cent growth and such high unemployment, myself included." Seasonally adjusted unemployment reached a four-year high last month of 4.2m.Mr Clement's comments came as Josef Ackermann, chairman of Deutsche Bank, last night attacked German reluctance to embrace reforms, insisting the country was "a prisoner of its status quo".

Pitching into the reform debate for the first time, Mr Ackermann said many people did not seem to appreciate "how serious the country's problems really were" and appeared to be trapped by existing social structures.He said Germany had long ceased to be the land of the Wirtschaftswunder, or economic miracle. Now commentators increasingly saw it as another Japan, trapped in a vicious spiral of slow growth and falling prices.Mr Clement said the European Union needed an "American approach" to setting interest rates, arguing that the rates set by the European Central Bank should be lowered to US levels.The ECB's policy of maintaining high interest rates was one explanation for Germany's economic problems, Mr Clement said. "From a German viewpoint, we need an interest rate policy similar to the American approach. That means sharp interest rate cuts."
Source: Financial Times
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So does this mean the pressure on Euro zone rates is now really going to be on. And what if Germany needs to head for the zero-bound, where will this leave the inflation riddled Mediterannean trio - Spain, Greece and Portugal - flying upwards out of the window perhaps (as I often comment the Spanish expression 'saliendo disparados' says it all). No idle question this in a week that sees Gustav Horn, Head of Macro Analysis at Germanys leading economic research institute thinking the unthinkable and asking the 'D' question, Germany on the road to deflation?

The outlook for the German economy is bleak. Given the still moderate pace of global economic activity, the deep crisis of confidence on capital markets and a hesitant monetary policy in the euro area, there is not much leeway for a production expansion all over Europe. In addition to that, recently published intentions of the German coalition government point to a marked reduction in public expenditure accompanied by a significant increase in taxes and social security contributions. Consequently, fiscal policy will be very restrictive next year. Against this backdrop, the German economy will almost stagnate towards the end of next year, again falling behind the rest of the euro area.

A matter of great concern is the development of prices. Already the German inflation rate is one of the lowest in the euro area, and accordingly real interest rates are higher than in the rest of the euro area, hampering a recovery. In such a low growth environment prices will be under heavy pressure. In the course of this process the German development is beginning to resemble the Japanese one at the beginning of the 1990s more and more. The Japanese deflation also started with a crash on stock markets, a lack of confidence and reduced wages in line with the cutting of bonus payments. For some years this just led to low inflation rates until price development turned negative during the mid nineties.

The general advice in such a situation is that monetary policy should reduce interest rates swiftly to prevent the unfolding of a deflationary process right from the beginning. However, in a monetary union such a course is only appropriate if the union in aggregate is negatively affected. At some later stage this will doubtless be the case. But a swift loosening may not be possible as long as inflationary tendencies in other countries are close to the stability target. In that case only fiscal policy could deliver immediate help. But the German government has blocked this road by planning to observe self-imposed deficit targets. Therefore there is a danger that the German policy mix may lead to a prolonged phase of stagnation, and this could easily prove to be the beginning of the dead end road to deflation.
Source: DIW Berlin, Economic Outlook
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US Inflation: On the Slippery Slope Down

US consumer prices barely budged in December ending a year in which costs other than energy rose by the smallest amount since 1964. Thursday's report on the Consumer Price Index merely confirmed what Alan Greenspan and many other economists have now been saying for some time: inflation isn't a problem for the American economy. In fact given the uneven nature of the economic recovery many companies have limited power to raise prices even if they wanted to. Consumer prices rose a mere 0.1 percent in December from the previous month, marking the same rate for a second month, the Labor Department reported. December's showing was a lower reading on inflation than the 0.2 percent rise many economists were forecasting. For 2002 as a whole, consumer prices rose by 2.4 percent, up from the 1.6 percent increase in 2001. Most of that pickup came from rising energy costs, including petrol, which moved higher on tensions in the Middle East and worries about supply disruptions if the United States went to war with Iraq. Excluding energy prices, consumer prices went up by just 1.8 percent in 2002. That was the smallest increase since a 1.3 percent rise in 1964, and down from a 2.8 percent increase in 2001. Here there is news to some all tastes. What some would call 'tame', others (including yours truly see as frankly preoccupying, especially when there's a 15% drop in dollar value to remember. Down deflations slipperly slope we go, and remember to watch the output gap on the way.

The generally tame inflation climate in 2002 offered some shoppers — especially those buying cars, clothes, computers and airline tickets — some good deals because prices fell for those items. But people paying energy, medical and education expenses, including tuition and books, took a hit in the wallet as those prices rose sharply. Energy prices, which can fluctuate wildly from year to year, rose by 10.7 percent in 2002, a turnaround from the 13 percent drop registered in 2001.

In the CPI report, food prices went up by 1.5 percent in 2002, the smallest increase since 1997, and down from a 2.8 percent advance in 2001. New car and truck prices fell by 2 percent last year, the biggest drop since 1971, as companies offered heavy discounting, free-financing deals and other incentives to lure buyers. Clothing prices declined 1.8 percent as retailers discounted merchandise to attract shoppers. Airline fares dropped 2.4 percent last year as companies sought to motivate would-be flyers. Computer prices plunged 22.1 percent in 2002 as the high-tech industry, hard hit by the 2001 recession, tried to get back on its feet. While the prices many goods were well-behaved last year, it was a different story for some prices in the service sector of the economy. Prices for medical care went up 5 percent in 2002, the biggest increase since 1993. Education costs, including tuition and supplies, rose 6.6 percent last year — more than two and half times the rise in overall inflation. "We do have a dichotomy. It's like a tale of two inflations," said Stuart Hoffman, chief economist at PNC Financial Services Group. "For goods, there is zilch inflation. But for services there is some. But the overall message is that inflation is still very tame."
Source: Yahoo News
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Japanese Banks Get Nervous about their Capital Adequacy Ratios

The plan announced Wednesday by Sumitomo Mitsui Financial Group to issue 150 billion yen worth of convertible preferred shares to Goldman Sachs is expected to lead to similar moves by other Japanese banks seeking to raise capital before the fiscal year ends March 31. According to Japanese sources, banking groups including Mizuho Holdings, UFJ Holdings and Resona Holdings are all considering jumping on the capital-raising bandwagon, with their plans to raise capital expected to be announced as early as the end of this month. The Goldman Sachs deal, widely interpreted in European and American news media as an indication of renewed confidence in the Japanese banking sector seems to have more to do with paying an increased risk premium to secure a cash injection and avoid government control. With banks, and many of their non-performing loans being back by goverment guarantees Goldman Sachs in fact seem to be risking little.

As SMFG President Yoshifumi Nishikawa explained during Wednesday's press conference, the current harsh domestic business environment prompted the group to "rely not on (our) clients, but to improve our capital base independently," with help from a major U.S. investment bank. The sluggish domestic stock market was a major factor in SMFG's decision not to issue shares to Mitsui and Sumitomo group companies as well as to other clients, the sources said.


SMFG will pay Goldman Sachs an annual 4.5 percent cash dividend on its preferred shares, more than triple the dividend the group pays to the government for the preferred shares it received in return for an injection of public funds in 1999. Although Nishikawa defended the large dividend payment promised Goldman Sachs as the result of "changes in the market environment," claiming the amount was "adequate given current conditions" as compared with 1999, analysts said the decision reflected Japanese banks' weakness in both financial management and credibility. UBS Warburg analyst Katsuhito Sasajima said, "(SMFG) must have decided to resort to all possible means to avoid another injection of public funds."
Source: Daily Yomiuri
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