Why Spain's Economic Crisis Is Something More Than A "Housing Slump"

Spain's inflation (as measured by the EU HICP methodology) was around 1.5% (year on year) in December 2008, according to the flash estimate issued by the stats office (INE) earlier this week. This number only offers us an initial glimpse of the final HICP reading, but, if confirmed, it will mean Spain's annual rate of inflation has dropped 0.9% (nearly one full percentage point) in the space 0f just one month - since in November the annual rate was 2.4%.



It will also mean that Spain's inflation for 2007 dropped its the lowest rate in a decade, down sharply from the 2007 rate of 4.2 percent. This is remarkable since Spanish inflation has generally been over the EU average for more than a decade now, and 1998 was the last year in which prices for goods and services rose as slowly as they did in 2008. And the big question is, just how much more disinflation is there now in the pipeline? Where, indeed, will this process end?


Putting Theory To The Test Over A Cup Of Coffee

Well, in order to dig a bit deeper into all of this in what I hope will be a practical and enjoyable way let me start by offering bit of free publicity for my local bar, which you can see in the photo at the top of this post. The bar is in fact situated in Barcelona's Plaça Lesseps (near to where I, myself, live, and also - for any of you who happen to visit Barcelona - directly en route for the Güell, or Gaudi, Park). The proximity to the park is obviously one of the reasons the chain who own the bar decided to put it where it is, since a significant proportion of the large number of tourists who make the daily pilgrimage to the park need to pass it on their way.

Well, the point of this small publicity spot is not simply to offer them a shamefaced and willy-nilly promotion, but rather becuase I have singled out this little bar for a small experiment. Basically Joaquin Almunia, Pedro Solbes, Miguel Fernandez Ordoñez and I are in disagreement about something. Better put, they all agree with each other, while I find myself in basic disagreement, since they hold that Spain will see very low inflation in 2009 but not outright wage and price deflation. Of course, the devil may be in the details here, since if we are talking about the whole year average, then they may well be right, but if we are talking about the trend, then on my view we are heading for negative price movements - and over a number of years probably - and the only real doubt I have in my mind is when this downward movement will start. Hence my small litmus test.

Basically I am going to take this bar as a test case, and in particular I plan to track the price of one particular product - their café con lleche (cafe amb llet in Catalan, café au lait for those who prefer the French version, but NOT, definitely not, the badly translated "milky coffee" - or coffee with milk - in English, since the art of this particular beverage is most definitely in the making).


Now for those of you who can read the price list (below, click on image for better viewing), the price of a café con leche in the bar is currently 1:15 euro (which isn't expensive if you consider the bar, its location, the quality of the coffee they serve - very good - and the level of prices generally in Barcelona). This price is already news, since they did not raise it on 1 January 2009, a move which has all too often been a custom here in Spain. So at least prices are more or less stationary now in Spain (or at least prices in the private sector are - see below). But I expect more. I expect to see these kind of prices fall, and keep falling, and it this process we will be following here on this blog as we move forward.

Now just to be clear where we are at the time of speaking, what we have in Spain at the present time is a strong disinflation process - not outright deflation. If we look at the index chart below, we will see that the general HICP index is not only stationary, it has been falling since July. Now this drop is largely the result of a sharp falling back in food and energy prices, and this is not in itself deflation. If we look at the performance in the core HICP index (taking out the "volatile" food and energy prices) we will see that the position is a lot less clearcut, since in fact the core index has continued to climb - following the line of the inbuilt inflation momentum - and has only started to steady up in the last couple of months.



So my argument is that the disinflation which is being produced by the negative energy price shock, in the context of very, very weak internal demand could in fact produce a negative feedback cycle of price reductions which extend well beyond food and energy.

Price Rigidities

There are two great obstacles to this downward movement, one is the existence of collective wgae bargaining structures which enable wages to rise when prices rise, but do not necessarily allow them to fall when prices fall - but it is inbuilt into my argument that the shock of demand contraction is simply going to be so strong over the coming 12 to 18 months that the ability of these agreements to withstand it in their present form has to be brought into question. The issue is, just how far and how fast are unions and government prepared to see unemployment rise before offering some sort of response, because this is just what the impact of these asymmetric wage rigidities will mean, very substantial pressure on employment as more and more companies are pushed towards bankruptcy. Of course, the "get out" may be the "pagos extra" (additional payments), which may simply become less frequent and less substantial. We will see.

The second rigidity is constituted by the so called "administered prices" - basically those prices which are controlled or authorised by a government agency in some shape or form or other. One area where the role of administered prices is going to be important is in energy. The Spanish government only last week agreed to let power companies raise electricity tariffs over 20 percent over the next three years. The agreement is, of course, part of the government's plan to eliminate the large gap between what utilities charge clients for electricity and the cost of generating it, a gap which is known as the tariff deficit, and of course in the process attempt to reduce that "other" deficit, the current account one. Utilities will be allowed to raise the maximum tariffs they may charge some consumers by between 7 and 9 percent per year over the next three years.

The industry ministry have so far introduced an average 3.5 percent rise in household electricity tariffs and a 2.8 percent increase in rates for small businesses, which come into effect from January 1. In return for permission to hike power rates, utilities will have to write off 2 billion euros of the tariff deficit, which sits on their books as a long-term government-backed credit. The government will guarantee up to 20 billion euros of tariff deficit and back the securitisation of the shortfall. The tariff deficit is estimated by Spain's energy regulator (CNE) to have swollen to 16.2 billion euros in 2008 from the 11.2 billion accumulated by power companies to the end of 2007.

Real And Nominal GDP

Now above you will find the first of two charts prepared by Japanese economist Richard Koo which I think will be useful to illustrate a number of points where we might find similarities between what is happening in Spain and what happened in Japan. The first of these points concerns the price of land (which is represented by the pink line in the chart - please click over image for better viewing). As you can see, Japanese land prices started to fall in 1991, and they really have not recovered to any significant extent to date (indeed land prices have now started falling again).

Now land has been the single biggest drag on Japanese asset prices since the early 1990s, and is one of the principal culprits behind all those years of protracted deflation, so I think people in Spain need to take note of this, and be warned. The second point to note is that outright deflation didn't set in in Japan till around the turn of the century, and what I am terming "outright" deflation is represented by the crossover point between real and nominal GDP. (Nominal GDP is GDP in current prices - ie the actual prices charged - real GDP is inflation corrected). Now as we can see, nominal GDP actually fell between 2000 and 2003, and this is a very complicated situation to handle, since debts retain their nominal values, while virtually everything else goes down. As a result, debt to almost anything up goes up, and this is the situation I fear we may see in Spain in 2009, or more probably 2010, where the economy contracts so fast, and prices also fall in a way that we get a sudden fall in nominal GDP. This, I think, would really be a nightmare scenario for everyone.

Consumer Confidence Holds At Its Low Level

As might only be expected, with such a sharp deterioration in operating conditions Spanish consumers are not exactly feeling happy these days, and while Spain's consumer confidence indicator rose ever so slightly in Decemebr - to 48.9 from 48.7 in November (according to the latest report from the Instituto de Crédito Oficial, ICO earlier this week) - is is still way, way below the long run series average.




The slight Decemebr improvement was largely due to a small increase in the sub component indicator for current economic conditions, but then it was December, and it was Xmas time. The current economic conditions indicator rose to 29.7 from 28.2 in November, while the consumer expectations component, on the other hand, dropped to 68.1 from 69.2. All in all we are still above July's historic low, but since confidence is still at a very low level that isn't exactly saying much.


Car Sales Fall Sharply Again In December

Spanish car sales fell 28.1 percent in 2008 over 2007, according to the car industry group ANFAC last week. This was the sharpest yearly drop ever, with Spanish car registrations falling 49.9% year on year in December, rounding out the year on the worst possible note - 72,377 cars were registered in December in Spain , down from 144,441 a year earlier. The car association reported that the drop was due to tougher financing conditions as well as the generally more difficult economic situation.

"Job losses and shrinking disposable income are undermining consumer confidence and hitting car sales," Anfac said. "If market conditions persist during 2009, new car registration will have fallen by over a million vehicles, which gives us an idea of the gravity of the situation."

Services Continue To Contract In December


But it isn't only manufacturing and the key car industry which is now being weighed down by the crisis, Spain's services sector is also feeling the pressure, and the December PMI showed the sector contracted sharply one more time as activity, new business and the workforce all shrank at a pace second only to November's record declines. The Markit PMI, covering Spanish service companies ranging from hotels to insurance brokers, dropped to 32.1 in December - way below the 50 level where growth starts - and the second-worst reading since the survey began in 1999, following November's record low of 28.2.

"The bad news in the Spanish economy just keeps on coming. The terrible PMI data for December were second only to November in their severity," said economist at MarkitEconomics Andrew Harker, "Any slight optimism seems largely based on wishful thinking, while it seems clear that conditions will continue to worsen in the first quarter of 2009 at least."

The Spanish government, who last month announced an extra 11 billion euros on top of the previously announced 40 billion euros in tax cuts and state credit in an attempt to stimulate an economy whose health is deteriorating rapidly, continue to assert that growth should pick up again from mid-2009, but as more and more waves of data come rolling in this looks increasingly unlikely and the Spanish economy seems set to contract all through 2009 and probably shrink again in 2010.


Current Account Deficit Narrows


One of the reasons why there is little room for optimism in the Spanish case is the need to correct the current account deficit, which, while it is now steadily falling back as internal demand weakens, is still running at something like an 8% of GDP annual rate. The deficit dropped again in October, according to the latest data from the Bank of Spain, hitting 7.86 billion euros, down from 8.11 billion euros in September and 9.02 billion euros in October 2007. As can be seen in the chart (below) the deficit has now been dropping steadily since March last year. The driving force behind the fall is more a question of declining imports than rising exports though, and, please note the very important point that the income account, which is the net balance of interest paid on loans and dividends on equities, still continues to deteriorate.




The deficit on income account was 3.53 billion euros in October, up from 1.77 billion euros in October 2007.



The reason for the deterioration in the income account isn't that hard to find, it lies in the growing external indebtedness of the Spanish economy (see chart below). This debt has now risen from 870 billion euros in Q3 2004 (or around 90% of GDP) to 1,686 billion euros in Q3 2008 (or around 155% of GDP). In fact the size of the debt has more or less doubled over this period, and it is still rising. The reason for the increase in debt isn't hard to find, since it lies in the need to attract funds to finance the large increase in the goods and services trade deficit which was created by attempting to run the Spanish economy so far above what could be termed its "capacity", and for so long.


So basically Spain's problem isn't simply a construction boom that went wrong. Spain's current economic malaise has deep structural roots that go back over a number of years - probably the best part of a decade. Basically Spain's economy overheated way beyond capacity for at least six years, and the smoking gun for this is what happened to the current account deficit (see chart below), as imports were steadily sucked in to meet the voracious demand, that was, of course, fuelled by the large rise in construction activity and the wealth-effect of steadily rising property prices.



And how, apart from the CA deficit, do we know that Spain's economy was operating "beyond capacity" - well one piece of evidence would be all that external debt which was accumulated by the inflow of foreign funds (which you can see in the earlier chart), and another would be the large number of migrant workers who were sucked in.

There are currently something like 5 million immigrants living and working in Spain, and they make up about 10% of the population, the highest proportion (of first generation immigrants) in the European Union. Even more strikingly, more than 4 million of these immigrants came to Spain after 2000, during the good years of the housing boom, they filled the toughest and worst paid jobs on building sites and farms.

So there you have it, an economy is basically a large cement mixer into which you throw money, people and raw materials in certain proportions - and out the product (national income) comes at the other end of the pipe. But Spain had neither the people, the money, nor the energy to fuel all this, hence all of these were imported, and in large quatities. Hence, ultimately, the CA deficit. Not all that hard to understand really I don't think.

But why did the economy overheat? Aha! Well just look at the chart below, and notice how the period when Spain was being subjected to negative interest rates coincides almost exactly with the sudden surge in the CA deficit. This is another tell-tale sign, another smoking gun. The monetary policy applied in Spain between 2002 and 2006 was thoroughly inappropriate. But now is not the time to quibble about this - when things are back under control again there will be plenty of time for a post mortem. Now is the time for action, and for doing something to try to ensure a more orderly correction than the one we are currently "enjoying", and it is this plan of action I find lacking, far more lacking than the mere absence of reflective self criticism.



Finally, (below), one last chart on Japan, again prepared by the Japanese economist Richard Koo. The thick blue line (please click over chart if you can't see adequately) shows the perception of large businesses of the willingness of banks to lend to them, as surveyed by the Bank of Japan for the Tankan index. You will note the line plunges twice, and it is the second plunge, or "credit crunch", which interests me at the moment. This was the crunch that finally drove Japan decisively off into deflation, and produced that now famed "liquidity trap". Basically the first credit crunch was resolved via large scale government contruction spending, the guaranteeing of bank deposits, and the swallowing by the banks of a large number of non-performing loans. Does all this sound familiar? It should. But then Japan reached a point were the financial system could struggle forward no further. So the crunch broke out again, and this time the only way to resolve the problem was with two massive injections of capital into the banking system. These injections served to push the Japan government debt to GDP ratio sharply upwards, and it is this part of the story that I feel we will see repeating itself here in Spain. Maybe in 2010, maybe in 2011. It all depends how far the system can limp forward before it folds in on itself.

The Second Great Depression Wends Its Way Forward in December

And lands in China.



Well China isn't quite in Great Depression mode yet, but manufacturing activity - which forms the core of the Chinese economy and accounts for 43% of all activity - is already very close to a technical recession, and phew, it wasn't very long ago that the Chinese economy was registering double digit growth. So the turn around is gigantic. The "close to technical recession in manufacturing industry" call comes from the people over at CLSA Asia-Pacific Markets, who compile the China purchasing managers index, and they base their judgement on the fact that their Chinese manufacturing index has now been registering contraction for five consecutive months.

Now for those of you who are new to the world of Purchasing Manager's Indexes (PMIs), welcome. Basically these indexes are very useful, since they give you a "just in time" point of reference to tell you what is actually happening. These are composite indexes - measuring things like current output, new orders (both domestic and export), employment and input prices. They are not perfect, but they are reasonably accurate - the fit which you can get between composite PMIs (manufacturing and services combined) and GDP is often attractively good - and in a country like China where the main data we get is year-on-year (which in a critical moment of rapid change like this one is virtually useless) it is very hard to see what is happening. The Shanghai-based Industrial Bank estimate, for example, that GDP growth in China will be 5.6% in Q4 2008. But what does that data point - if accurate - tell us? That the economy is slowing fast, well we already knew that. But just how fast? Well GDP was 9% in Q3 - down from 10.1% in Q2. So the deceleration is very rapid, but did the Chinese economy actually manage to contract in Q4? I doubt it, but it may do in Q1 2009, although the only way we would really know would be if the National Statistics Office published quarter-on-quarter seasonally adjusted numbers, which as far as I can see they don't. Indeed only a small group of highly developed economies actually take the trouble to do this, and you don't even find all EU member countries doing it yet, although Eurostat (thank god for Eurostat) do require such data from members (but those of you who ever get round to checking will see there are still blanks for some countries in the Eurostat quarterly releases).

Hence you can see why, in the case of somewhere like China, the PMIs are very, very useful, for those of us who would like to try and follow what is happening as it actually happens.

As for the PMI itself, China’s composite manufacturing index contracted for the fifth consecutive month in December as recessions in the U.S., Europe and Japan bit deep into demand for exports - indeed China's exports fell year on year for the first time in seven years in November. The CLSA China Purchasing Managers’ Index registered a seasonally adjusted 41.2, compared with a record low of 40.9 in November. On such indexes any reading below 50 reflects a contraction.

Despite the apparent small improvement in December the current output index actually fell sharply, and was down to a record low of 38.6 from 39.2 in November, so production was falling, and the index was basically nudged up slightly by other factors, such as the measure of new orders which rebounded to 37 from 36.1, driven by a rise in export orders to 33.6 from a horrific 28.2 in November. However, according to the report, Chinese manufacturers reduced the size of their workforces at a series record in December, and the employment index has now contracted for five consecutive months, to hit 45.2 in December.


So where exactly are we? Well we aren't (quite) in the Second Great Depression yet, but the situation is deteriorating, and rapidly. Manufacturing output is now contracting at quite a sharp pace, while it was rising in the first half of the year at something like a 15% year on year rate. In a useful summary of the Chinese situation back in November, Nouriel Roubini defined a hard landing in China - which he felt was coming - as follows:

There is thus now a growing risk of a hard landing in China. Let us be clear what we mean by hard landing. In a country with the potential growth of China, a hard landing would occur if the growth rate of the economy were to slow down to 5-6% as China needs a growth rate of 9-10% to absorb about 24 million folks joining the labor force every year; it needs a growth rate of 9-10% to move every year about 12-14 million poor rural farmers to the modern industrial/manufacturing urban sector.

This is more or less the consensus view of what we used to think a hard landing would mean in China, but I think the latest data already take us beyond that. I think there is now a real risk of a technical recession in the more or less classic sense of two consecutive quarters of negative growth (let's say that the risk is 50-50 at this point), and of serious economic and financial dislocation following in the train of this (btw, just how quickly can you burn your way through $1.7 trillion in reserves, it will be an interesting experiment I think).

Brad Setser (further down the same link) has long been more cautious on China, being sceptical about the impact of a dramatic slowdown in exports (and even more importantly in export oriented investment) on an export driven economy, but those of us who have been closely watching other export dependent economies like Germany and Japan over the last decade and a half were surely not quite so sceptical. However even Brad himself is clear that the possibility of an export downturn feeding its way back into the domestic economy - via some sort of negative feedback process - is real enough:

But the real key to forecasting China’s future growth consequently is determining whether domestic consumption and above all investment will continue to grow strongly in the absence of strong export demand. Remember, over the past few years both domestic investment and exports increased rapidly. If they fall together as well, Chinese growth will slow quite significantly. And unfortunately the latest indicators seem to suggest that they are correlated; consequently domestic demand may fall along with exports.

The $1.7 trillion question is, then, just why China is so export dependent? Doubtless there are many factors at work, but one of these is, I am almost sure, China's very special demographics (30 years of one child per familiy policy), and the special problems that these present in the context of building a sustainable national pensions system at the same time as the population pyramid inverts. Obviously the absence of a credible pension system has to be one of the factors influencing the strong desire to save which we are seeing in China. Economics Nobel Franco Modigliani also thought this, and specifically addressed the Chinese saving puzzle in his last published paper:

China's per capita income ranks below 100th in the world. Its saving rate, however, has been one of the highest worldwide in recent decades. In this paper, we attempt to explain the seeming paradox within the framework of the Life-Cycle Hypothesis developed by Franco Modigliani. The key LCH variables are income and population growth. Our results based on data we put together from official sources show that income growth has been the dominant factor behind the dramatic increase in China's saving rate, as predicted by the LCH. Demographic structure and inflation also had significant impact on the fluctuations of the saving rate.
The Chinese Saving Puzzle and the Life-Cycle Hypothesis - Franco Modigliani and Shi Larry Cao

By Way Of Brief Conclusion

Well basically, the conclusion here is that there is no conclusion, at this point at least. But I would draw attention to two potential points of interest for all you "economy watchers".

Firstly, a couple of months back my fellow blogger Doug Muir drew our attention to a very interesting point being made by US economic historian Scott Reynolds Nelson:

As a historian who works on the 19th century, I have been reading my newspaper with a considerable sense of dread. While many commentators on the recent mortgage and banking crisis have drawn parallels to the Great Depression of 1929, that comparison is not particularly apt. Two years ago, I began research on the Panic of 1873, an event of some interest to my colleagues in American business and labor history but probably unknown to everyone else. But as I turn the crank on the microfilm reader, I have been hearing weird echoes of recent events.

At the time of reading this I thought to myself hmmmm! This isn't that simple, but he is on to something. Basically I think no two (or does that make it now three) Great Depressions are ever really exactly alike. I certainly think the resemblence between what is going on now and what happened between 1929 and 1933 is more than passing (especially for the sequencing, of which more in another post), but evidently there are elements of the 1873 one too, and Scott Reynolds puts his finger on some of them, especially in the context of surplus to requirement investment and large capacity overhangs. So my best guess is that what we have is a hybrid, and that what is now happening in China is the best example of the underlying dynamics behind that other great depression that hit our grand- (or great grand) parents and that may well be now about to come back to hit us, boomerang style.

Which brings me to my second point, the Smoot-Hawley Tariff Act, which, as wikipedia explain, was signed into law on June 17, 1930, and raised U.S. tariffs on over 20,000 imported goods to record levels. After the act was passed, many other countries retaliated with their own increased tariffs on U.S. goods, and American exports and imports plunged by more than half. Many economists now regard the Smoot-Hawley Act as having been the principal feedback catalyst for the severe reduction in U.S.-European trade, and which took it from the 1929 high down to the depressed levels of 1932 and which thus accompanied the start of the Great Depression. And here, in the spectre of a repeat performance comes just the danger we face in the wake of the dramatic contraction which is now underway in China.

It is my personal guess that the first major issue to face Barack Obama as President of the United States may well be what to do about China, and especially what to do about a China which lets - as I now suspect they may well do - the yuan float, in order to see it float DOWN as the economy unwinds. If this does indeed happen then Obama will really have to struggle to hold back the protectionist pressure I think.

As The Politicians Battle It Out Ukraine's Economy Tunnels South In Search Of Australia

“In Ukraine, the evidence is still that policymakers do not quite understand the seriousness of the challenges they face,”. Timothy Ash, analyst at the Royal Bank of Scotland.

“There is a burgeoning economic crisis in the European periphery,” Krugman said on the ABC network Dec. 14. “The money has dried up. That’s the new center, the center of this crisis has moved from the U.S. housing market to the European periphery.”

Make no mistake about it. What is taking place right now in Ukraine is extraordinarily serious. The IMF have recently agreed a support loan to the country, but the politicians themselves still can't agree on whether or not they are actually going to abide by the conditions attached to it. Meantime, as we can all see on our TV screens, tensions with Russia continue to escalate, fuelled by the conflict-ridden negotiations over Ukraine's gas debt.

And just to add to the nighmare, Ukrain's economy made a dramatic entry into recession in Q4 2008. In fact, so severe has been the slowdown that nobody at this point can even muster enthusiasm for opening up one of those interminable discussions about whether or not what the country is going through really counts as a "technical recession" (in terms of two successive quarters of GDP contraction) or not, since the drop in national output has been enormous, and it it fairly obvious that isn't about to come bouncing back up again. At least not for the next several quarters it isn't, and - to give us an early glimpse of the terrain onto which we are now entering - the World Bank have just forecast a 4% contraction in GDP for 2009.

In a year when you would think little would surprise us the sharp change in real Ukraine GDP dynamics has been astonsihingly swift, with the growth rate moving from the 11% year on year expansion registered in August to the 14% year on year contraction reported in November (according to data put together by the World Bank). GDP for the whole January-November period is now down to 3.6% when compared with the equivalent months in 2007, and this is reall a sharp drop, since the average over the first nine months of the year was a growth rate of 6.9%. For his part the office of Ukraine President Viktor Yushchenko is suggesting that gross domestic product may contract at an annual rate of between 7 percent and 10 percent in the first quarter of next year, and by 5 percent over the whole year, according to Oleksandr Shlapak, deputy chief of staff to the president.


The contraction has been led by sharp falls in manufacturing and construction, while the financial system has been in serious trouble since late September, and the loss of UAH deposits from the banking system has amounted to 14% during October and November. But the real problems Ukraine is facing in confronting this most serious economic crisis, lieas in the political sphere, and the complete lack of the kind of political consensus which is so necessary to see through the measures which can it to an end.

Political Chaos Adds To The Problems

Ukraine’s government - which is laways a chaotic process at the best of times - is once more having a serious identity crisis about who it is and what it wants to do, with one of the exectutive's two visible hydra's heads (Prime Minister Yulia Timoshenko) seeking to respond by manipulating the currency downwards, by boosting social expenditure to an extent which will push next year’s budget deficit up to 2.96 percent of gross domestic product (from an agreed 1.4%) and well beyond the IMF pact level, and by attempting to resolve the trade deficit problem by imposing an administrative tax on imports. The other head of the hydra (President Viktor Yushchenko) is busy opposing all these moves on the grounds that they may jeopardize the second tranche of a $16.4 billion loan from the International Monetary Fund, and obviously, were this to be the case, the country would basically find itself bankrupt, and at the mercy of whatever sentiments the global financial markets wish to express when it comes to Ukraine.

Of course regular readers of this blog will not be surprised to find that this politically split personality crisis goes right into the heart of the central bank (see my Monetary Chaos Breaks Out At the Ukraine Central Bank post) and no one will be really that surprised to find that the two key characters in this round of the saga are (yet one more time, read the linked post, its all explained there) National Bank of Ukraine Governor (and board chairman) Volodymyr Stelmakh’s and Petro Poroshenko head of the central bank council.

Well things are really hotting up at the moment, with Viktor Yushchenko this week threatening to fire some central bank employees (presumeably those who were not implementing the decision to allow the Hryvnia to float), while Yulia Timoshenko was busy demanding the dismissal of National Bank Volodymyr Stelmakh himself - presumeably because he was trying to stop further currency intervention. In an official statement the central bank council responded by accusing Timoshenko of stirring up “chaos” and undermining the nation’s banking system, while Timoshenko, for her part has now taken the matter to the Ukrainian parliament (the Verkhovna Rada - where she may well carry a majority) which will now hold a full debate the role of the central bank next week. It seems not to matter too much here that the bank council is simply trying trying to implement a set of policies which were agreed to (or everyone thought they were agreed to) as part of the IMF loan agreement.

“A hryvnia level above 9 per dollar is unacceptable, it threatens the economy and banking system,” Petro Poroshenko, the head of the central bank council said. “The situation with the hryvnia rate demands urgent measures.”

Volodymyr Stelmakh, Central Bank Governor, the Yulia Tymoshenko Bloc is proposing his immediate arrest.

(Interfax-Ukraine) - Yulia Tymoshenko Bloc has proposed that, based on results of a report by an ad hoc parliamentary commission scrutinizing the National Bank of Ukraine's activities, an address should be sent to the Prosecutor General's Office and that National Bank Chairman Volodymyr Stelmakh should be arrested. "I think that, based on the report's findings, there will surely be an address to the Prosecutor General's Office of Ukraine and other law enforcement agencies, which, by the way, are already conducting inquiries," Volodymyr Pylypenko of the Yulia Tymoshenko Bloc said in an interview with Interfax on Wednesday. "The best gift in this situation can only be an order on taking [National Bank of Ukraine Chairman Stelmakh] into custody for all wrongdoings the National Bank has committed in the past months," Pylypenko said.

President Yushchenko did express the hope last Tuesday that Ukraine's currency market might be moving rightside up, with the hryvnia trading at about 7.8-8.0 to the dollar and level of "stabilising" dollar purchases by the central bankdeclining, but Prime Minister Tymoshenko remained unconvinced that this was a desireable level, and demanded more concerted intervention to move the currency up to a much higher level - around the 6-6.5 to the $ mark. She gave Yushchenko a week-and-a-half apparently, since otherwise she stated the country would face increasing problems with inflation, and in the banking and other sectors. It is not clear (at least to me) why these problems (which are, and will continue to be, serious) should suddenly deteriorate within the time scale of ten days, but presumeably there was another, more political, message behind this choice of words.

Adding to the confusion, Ukraine's parliament, has decided to impose an additional 13% temporary duty on all imported goods - and this despite the fact that Ukraine only recently entered the WTO. A total of 269 MPs from the ruling coalition and the Communist Party voted for the relevant law which amended existing Ukranian lefislation - with, it was said, the aim of improving the state of Ukraine's balance of payments. "Duties have been increased on all imported goods, apart from a [so-called] 'critical' [list of goods]," the head of the parliament's committee for tax and customs policies, Serhiy Teriokhin, is quoted as saying.

"I'm alarmed by the report of my legal department on parliament's decision to impose an additional temporary duty on all imported goods. Parliament's decision puts Ukraine's presence in international programs in jeopardy," President Yushchenko said at a press conference yesterday. "Similar decisions by Russia and Europe might be made against us in three days,".

IMF Taking Large Political Risk

Last month, a point in time which now seems so distant it feels like eternity, Ukraine received approval for a two-year IMF loan intended to help support its banking system and cover the country’s widening current-account gap during what was always seen as being a difficult adjustment process. Under the terms of its agreement with the IMF, Ukraine is expected to have a balanced budget next year. If the Cabinet fails to meet the target, then the Fund may withhold the second tranche of the loan, according to press statements by Balazs Horvath, IMF representative in Kiev. Ukraine received the first installment of $4.5 billion last month, and is due to get the second tranche in February. Obviously the IMF is by now well accustomed to playing the part of the "bad boy" in this type of situation, but what if the country they are trying to deal with should simply "implode", right in its face, I'm not sure even the hardened hand of the IMF are ready for this. So let's just hope I'm exaggerating, and that it won't happen (fingers tightly crossed everyone, please).



Discrepant GDP Forecasts

So Ukraine faces a crisis on three fronts, financial, economic and political. On the real economy side, the Ukraine cabinet currently expects growth in the country’s economy to slow to 0.4 percent next year, compared with a final rate which turn out to be somewhere between 1.8 percent and 2.5 percent this year. As I say the World Bank now expects a 4% contraction in GDP next year, and thus a 0.4% expansion in the budget is potentially a very serious problem indeed for the deficit, if the economy underperforms, as it surely will.

“The draft budget, prepared by the Cabinet, is not realistic,” Yushchenko said today in a statement on his Web site. “The 2009 budget is a tragedy; it is the most irresponsible document worked out by the government. Professionals should plan a realistic budget, not optimistic.”

The government plans to cover the budget deficit by selling bonds in domestic and foreign markets, and is to receive a $500 million loan from the World Bank to cover the budget deficit. Under the terms of the IMF agreement with the Inernational Monetary Fund Ukraine has pledged to keep its 2009 budget deficit under 1 percent of gross domestic product, below the 2 percent initially planned by the government. In October, the government reduced its planned 2008 budget revenue from the sale of state assets to 401 million hryvnia ($59.4 million) from 8.6 billion hryvnia, citing the unfavourability of the moment for selling.



Pressure On The Hryvnia


The Hyrvnia has been falling for a number of weeks, but the rate of decline has really accelerated in the last ten days, and we are really now talking about one of those famous currency crises. The national currency has fallen 50 percent against the dollar since June, and according to Michael Ganske, head of emerging markets in London for Commerzbank, it may well drop another 24 percent in the next few weeks given market sentiment and that the International Monetary Fund package effectively limits central bank intervention to halt the slide. The terms of the IMF $16.4 billion bailout package, agreed to last month, require Ukraine to move toward a flexible exchange rate and place a maximum limit of 4 percent for any reserves reduction during the remainder of 2008 (from the base of around $32.8 billion). Thus while the agreement does allow intervention to stem “disorderly” swings, it places a tight limit on what this means. And this now is just the problem, although before we jump to our guns, we should bear in mind that what is provoking the fall is not the IMF and the bailout, but confidence in the ability of the political system to implement a workable recovery plan. Trying to run a currency corridor, and accepting the inflation that went with it, is how we got here in the first place.

The only real remedy Ukraine’s central bank has at its disposal at this point is to raise its base refinancing rate, and this it duly did last week, taking it up from 18 percent to 22 percent in an attempt to arrest the hryvnia’s decline To give us some idea where we are at this point, at the start of 2008 the dollar bought 5.04 hryvnia, while right now it can purchase around 8.25 hryvnia.



The central bank is currently offering to sell dollars at 8.0 hryvnias and to buy them at 7.8788 on the interbank market. Yushchenko told a news conference last week that the central bank had bought $270 million on Monday and Tuesday, but had been required to sell only $30 million on Tuesday. He informed the assembled journalists, however, that complete stabilisation would need to wait until after the debts for Russian gas and other expenditures had been paid (you should be able to start to smell just how complicated all this is by this point, just who exactly is batting for who here?). "Until debts are paid for gas, and settling the debts of (the national road network) Ukravtodor, it would be madness to talk about steps aimed at a fundamental, professional stabilisation". "Everything is earmarked", he claimed, "$3 billion (for intervention from reserves), more than $2 billion set aside for gas arrears, $1 billion for repayment of a loan to Ukravtodorom, $200 million to (rocket maker) Yuzhmazh, leaves only an additional $400 million to defend the hryvnia."


As a result of the $7.5 billion the Ukraine central bank spent supporting the hryvnia in October and November foreign reserves fell to $32.7 billion as of Nov. 30. At the same time the hryvnia has declined 21 percent against the dollar over the last month alone . Under the terms of the agreement with the IMF, the reserves should not fall below $31.4 billion by the end of this year, so we are talking about a very close call on this front too.



Equities Down And Credit Default Swaps Up

Ukraine’s stocks have also been falling, and the benchmark PFTS stock index is down 74 percent this year, the third-steepest decline among the 22 so-called frontier markets tracked by MSCI Barra. Mariupolsky Metallurgical Plant, Ukraine’s largest steel company by revenue, has fallen 92 percent on the Kiev stock market. On the other hand the extra yield investors demand to own Ukrainian government bonds instead of U.S. Treasuries has increased more than nine times this year to 25.86 percentage points, according to JPMorgan Chase’s EMBI+ indexes, which compares with an average three-fold increase in the main emerging-market index to 7.09 percentage points.


Loan Defaults Coming


And as the currency slides, so too does the ability of the average Ukrainian to pay his or her debts. Another Yushchenko aide, Roman Zhukovskyi, recently estimated that up to 60 percent of foreign-currency loans and mortgages could default given the extent of the decline. Ukraine, which has around $105 billion in corporate and state debt, has the fourth-highest credit risk worldwide, according to credit-default swap data. The cost of insuring Ukraine bonds against default is up more than thirteenfold this year, to an astonishing 31 percent of the amount of debt protected. This puts the country behind only Ecuador, which defaulted last week (59 percent), Argentina, which defaulted on $95 billion in bonds in 2001 (46 percent), and Venezuala ( 33) percent, according to the data from CMA Datavision.

Ukrainian companies need to repay as much as $4.1 billion this month while lenders refuse to refinance debt, according to Dmitry Gourov, an economist at UniCredit in Vienna (oh, no, not Unicredit again, see this post). Dollar denominated loans made up 53 percent of credit issued by Ukrainian banks as of 30 September, according to central bank data.

Thus, with just over half of all bank loans denominated in US dollars, they obviously become vastly more expensive for borrowers who are paid in the national currency.

Aggressive lending by banks that borrowed heavily from abroad has obviously contributed to Ukraine’s ballooning private sector external debt (currently estimated at $85 billion). Official figures indicate that only some 2.5 percent of loans are currently problematic, but this situation is obviously about to worsen considerably next year as the currency is down and the economy contracting.

Earlier this month, Finance Minister Victor Pynzenyk called on banks to refinance loans amid a weakening hryvnia and rising interest rates. Some banks in recent days said they would seek compromises with clients, rather than hike interest rates further. Pynzenyk’s proposal called on the NBU to amend its rules to allow borrowers either partially or in whole to pay back loans in the national currency at the exchange rate which was operative when the loan agreement was signed. The banks, in turn, would be allowed to lower their capital/asset ratios and write off their losses, thus paying lower taxes, which would also require amendments to the tax legislation. Obviously some such solution will need to be found for this problem. (There has already been some move in this direction in Hungary, another of the countries which is strongly affected by the forex loans problem).

Other measures under consideration at the present time include extending loan periods, and the temporary reductions in loan payment installments. If the hryvnia-dollar exchange rate further widens, mass loan defaults are inevitable, according to Yuriy Belinsky, head analyst at Astrum Investment Management. At the current Hr 8 to the $1 rate, “40 percent won’t be able to pay their loans,” Belinsky told Korrespondent, a Russian-language Ukraine newspaper.

And the situation is deteriorating fast, a quick visit to the foreclosure sections on the websites of banks like Finance and Credit Bank or Alfa will turn up plenty of property and cars already listed for sale or soon to be auctioned. But given the slump in the real estate market and falling house prices it isn't clear that banks will find it any too easy unloading any property they do repossess. We are back to the "you owe them a little money and you have a problem, and you owe them a lot of money and they have a problem" situation. Last weekend, the NBU also recommended that banks lower interest rates on foreign-currency denominated loans, but the problem is going to be, as ever, who is actually going to fund these measures?

Industrial Output Plummets

Meantime in the world of the real economy things simply get worse and worse. Industrial production shrank by a record 28.6 percent in November as steel, machine building and oil refining slumped, after a 19.8 percent decline in October.

And as output falls, prices come tumbling behind. Steel production dropped 48.8 percent in November, while the price of the benckmark European hot rolled coil has fallen 47 percent since August and is now at around $425 a metric ton, according to data from U.K. industry publication Metal Bulletin.

World Bank Forecast

The World Bank have predicted a sharp recession for Ukraine in 2009, with GDP being expected to fall by some 4.0 percent. This compares with their July forecast of 4.5 percent growth. The Bank also cut back its forecast for 2008 growth to 2.3 percent from a previously forecast 6.0 percent. It raised its inflation forecast for this year to 22.8 percent from 21.5 percent previously predicted, up from 16.6 percent in 2007. It cut its forecast for inflation next year to 13.6 percent from 15.3 percent.

(please click on image for better viewing)

The Bank take the view that the Ukraine government - in agreeing to the terms of the IMF loan package - have initiated an important programme of macroeconomic adjustment measures, but (with a wary eye on what is actually going on in the Parliament) stress that consistent implementation is essential to avoid a further erosion of market confidence. In their latest report the Bank highlight the shift towards a flexible exchange rate policy, financial sector stabilisation measures , and a more conservative fiscal policy, but as we have seen, these are just the measures which seem to be being challenged by some of the political participants .


So What Does The Future Look Like?

Obviously Ukraine is heading into a major recession in 2009 fuelled by the nasty cocktail of a credit crunch, a terms of trade deterioration, and a consequent massive slowdown in both internal and export demand. Given the damage to competitiveness caused by two years of double digit inflation, macroeconomic stabilization will require a very large and significant correction, and this will mean a significant tightening of aggregate demand and a shift in its composition away from domestic consumption and towards net exports. The government debt stock is currently low at 10 percent of GDP, and will undoubtedly remain sustainable throughout and after the adjustment, even allowing for the potential costs of bank recapitalization. But the ability of the Ukraine administration to carry out the necessary adjustment hinges critically on the willingness of external creditors to refinance the banking and corporate sector debts, and this willingness in its turn depends on the perception those creditors have of the level of political coherence and stability the country has. And as we are seeing such perceptions must be reasonably near an all time low at the present time.

But even with the best political system in the world, the economic correction facing Ukraine is going to be large and the stresses enormous. The World Bank more or less spell this out in the paragraph I extract below. A 200% contraction in real imports (ie not due to cheaper energy prices or something) is massive, and we are talking about a basically balanced budget (ie very little fiscal stimulus) and monetary policy where interest rates are at the current giddy heights of 22%.

The basic macroeconomic parameters in our forecast are broadly consistent with those of the IMF program. Balance of payments pressures will lead the economy to adjust the composition of growth through 2009. As a result, the current account deficit is expected to improve from over 6 percent of GDP in 2008 to 1-2 percent of GDP in 2009-11. To achieve this adjustment, an over 20 percent real import contraction will be needed in 2009 in order to counter the 7 percent forecast terms of trade deterioration. Real wages and employment are forecast to decline in 2009 to restore price competitiveness of Ukrainian exports in the wake of declining export prices and to support the adjustment in aggregate demand. With this current account adjustment and with the support of the IMF Stand-By, the external financing gap would be closed under our baseline assumptions. Declining commodity prices, tightening liquidity and the forecast decline in domestic demand will contribute to disinflation. However, offsetting this, the exchange rate correction and the adjustment of energy and utilities tariffs will make disinflation a more prolonged process. We assume that the government will maintain a balanced budget in 2009 (not accounting for bank recapitalization costs) and have a small deficit thereafter.

So I think we need to be very clear at this point. The Ukraine position is very difficult, and everything is very delicate. The danger of total financial meltdown (which would be in this case in the private banking sector, not sovereign debt) is real and significant. The economic downturn has only just started and further downside risks are large and depend critically on the size of external shocks and the limitations imposed by inadequate policy responses.

Any further deterioration in the terms of trade (unlikely at this point given how far steel prices have already fallen, but these prices may stay lower for longer than many in the sector can sustain) or further decline in export demand would certainly put almost unsustainable pressure on the real sector. Banking sector vulnerabilities may be further exacerbated by further overshooting of the exchange rate and external debt refinancing difficulties as corporate balance sheets weaken further and household incomes come under strain from rising debt service costs.

Prudent fiscal, monetary, and financial policies (many of them anchored in the program supported by the IMF), accompanied with renewed efforts to deepen structural reforms, can help Ukraine to stabilize its situation and move the economy towards recovery. Conversely, a continuation of the current disorderly response and poor implementation of the agrred policies may easily trigger further financial chaos leading to an even shaper downturn and a postponement of any recovery off into the distant sunset.

But Beyond The Recovery, What About The Demography?

One of the reasons why I think the IMF and the World Bank are taking such a big risk with their credibility in Eastern Europe at the moment, is that I don't think they are getting through to the heart of the problem. One way of thinking about this is to take Paul Krugman's favourite Keynes quote - "we've got magneto trouble" - and ask ourselves whether all we have before us in the CEE countires right now are magneto problems, or whether, to continue with the metaphor, we may not have issues with the cylinder head gasket. And it gets worse, because the cylinder head gasket does seem to have blown (and it will keep blowing) because we have leakage problems in the sump, and the main oil pump isn't working - and who knows, maybe the crankshaft even needs replacing. As they always tell you when you take the car into a garage for "fixing", we won't know till we take the thing apart. What do I mean?

Well take a look at the chart showing the relative size of annual births and deaths in Ukraine over the last twenty years.

I mean to the normal and untrained eye stands the problem stands out a mile, population dynamics went underwater in the Ukraine in the early 1990s, and they aren't coming back to the surface again (not now, not in thirty years, not...... well maybe never is too much of a long time, but certainly not over a time horizon which is going to make any essential difference to anyone who is already alive today.)

And this is without taking any outward labour migration into account, so just think about the negative labour market dynamics that this implies, and already has implied. Can anyone really be surprised that Ukraine has been suffering from acute inflation as its number one problem?

To some extent it is worth stressing here that what really matters is the actual numbers of annual live births, rather than any more complex measure of fertility. In 1989 for example there were nearly 700,000 children born in Ukraine. By 1998 this number was near to 400,000 (ie there was a drop of 40% or so in a decade). In practical terms (and if we take 18 as an average age for labour market entry in a country like Ukraine) next year there are potentially 650,000 people to enter the labour force, but by 2016 this number will be only 400,000. So it isn't simply a question of pushing the fertility rate up towards the replacement rate (a difficult, but not impossible task), we also need to think about what economists term the "base effect" here, that is that with each passing year and cohort you have less and less women in the childbearing ages, so even if those women replace themselves, the base of the pyramid is still much narrower than the top, and it is the people at the top who need caring for and financing.

And even if some of this loss can be offset at the workforce level by increasing labour force participation at the older ages, we would still be talking about a very sharp rise in the average age of the workforce. And productivity improvement alone cannot possibly hope to compensate for the kind of labour force contraction we should reasonably expect, at least not over such a short period of time it can't. So this is just one more reason why, against all expectation, fertility really does matter.

While many continue to believe that falling populations don't actually have any tangible impact on economic performance, it is very striking to notice that when it comes to ageing and declining populations we really lack ANY evidence to substantiate that claim in the affirmative. On the other hand we do have plenty of evidence from countries where the population is either falling or gathering negative momentum to suggest that these countries face some very special kinds of economic problems. The example of Eastern Europe is clear enough I would have thought, but people really do need to take a closer look at what has been happening in recent years in countries like Japan, Germany, Italy and Portugal. And if falling population does produce its own kind of economic problems, well then we should be expecting to see plenty of them in Ukraine, since as we can see in the chart below Ukraine's population peaked in 1993, and has been in some sort of free-fall ever since.

Evidently there are a number of factors which lie behind this dramatic decline in the Ukrainian population, fertility is just one of these (with poor health and net emigration being the others). Ukraine fertility is currently in the 1.1 to 1.2 Tfr range, and, as we can see in the chart below, it actually dropped below the 2.1 replacement level back in the 1980s.




Another major influence on demographic dynamics is health, and one good measure of this is the level of life expectancy, which in the Ukraine case has shown a most preoccupying evolution, since it has been falling rather than rising. The chart below shows life expectancy at birth for both men and women, the male life expectancy is evidently significantly below the combined figure.




This life expectancy situation is, as well as being preoccupying, highly unusual (it is however paralleled to some extent in Russia itself, and some other CIS countries). Apart from the obvious, the deteriorating health outlook which this data reflect places considerable constraints on the ability of a society like Ukraine to increase labour force participation rates in the older age groups, and this is a big problem since this is normally though to be one of the princple ways of compensating for a shortage of people in the younger age groups.

So what about the future? Well, two issues are really starting to worry me at present, the first of these is the short term fertility shock Ukraine will undoubtedly receive on the back of the current crisis. If young people were already rather reluctant to have children, then then will now almost certainly be much more so, given the downward pressure on living standards we are about to see.

The second worry concerns the future of the country itself. A recent study carried out jointly by the Kiev based Democratic Initiatives Foundation and Nova Doba History and Social Sciences Teachers Association found that while more than 93 percent of the Ukrainian seventeen year olds they inteviewed considered themselves Ukraine citizens, only 45 percent said they planned to live and work only in Ukraine, citing Western Europe, Russia and the United States as possible future destinations. When 55% of your potential future labour force are thinking of working elsewhere you have a problem, and one which needs a solution. Simply putting a strip of band-aid over a festering wound won't work, I'm afraid, however much the Ukrainian people may struggle and sacrifice. With or without Keynes, we've got more than magneto problems on our hands here.

Postcript

A much fuller analysis of the problems presented by Ukraine's long term population implosion (including the issue of out-migration patterns and trends) can be found in this post here.

Did (or Didn't) Japan Just Re-introduce Quantitative Easing?

With the US Federal Reserve now adopting what is widely regarded as some variant of quantitative easing (QE), and with the Bank of Japan cutting interest rates amidst economic conditions which BoJ Governor Masaaki Shirakawa describes as "severe", perhaps it is worth taking time out to have a looking at some of the earlier experience of quantitative easing in Japan, in order to ask ourselves why it is that central banks may favour this particular approach this time round, and why it is that with monetary policy at very low levels in a number of countries we are not seeing a simple knee-jerk return to/introduction of some form of Zero Interest Rate Policy (ZIRP). In order to answer such questions we will also need to look at the (none to evident) issue of whether or not it is the case that last week's decisions at the BoJ to all effect and purpose do actually constitute a return to QE.

To anticipate a little bit what will be argued in this rather lengthy post, there is a fundamental difference between the recent move towards QE taken by the Fed (especially after the end of September as explained by James Hamilton in this excellent post), and the policy pursued by the BoJ between 2001 and 2006, and this difference concerns the objectives of the policy. While both initiatives have in common that they are strategies to get that "something extra" out of monetary policy in a very low interest rate environment (near the so-called zero bound), they differ in that the Fed's current objective is to provoke a recovery in economic activity in the US, whereas the BoJ had the objective of provoking a sustained rate of inflation above zero. Obviously the two processes - provoking growth and provoking inflation - are related, but there are also subtle differences in the way the respective banks attempt to achieve these objectives. The Fed is concerned about the liquidity question as part of an ongoing attempt to ease a credit crunch, which it is trying to do by bringing yield spreads (and in particular the so called TED spread) down. No one doubts that once this objective is achieved the Fed will rapidly wind down its balance sheet just as rapidly as it wound it up at the end of September. The BoJ, on the other hand, was concerned to convince market participants that the excess balances would be maintained for a long time interval, beyond the point where the price index simply indicated it might move into positive territory. The BoJ had to convince market participants that they were serious about provoking inflation (that is, what they were really targetting weren't bank reserve balances as such, since they were simply using the levels of these balances as an indirect tool for influencing inflation expectations) while the Fed (at this point at least, of course on a worst case scenario of outright deflation in the US, I am sure Bernanke has a Japan-style "plan b" up his sleeve) currently has no inflation target beyond its general objective of price stability and is not trying to steer inflation expectations upwards. Not yet, anyway. And with that caveat......

The BoJ Cuts Rates, But Not To Zero

So if the Fed isn't exactly applying the BoJ 2001-2006 playbook at the present time, what about the BoJ, is it applying some kind of Bernanke style markII QE, and expanding its balance with the objective of easing the credit crunch? Well, this is a much more plausible interpretation of what is happening, and in some senses the earlier BoJ move (in October) in lowering interest rates from 0.5% to 0.3% could be thought of as some kind of initial step towards the reintroduction of some kind of QE in Japan, while last Friday's cut in the BOJ key policy rate to 0.10 percent (when taken together with the commitment to expand the balance sheet, increase its purchase of JGBs and begin outright purchases of commercial paper) really represents its de-facto initiation , despite the fact that Governor Shirakawa was quick to stress that the bank's decision to cut interest rates and buy more assets did not mark a direct and immediate return to the earlier version of quantitative easing. He was able to say this because the BoJ - despite the evident danger signals - still does not anticipate a return to deflation, and thus is not willing to undertake any commitment to provoke inflation. Of course, they may well be criticised later for not being sufficiently proactive here, just as they were in 1998/1999.

What the BOJ did decide to do was raise the ceiling on the amount of Japanese government bonds it buys each month from 1.2 trillion yen to 1.4 trillion (a 17% increase), as well as committing itself to the purchase a of wider range of bonds, and expanding the range of eligible JGBs to include 30-year bonds, floating rate bonds and inflation-indexed bonds.

The Bank also decided to temporarily buy commercial paper outright, following in the footsteps of the U.S. Federal Reserve, despite the strong reservations which have been expressed by a number of BOJ officials in the past about accepting such assets with credit risk. In fact the Bank of Japan has long accepted commercial paper as collateral in its fund operations (and indeed such purchases were an important ingredient in the earlier QE experiment) but has up to now resisted calls to purchase them directly from issuers. The terms and conditions for such purchases still have to be decided, while Governor Shirakawa is still voicing his doubts, so in its press release the BoJ simply stated that all that it had done at this point was undertake to examine the range of corporate instruments and the degree of risk taking that are appropriate for the BoJ.

Thus the BoJ has obviously taken an important step, and is clearly open to the idea that such purchases could be a major instrument in monetary policy. We will obviously need to see more of the details, and some indication of the size of the CP-programme before we can be clearer about how aggressively the BoJ intends to proceed with the initiative at this point, although evidently, once the door is open the measures can obviously be expanded as the situation evolves.

What we can say with rather more conviction is that BoJ policy at this point seems to be oriented more towards the spread between three-month JGBs and the three-month interbank offered rate, Tibor, which rose to its highest level in a decade(0.922%) on December 16 before falling three straight days to hit 0.905% at the Friday fixing. The difference between what the government and Japan’s banks pay to borrow for three months, the so-called TED spread, was running at 46 basis points in mid-week, and this compares with an average of 16 basis points for 2007.

Fiscal And Monetary Tandem

To some extent fiscal and monetary policy is moving in tandem in Japan at the present time (as it is in the US) and the Japanese government also announced last week that it was going to purchase commercial paper, saying that it would buy as much as 20 trillion yen worth of shares held by banks in order to to boost their capital. The measure formed part of an emergency stimulus package worth 43 trillion yen ($489 billion). Thus nearly half of the package will be for purchasing commercial banks' equity holdings as part of efforts to improve the lenders' liquidity, according to the Nikkei business daily.

Evidently if such measures are approved by the Japanese parliament they will push spending to even higher levels. The Finance Ministry's draft budget suggested a spending increase of 6.6 percent to 88.5 trillion yen ($990.9 billion) for the next fiscal year — the biggest ever figure in an initial proposal. The budget proposal expects general spending to rise to 51.7 trillion yen ($578.9 billion) in the next fiscal year, even though tax revenue is projected to fall 13.9 percent to 46.1 trillion yen ($516.2 billion). As a result, Japan will see its primary budget deficit jump to more than 13 trillion yen ($145.6 billion) from 5 trillion yen ($56 billion) this year. This will mean bond issuances will need to rise to 33.9 trillion yen - up by 31.3 percent over fiscal 2008 - to cover the revenue shortfall. The expansion means saying an effective goodbye to Japan's governments goal of balancing the budget by 2011. But Prime Minister Taro Aso, whose popularity rating is falling more quickly than the Spanish construction industry, has made it clear he sees no role for fiscal discipline at a time like this.

In the current fiscal year (which ends next March) tax revenues are now expected to fall 7.13 trillion yen short of an initial estimate of 53.55 trillion yen due to slump in corporate tax revenues as the economy has slid into a recession. The bulk of the tax revenue shortfall will be covered by the government issuing deficit-covering bonds in the second supplementary budget that totals 4.8 trillion yen. To fund the economic steps through the extra budget, the government will also issue so-called construction bonds, which are used for specified purposes such as public works, worth 390 billion yen while dipping into reserves set aside in a special account for "zaito" fiscal investment and loan programmes (FILP). Thus spending in fiscal 2009 is expected to rise by 9.4% while revenue is expected to fall by 13.9% with evident consequences for the fiscal deficit and the size of the accumulated government debt.

On 12 December Prime Minister Aso introduced a 23 trillion yen "livelihood protection package". As part of that package there was a 2 trillion yen ($22 billion) CP purchasing allowance and the government instructed the Japan Finance Corporation (JFC) to engage in "crisis respone operations" and help struggling companies. The Development Bank of Japan is to serve as cashier to fund the CP purchases. Japan's 124 commercial lenders had 25.6 trillion yen in stockholdings at the end of March.

Around 1 trillion yen of low-interest financing for medium to large enterprises was also included and this expenditure will be counted as part of the Fiscal Investment and Loan Programme (FILP), and as a result the programme will expand for the first time in ten years. The ruling LDP has also established a new body the Team To Realise Financial and Real Estate Countermeasures, and this body seems to be pressing for the BoJ to commence open market purchases of JGBs and stocks and REITs, with the estabishment of an entity to purchase more than 10 trillion yen of stocks.


Why Not All The Way To Zero?

Certainly in the United States, it increasingly seems that Ben Bernanke has decided to adopt QE rather than a more straightfoward lowering of the federal funds rate directly to zero. Part of the thinking which lay behind this move was explained by Bernanke himself, in a paper he prepared with Vincent R. Reinhart (Director, Division of Monetary Affairs, Federal Reserve Board) back in 2004.

Bernanke and Reinhart give two reasons for not going all the way to zero. Firstly:

Observers have pointed out that rates on financial instruments typically priced below the overnight rate, such as liquid deposits, shares in money market mutual funds, and collateralized borrowings in the "repo" market, would be squeezed toward zero as the policy rate fell, prompting investors to seek alternatives. Short-term dislocations might result, for example, if funds flowed in large amounts from money market mutual funds into bank deposits. In that case, some commercial paper issuers who have traditionally relied on money market mutual funds for financing would have to seek out new sources, while banks would need to find productive uses for the deposit inflows and perhaps face changes in regulatory capital requirements. In addition, liquidity in some markets might be affected; for example, the incentive for reserve managers to trade federal funds diminishes as the overnight rate falls, probably thinning brokering in that market.

and secondly:

"A quite different argument for engaging in alternative monetary policies before lowering the overnight rate all the way to zero is that the public might interpret a zero instrument rate as evidence that the central bank has "run out of ammunition." That is, low rates risk fostering the misimpression that monetary policy is ineffective. As we have stressed, that would indeed be a misimpression, as the central bank has means of providing monetary stimulus other than the conventional measure of lowering the overnight nominal interest rate."

Thus, in the first place distortions occur in the normal functioning of the money markets, while in the second a mis-perception arises (on Bernanke's view) among the public that policy is ineffective and that the central bank can then do nothing. Both these lines of reasoning may help explain why the preferred line of attack at this point is to take rates to a very low level, just above zero, but not all the way to zero.


Quantitative Easing In Japan

Returning for a bit to the Japanese experience of QE in the early years of this century, we find that the Bank of Japan embarked (back in March 2001) on what was then an unprecedented monetary policy experiment. This experiment, which is commonly referred to as "quantitative easing," was an attempt to stimulate a Japanese economy which had become stagnant under the dead weight on continuing ongoing deflation expectations and a monetary policy which seemed to have gotten stuck at what had become known as the "zero bound". The BoJ had come under considerable criticism from a number of academic economists (most notably Ben Bernanke and Paul Krugman, see bibliography below) for failing to respond aggressively enough to the deflation problem in the 1990s.

QE was introduced as a response to what was seen as the failure of earlier monetary policy. As a response to the growing deflation problem following the onset of a sharp recession Japan lowered its overnight call rate from around 0.43% to 0.25% in September 1998. The rate was further lowered to near 0% in March 1999. In April 1999, the BOJ made an initial promise (subsequently seen as inadequate) to maintain a zero interest rate “until deflationary concerns are dispelled” - thus began the so-called zero interest rate policy (ZIRP). Following the application of this policy the Japanese economy appeared to be recovering, although not the price level, since it grew at a 3.3% year on year pace between Q3 1999 and Q3 2000. As a result the BoJ abandoned the ZIRP policy in August 2000, and it was this abandonment which has been the object of so much criticism - especially, and most notably, from Paul Krugman.

The economy, however, rapidly fell back into another serious recession following the global decline in the demand for high-tech goods subsequent to the internet bust. Actually my feeling here is that many of the critics are confusing two (logically, if not always practically) separate issues here, the export dependence of an elderly Japanese economy with insipid domestic demand growth, and the problem of the internal price level, or deflation. The two are obviously inter-related, but not so simply as to say that the Japanese economy fell back into recession due to the 2000 BoJ tightening of monetary policy. Undoubtedly the deflation problem worsened as a result of this policy, but the recession came because Japan was unfortunate enough to apply this policy just as the global economy went south bigtime, and again we can see the same sort of process at work in 2007, since the move of Japan's economy back towards recession is connected with export dependence (which could be to do with the high median age of its population) and not a by-product of the decision to end QE in 2006.

Be all this as it may, as a reaction to the renewed recession the BOJ announced the introduction of the quantitative easing policy in March 2001.

As I say above a key component of QE is the way the central bank handles expectations, and the BOJ initially committed to maintain the policy until the core consumer price index registered "stably" a 0% or a positive increase year on year. This commitment was further modified in October 2003 when the BOJ committed itself to continue providing ample liquidity "until both actual and expected inflation turned positive".

The core of QE was the maintainence of an ample liquidity supply by using the current account balances (CABs) at the BOJ as the operating policy target, with the commitment to maintain ample liquidity provision until the rate of change in the core CPI becomes positive on a sustained basis. Thus the focus of policy becomes not the interest rate itself, but the amount of liquidity as reflected in the current balances. In fact during the ZIRP period, the overnight call rate never actually reached zero, but declined to at most 0.01%, while during the period of QE, the rate further declined to 0.001%.

The BOJ also announced that it was ready to increase the amount of purchases of long-term government bonds in order to meet the target on the CABs. The target on the CABs was raised several times, reaching ¥ 30-35 trillion in January 2004, compared to the baseline required reserves which were running at approximately ¥ 6 trillion. In order to meet such targets the BOJ conducted various purchasing operations including the purchase of bills and commercial paper (CPs) in addition to treasury bills (TBs) and government bonds. After 2003, the BOJ also started buying asset-backed commercial paper (ABCPs) and asset-backed securities (ABSs).

Initially the CAB target was set at ¥ 5 trillion (in March 2001) at a time when the level of CABs was around ¥ 4 trillion, thus the initial diffeence was not that great. By May 2004 the CABs had grown eightfold, with an average annual growth rate of 92%. The principle vehicle of liquidity intervention was the purchase of JGBs and during the same period the BoJ purchased ¥ 37.8 trillion in Japan government bonds. The amount of monthly purchases of JGBs has been set and pre-announced by the BOJ. This amount was equivalent to 0.4 trillion yen per month in March 2001 and was gradually increased to 1.2 trillion yen by May 2004. As a result of these policies Japan's monetary base grew by 67% over the same period.

The three building blocks of Japanese QE were thus ensuring ample liquidity provision, commitment to continue such liquidity provision, and the use of various types of market operations, especially purchasing of long-term government bonds, and in many ways these correspond to the three balance sheet expansion mechanisms identified by Bernanke and Reinhart (2004) whereby a central bank can operate an expansionary monetary policy even at very low interest rates.

However, the two approaches are not identical. The BOJ policy of increasing the CAB target may have had the effect of making the liquidity-providing commitment more credible, and the BOJ’s long-term government bond purchasing operations certainly represented the major tool to meet the target on the CABs. The possibility remains, however, that changes in the composition of the BOJ’s balance sheet caused by its market operations have had some effects on the term structure of interest rates. While there exist differences between the policies these authors propose and those adopted by the BOJ, the basic ideas are the same. Even at a zero short-term interest rate, it is possible to pursue further monetary easing that affects expected future short-term interest rates and thus current long-term interest rates through a commitment to appropriate future monetary policy paths.

The policy was lifted five years later, in March 2006. At the launch of the program, many were skeptical that it would have any impact on the real economy, as overnight interest rates were already close to zero, and thus flooding Japanese commercial banks with excess reserves might only amount to swapoing two assets both of which had close to zero yields. Others had been highly critical of the Bank of Japan in the years prior to the introduction of QE (among others Ben Bernanke himself, see here), in particular for their strong reluctance to engage in open ended "unsterilised" interventions. With the introduction of quantitative easing all of that changed to some considerable extent.

Whether the ZIRP and/or RZIRP have affected expected future short-term interest rates, however, is a more subtle question than it initially appears to be. Even without any commitment by the central bank, the market normally forms expectations about future monetary policy stances, ie the path of short-term interest rates.

The Latest Fed Initiative


The Federal Reserve Open-Market Committee decided this week that it was going to use “all available tools” in an attempt to generate a resumption of GDP growth in the United States. This, and the maintenance of price stability, would seem to be the Fed's principal objectives at the present time, and the effective demotion of the benchmark interest rate as a focus of policy attention (the target for overnight loans between banks will henceforth and until conditions improve be maintained in a range between zero to 0.25 percent) is merely a commitment to maintaining a low interest rate environment while the other tools, the balance sheet enhancing ones, do the actual heavy lifting. Since this rate objective is now not going to change in the foreseeable future (the Fed's commitment is for "as long as it takes"), the focus of attention will turn to the liquidity providing measures which the Fed will adopt and to the TED spread as an indicator of the degree of severity of the credit crunch.

As a consequence the Federal Reserve is now exploring a wide range of possibilities, including open market purchases of lower-rated securities, with backing from the Treasury. The Fed thus looks set to expand its current $600 billion initiative to buy debt issued or backed by the government-chartered mortgage-finance companies - it is alreadt trying to lower mortgage rates via the purchase of up to $100 billion of Fannie Mae and Freddie Mac debt as well as $500 billion of mortgage-backed securities they have guaranteed. It is also “evaluating” purchases of longer-term Treasury securities. It may well also enhance other existing programs which include the purchase of commercial paper from companies and financial firms and a offering a backstop for money-market mutual funds.

Thus composition and size of its balance sheet will now be the Fed’s principal policy focus, and, in a key difference with Japan’s earlier quantitative easing experience, the Fed is targeting specific assets for purchase to lower credit spreads rather than expanding the amount of cash in the banking system per se. In fact the Fed will still work to maintain large quantities of liquidity in the bank reserve balances, but whereas the BoJ principally increased the balances through the purchase of JGBs the Fed is placing much more emphasis on the direct purchase of agency securities, on the acquisition of mortgage-backed securities and on lending money directly to the private sector.

“The focus of the committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level,” the FOMC said.

The Fed “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the Federal Open Market Committee said today in a statement in Washington. “Weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

These moves have already increased the Fed’s balance sheet substantially, and it has risen to a current $2.26 trillion from $868 billion in July 2007. And in addition there is the $700 billion Troubled Asset Relief Program, which the U.S. Treasury has been using since October to channel about $335 billion of capital injections into banks and other financial institutions.

The federal funds target rate has been steadily weakening as a monetary policy tool simply because the flood of funds the Fed has been sending to the markets since late September has meant that the average daily rate (or effective rate) has trade below the actual policy goal rate on every day since Oct. 10. The gap between the target and the effective rate, or average daily market rate, has averaged about a half point since September 12. The gap averaged just above zero from the start of this year up to September 12. This state of affairs is thus not that dis-similar from the Japanese situation in 1998/99, since at that point the actual Japanese overnight market rate was systematically trading below its overnight target and a reluctant BoJ was eventually forced to cut its target rate in two small steps.

So is this quantitative easing? Well the Fed statement said simply that it would be using its balance sheet to support credit markets and the economy, however a senior Fed explained to the somewhat bemused journalists that the bank's approach is seen as being distinct from quantitative easing as practised by the Japanese. The official pointed out that Fed's balance sheet has two sides: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan's quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed's focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. This securities-lending approach is intended to directly affects credit spreads, which is where the Fed perceives the problem to be today.

The Fed official stressed in his explanation that the Fed does not expect deflation, but expects inflation to fall.


Quantitative Easing Or Not Quantitative Easing?

So do we or don't we have quantitative easing in Japan? Well my opinion is that the BoJ has effectively turned to some kind of quantitative easing regime, despite protests to the contrary from Governor Shirakawa at the BoJ post meeting press briefing. But this version of QE is different from the previous one, since the BoJ is not targeting inflation expectations at this point. Governor Shirakawa has argued strongly for keeping short-term money market interest rates slightly positive to improve the functioning of the money market, so it is unlikely the BoJ will move to further reduce the overnight target rate. What I do think we will see, however, is more moves to expand the BoJ's balance sheet, focussing initially the asset side and on the three-month Tibor rate spread with three-month JGBs - purchasing ever increasing quantities of government debt, followed by a subtle shift over to emphasising the liabilities side of the balance sheet, and the size of current balances as deflation locks in and the bank once more attempts to "steer" expectations about the price level.

To try to help us understand where we are, and where we aren't here, below I am reproducing a selection of Sirakawa's comments in the press conference which followed the rate setting meeting.

Shirakawa's Comments After The Announcement

"In broad terms, Japanese interest rates are already close to zero. The last time the BOJ adopted quantitative easing, it aggressively supplied cash to markets to push down rates to zero. In that sense, we haven't adopted quantitative easing or a zero rate policy ...

"It was a decision reached after a comprehensive assessment on how to stimulate the economy and also pay heed to market functions."


"Of course, we can't say we will never opt for a certain monetary policy step in the future. This time we cut the call rate target but left the interest we pay to excess reserves parked at the BOJ at 0.1 percent, after much debate about how to maintain money market functions ...

"We cut rates to 0.1 percent and decided to buy various assets, but these measures are not aimed at expanding the BOJ's balance sheet. We will of course aim to stabilise financial markets and support corporate financing. We are taking measures for these purposes, not to expand our balance sheet."

(Asked about the effect of the BOJ's past experience of pledging to keep monetary conditions easy until consumer inflation emerged, or so-called 'policy duration effect')

"Pledging to maintain low interest rates even when the economy was recovering had a certain effect in pushing down long-term interest rates ... When the economy is in bad shape, no one believes the central bank will raise rates so the impact of the commitment is not big."

"We've raised JGB buying by 200 billion yen in the past. So I think it was a natural increment........We'll start buying long bonds and we'll start buying based on maturity ... Long bonds will remain on our balance sheet for a long time. But we judged that our holding of JGBs will remain below the amount of notes in circulation even after the increase.......I'm not planning to increase the amount of JGB buying further for the time being......Regarding the question of whether we are aiming at bringing down long-term interest rates, the increase in the purchase of long-term bonds is not aimed at that.

"This is about money market operations, not about lowering long-term interest rates......It is aimed at avoiding a distortion of money markets that could occur by relying too much on short-term market operations in providing long-term funds......The increase could affect the demand-supply balance of a certain sector of JGBs as a result. But we are not aiming to reducing risk premium (on long-term bonds)."

"The last time Japan adopted quantitative easing, it was a policy aimed at stimulating the economy through massive liquidity supply by targeting the amount of current account reserves at the BOJ. In this sense, both the United States and Japan have not adopted quantitative easing.

"Of course, we continue to provide liquidity actively to maintain financial market stability and smooth corporate financing. The current account balance could increase as a result of measures to stabilise the financial market and banking system, but that has a somewhat different meaning than last time ...

"Given our experience in the past, we can say that increasing the amount of money was effective in stabilising the financial system. As for its impact on the economy and prices, I'm not saying it didn't have an effect at all. But it was hard to find a clear effect.......It's hard to say anything about the future because members of the policy board could change by then ... Still, no one on the BOJ board seems to think that boosting base money would stimulate the economy."


"Every board member agreed that economic conditions are very severe. We want to stimulate the economy through interest rates but given that rates were already at 0.30 percent so there was limited room for cuts. ......And we wanted to keep the functioning of money markets. We didn't want it to weaken because of our policy.....By cutting interest rates to 0.10 percent, some of the function of money markets may be hampered. But by maintaining positive interest rates, there will remain incentives for trade and the bedrock for financial activity."

Well, there certainly do seem to be a lot of subtleties and nuanceshere, and a lot market observers may well have real difficulties in understanding what he is trying to say, although I do hope that after reading this post, many of my readers may not now be labouring under that difficulty (it certainly took me some time to get through to what was actually going on). In this sense Shirakawa might do well to reflect on this key point in Bernanke and Reinhardt:

"Note that the expectational and fiscal channels of quantitative easing, though not the portfolio substitution channel, require the central bank to make a credible commitment to not reverse its open-market operations, at least until certain conditions are met. Thus, this approach also poses communication challenges for monetary policy makers."

The Fed does seem in this sense to have been somewhat clearer:

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. "

Did Quantitative Easing As Tool For Monetary Policy Caught In A Liquidity Trap Actually Work In Japan?

Well, this is the three trillion yen question isn't it. Certainly there is no consensus that this policy, rather than the sudden sharp rise in global commodity prices, was what dragged Japanese headline CPI numbers kicking and screaming out of years of deflation, nor is it clear that the termination of this policy, rather than the global trade slump which has followed the credit crunch, is what is sucking the Japanese CPI back below zero. There is little strong evidence on either side about the precise impact of QE on the price level, and certainly any effect there may be is small. Perhaps the best that can be said is that this policy helped avoid a worse outcome, with Japanese prices sinking ever deeper into deflation.

But it does now seem that back we jolly well go, since Japanese core annual inflation slowed in October for a second straight month, raising concerns that the sharp negative energy price shock heightens the risk of a return to deflation as we enter 2009. The core consumer index - which excludes volatile prices of fresh fruit, vegetables and seafood but includes the cost of oil products that are falling rapidly in price - rose 1.9 percent in October from a year earlier, slipping back from the 2.3 percent increase in September. Annual inflation excluding oil products dipped to 1.2 percent while Tokyo figures for November point to further falls in inflation.

If we look at what is known as the "core-core" index (which strips out both energy and fresh food) then we can see that it is far from clear that Japan ever really escaped from the deflation trap, since this reading has been completely flatlining around (and normally slighly below) zero over the last twelve months, and with a very large capacity overhang now developing, this index will almost certainly get back into negative territory very, very soon.

Appendix: Why Japan And The United States Are Different

Finally, should we anticipate a Japanese "outcome" in the United States. I think not. The US economy may well have a brush with deflation in 2009, and monetary policy may not be as effective as Bernanke hopes in avoiding this, but equally the US economy is unlikely to get stuck in deflation in the same way that Japan has (which isn't the same thing as saying we may not see a protracted slowdown in headline US GDP growth) since Japan's ongoing deflation issue is structural, and associated with the country's underlying demographic dynamics. As an illustration of this, I am reproducing here in the form of an appendix some excerpts from one of Paul Krugman's more widely read analytical papers on the Japan problem - It's Baaack! Japan's Slump And The Return Of The Liquidity Trap. Obviously this extract doesn't "establish" anything, but it does provide an illustration of one possible way of looking at the Japan question, and does suggest (since US demographics are very, very different) one good reason for not anticipating a Japan outcome in the US.

One way of stating the liquidity trap problem is to say that it occurs when the equilibrium real interest rate, the rate at which savings and investment would be equal at potential output, is negative. An immediate question is therefore how this can happen in an economy which is not the simple endowment economy described above, but one in which productive investment can take place - and in which the marginal product of capital, while it can be low, can hardly be negative. An answer that may be extremely important in practice is the existence of an equity premium. If the equity premium is as high as the historic U.S. average, the economy could find itself in a liquidity trap even if the rate of return on physical capital is as high as 5 or 6 percent. A further answer is that the rate of return on investment depends not only on the ratio of capital's marginal product to its price, but also on the expected rate of change of that price. An economy in which Tobin's q is expected to decline could offer investors a negative real rate of return despite having a positive marginal product of capital. This point is actually easiest to make if we consider an economy, not with capital, but with land (which can serve as a sort of metaphor for durable capital) - and also if we temporarily depart from the basic setup to consider an overlapping-generations setup, in which each generation works only in its first period of life but consumes only in its second. Let A be the stock of land, and Lt be the labor force in period t - that is, the number of individuals born in that period. Given the special assumption that the young do not consume during their working years, but use all their income to buy land from the old, we have a very simple determination of qt, the price of land in terms of output: it must simply be true that

qt.At = wt.Lt


where wt is the marginal product of labor. So in this special setup q itself is not a forward-looking variable; it depends only on the size of the current labor force. However, the expected rate of return on purchases of land is forward-looking. Let Rt be the marginal product of land, and rt the rate of return for the current younger generation. Then we have that:


1 + rt = Rt+1 + qt+1 /qt

Now suppose that demographers project that the next generation will be smaller than the current one, so that the labor force and hence (given elastic demand for labor) the real price of land will decline. Then even though land has a positive marginal product, the expected return from investing in it can in principle be negative. This is a highly stylized example, which begs many questions. However, it at least establishes the principle that a liquidity trap can occur despite the existence of productive investment projects.


In fact, this exercise suggests that the real puzzle is not why Japan is now in a liquidity trap, but why this trap did not materialize sooner. How was Japan able to invest so much, at relatively high real interest rates, before the 1990s? The most obvious answer is some version of the accelerator: investment demand was high because of Japan's sustained high growth rate, and therefore ultimately because of that high rate of potential output growth. In that case the slump in investment demand in the 1990s may be explained in part by a slowdown in the underlying sources of Japanese potential growth, and especially in prospective potential growth.

As noted above, there is considerable uncertainty about the actual rate of Japanese potential growth in the 1990s. Nonetheless, it is likely that there has been a slowdown in the rate of increase in total factor productivity, even cyclically adjusted. 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; indeed, the budgetary consequences of an aging population have been a preoccupation of the Ministry of Finance, and an important factor inhibiting expansionary fiscal policy. Why, then, didn't this prospect start to affect long-term investment projects in the 1980s? One answer is that businesses may have believed that total factor productivity would grow rapidly enough to make up for a declining work force. However, the "bubble economy" of the late 1980s may also have masked the underlying decline in investment opportunities, and hence delayed the day of reckoning.

Excerpted from Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap

Bibliography

Ben S. Bernanke and Vincent R. Reinhart, Director, Division of Monetary Affairs, Federal Reserve. Conducting Monetary Policy at Very Low Short-Term Interest Rates. Paper Presented in the form of a Lecture at the International Center for Monetary and Banking Studies , Geneva, Switzerland, 2002.


Ben S. Bernanke, Japanese Monetary Policy: A Case of Self-Induced Paralysis?, University of Princeton, Working Paper, 1999

Athanasios Orphanides, Board of Governors of the Federal Reserve System, Monetary Policy in Deflation: The Liquidity Trap in History and Practice, December 2003.

Kobayashi, Takeshi, Mark M. Spiegel, and Nobuyoshi Yamori. "Quantitative Easing and Japanese Bank Equity Values.", Journal of the Japanese and International Economies, 2006

Oda, Nobuyuki, and Kazuo Ueda. 2005. "The Effects of the Bank of Japan's Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach." Bank of Japan Working Paper Series, No. 05-E-6.

Baba, Naohiko, Motoharu Nakashima, Yosuke Shigemi, Kazuo Ueda, and Hiroshi Ugai. 2005. "Japan's Deflation, Problems in the Financial System, and Monetary Policy." Monetary and Economic Studies 23(1), pp. 47-111.


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Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap

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