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Sunday, October 13, 2002


Glenn Hubbard, the chairman of Bush's Council of Economic Advisers makes it official, deflation is greatly over-rated because the US Economy is going just fine:

This modern deflation scenario seems to make a lot of sense - until you get out your calculator. When you do, the basic features of the US economy look quite good and deflation appears unlikely. To start with, analy sis of the productivity data over the past six quarters confirms some of the best news that economists have delivered in a generation - the acceleration in productivity growth that began in 1995 continues unabated. Thanks to this, today's consumers can look forward to real incomes that grow much more quickly than they have during the past 30 years - a good omen for current consumption.

Of course, one can point to the strength of the housing market as a factor keeping consumption strong. House values have risen and low mortgage rates have encouraged homeowners to take out some of the equity in their homes through refinancing. But while this process has been a part of healthy consumption growth, it has been only a part..............The question of why house prices have risen so much in the past few years is interesting. The surge in immigration during the 1990s and the lack of land suitable for new housing in some cities with tight zoning restrictions are probably part of the answer. But fears that the US housing market is in the midst of a bubble are unwarranted. Behind any bubble is the hope that an investor can purchase an asset for one price and sell it quickly for a higher price. This is hard to achieve with houses, because of the high transaction costs in housing markets. And without a rapid and nationwide decline in housing wealth, it is hard to see how deflation can occur.

While in the long run deflation - like inflation - is a monetary phenomenon, low aggregate demand is not likely to push the US toward deflation any time soon. It is a pretty boring story, compared with those told by the deflationists. But it does pretty well when confronted with the facts.
Source: Financial Times

Now perhaps this article would be eminently forgetable, were it not for the fact that Paul Krugman has seen fit to enter the fray. I post the Krugman piece in full.

JOBS, JOBS, JOBS (10/10/02)
Of all the things to be upset about right now, a silly fallacy in Glenn Hubbard's FT article today doesn't rate very high. But it's a fallacy I hear a lot, so let me take a minute to bash it.

Hubbard, like so many people, asserts that one reason for optimism about economic recovery is our continuing high rate of productivity growth. At first this sounds right: higher productivity growth means, other things equal, faster income growth, which means more spending, which means faster demand growth. So all that is good for recovery, right?

No, not really. What most people mean by recovery is job growth - an economy that is growing, but in which employment grows more slowly than the labor force, may be in recovery by some measures, but it will feel like it's still in recession.

Now what does productivity growth do? It raises incomes and hence demand. But it also raises the growth rate the economy needs to achieve to create jobs, and to a first approximation it does so by exactly the same amount. That is, an economy with 3 percent productivity growth will, other things equal, have 2 percent faster demand growth than an economy with 1 percent productivity growth; but it will also need a growth rate 2 percent higher to keep unemployment from rising.

In fact, the "productivity growth helps jobs" story, if that's what it is, is just the flip side of the lump-of-labor fallacy, which says that productivity growth reduces employment - and equally wrong. (There's a different argument, about how productivity growth reduces the NAIRU - but that's about the supply side, not the demand side).

You might say that I'm being too abstract; what about the lessons of history? But they all confirm this point. Terrific productivity performance in the 1920s didn't protect us against the Depression; all through the 70s and 80s Europe had higher productivity growth than the U.S., but worse job growth; you can multiply the examples.

I'm not surprised that Hubbard would make a silly argument; he is not, after all, a free man. But it's a sign of desperation, I think, that so many people have bought into this fallacy.

Hubbard clearly has it wrong. Rising productivity can be accompanied by either rising incomes, or falling prices, it depends. And it's this 'depends' that really is at the issue here. Hubbard clearly believes that the current increasing LABOUR productivity will lead to increasing real incomes, increased consumption, and thus, presumably increased investment (although this is my deduced mechanism since it isn't presented explicity), because he says so.

"the acceleration in productivity growth that began in 1995 continues unabated. Thanks to this, today's consumers can look forward to real incomes that grow much more quickly than they have during the past 30 years - a good omen for current consumption."

The deflationist argument is that the other possibility exists, that the increased productivity leads to falling prices as firms compete to sell. This is the role of the output gap argument. This argument is also backed by the idea that current consumption has been maintained by borrowing. It's not the wealth loss caused by the drop in the financial markets that's the problem, but the increased debt encouraged by the false sense of security provided by rising assett, and subsequently rising property, values.

One of the problems here is that productivity is a poorly understood phenomenon - by all of us. The majority of the numbers being bandied-about at the moment seem to be numbers for 'labour productivity' from the BLS. And this is where the argument starts, because the 'jobless recovery' is a product of another process, the relentless drive by corporate America to cut costs, ergo increase output while not contracting new labour, or hiring young workers on short term contracts etc. It's very early to start making conjectures about these numbers because the serious analysis isn't through yet. But it is entirely consistent with the deflation/output-gap argument. US workers are trapped in a kind of modern version of the olive press, and at some stage all that can be will have been squeezed.

"Now what does productivity growth do?" Perhaps this is an unfortunate way to present the story, since maybe productivity growth doesn't 'do' anything. In the present context this productivity growth is an effect of something, and it's understanding this 'something' that is the problem.

Paul Krugman himself in another piece on the related topic of the output gap clarifies what he is saying: "Brad DeLong is quite right that there's no such thing as excess capacity for the economy as a whole. I've been vociferous about that myself in the past. What I meant to say was over-investment in short-lived business capital, mainly tech, relative to other resources...."

However it is in this last point, rather than the conjuctural productivity/output-gap argument, where the real problem lies. You see, I think it's just not credible to say that "over-investment in short-lived business capital" is pushing the global economy into a period of secular deflation (I take it as read that Hubbard just doesn't understand what's going on here). The normal expectation would be that this excess capacity would be worked-off, and on we would go again. But it's all too evident that this just isn't happening.

I've already indicated in this column (ad infinitum) some possible candidates: the continuing fall in ICT and biotech prices, the structure of world trade (especially China, but my guess is India won't be too long making its presence felt), and demographic processes in the G3 countries.

If demography is going to be important in the story then the deflation problem should be more acute in the EU countries (Italy and Spain in particular, but also Germany) than in the US, but obviously with Japan and Europe going downwards the US is bound to be sucked in.

Put this another way: if demography is not important, then why, in Stephen Roach's words is the world lacking an alternative global growth engine right now. Surely using conventional growth theory the 'convergence factor' should be offering plenty of catching-up momentum elsewhere.

Perhaps demography will turn out to be the modern economists 'pons assinorum'.

Incidentally, while the Glen Hubbard piece may be eminently forgetable, the ever-to-be-recommended Economist has a very nice (Krugman influenced?) piece on deflation (see below), and especially the dangers for Germany right now - going 'naked into the conference chamber' - thanks to the voluntary Euro disarmament. (It's hard to remember that it was only 10 months ago that the world was cheering on this single currency 'experiment' - so why, oh why, have all the evangelists suddenly gone silent?).
Now as far as the liklehood of deflation goes, either you believe the deflationist story or you don't. But Hubbard is wrong. There are TWO possible outcomes, and this time next year we'll have a better idea which one of the two it is going to be.

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