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Friday, March 28, 2003

German Growth Forecasts 2003

How much will the Germany economy grow in 2003? The intelligent answer, I suppose, really should be that this is a fools' question, and the answer is anyone's guess. That of course is not the position adopted by the German government who, if the reports are correct, are busy debating whether to drop the anticipated growth forecast from its current 1% to the 0.25% - 0.5% range, or to make only a more 'moderate' reduction. And how many camels can you balance on the end of a needle you may well ask? My own view is all of this is full of plenty of downside risk. I wouldn't want to stick my neck out too far yet, but negative growth 2003 in Germany would not surprise me at all. Of course I don't have all those fancy government models to play around with (but then neither do I have to convince anyone that I'm staying within a 3% deficit limit), so this is based pretty much on looking at the information coming in, especially the February figures, and applying my 'animal instincts'.

The German government will next month bow to the harsher economic climate caused by the war in Iraq and slash its growth forecast for this year. The size of the cut from the 1 per cent estimate for gross domestic product growth remains unclear, amid a stand-off between senior ministers. Hans Eichel, the finance minister, favours a sharp reduction to between 0.25 per cent and 0.5 per cent. By contrast, officials say Wolfgang Clement, the economics and labour minister, prefers a smaller cut to avoid weakening already shaky business confidence. Either way, 1 per cent has appeared increasingly untenable in the light of much less optimistic predictions from Germany's six leading economic institutes, and private sector economists, some of whom expect growth to be little better than last year's 0.2 per cent.

A formal revision had been expected by May, when a specialist government tax forecasting panel produces its latest report. But officials said the announcement would be brought forward in view of forthcoming, separate reassessments of the economy by the institutes, the International Monetary Fund and the Organisation for Economic Co-operation and Development.The revision will have repercussions for this year's budget and Germany's expectation of holding the deficit below the 3 per cent ceiling set out in the rules for the euro.Mr Eichel has said he expected the budget deficit to be 2.85 per cent of GDP this year, but warned that matters could deteriorate through unforeseen circumstances, such as prolonged economic instability because of Iraq.

Economists, who had already said the figure was optimistic, added that new spending measures announced this month made it inevitable that Germany would exceed 3 per cent of GDP for a second year running. In 2002, the deficit was 3.6 per cent of GDP.The new growth forecast would mark the second downward revision in two months after the government cut its former 1.5 per cent estimate to 1 per cent in January. Growth of just 0.5 per cent would mean tax revenues alone would be about €2bn ($2.14bn, £1.35bn) below expectations. Official figures for January and February showed revenues had already fallen 5.9 per cent below last year's already weak level. Lower growth would also have ominous implications for government spending, already subject to some bold assumptions this year. The government's aim - questioned by many economists - to eliminate subsidies to the Federal Labour Agency, responsible for unemployment benefit, would appear more doubtful than ever. Forecasts for pensions would also have to be revised, all leading to a likely rise in borrowing.
Source: Financial Times

Thursday, March 27, 2003

The Gloom of Consensus

Looking into the screen at all the info that's coming in, it's kinda hard to be optimistic. The news on the housing front, if confirmed, will make a consumer cave-in all but inevitable. So then we must look to the other, business investment side. And it's looking at this that makes it hard to be an optimist. Stephen Roach started the ball rolling in Beijing:

The overall sentiment of this group of investors made me look like a bull. They conceded the downside to virtually every gloomy forecast I tossed out, whether it was GDP growth, prices, or profits in every major region of the world. And this wasn’t a group of cyclical bears -- most of them were caught up in the grips of more secular perils. Mainly Asian specialists, augmented by a sprinkling of European and US-focused investors, the assembled group had lived through many a boom-bust cycle. A majority came from bubble-prone Hong Kong, where despair is deepening by the day. The prewar upswing in world equity markets did little to whet their appetites. Long bruised and battered, these investors viewed rallies as selling opportunities -- not make-or-break entry points. Macro was dead (again) and stock selection was seen as the essence of investor survival.
Source: Morgan Stanley Global Economic Forum

Then Morgan Stanley's Robert Alan Feldman chipped-in his sixpennny worth: investors have become interested in, of all things, Japan. But here's the rub, they're interested in order to see what may be in store for Europe on the one hand, and how to make pickings from the carnage, on the other:

At a recent Morgan Stanley conference of global investors in Beijing, the gloom of the consensus was overwhelming, as Stephen Roach described in his piece “Pondering Two Worlds in China” (Global Economic Forum, March 24, 2003). At that conference, however, there was an interesting sub-theme for those who invest in Japan. In contrast to other recent Morgan Stanley conferences, there was huge interest in Japan, which took two forms. One was an interest in the pathology of Japan’s weak performance over the last decade. The second form of interest concerned allure -- i.e., identifying winners in Japan -- which heretofore has been routinely dismissed as an oxymoron. Not so with this group.

In the pathology department, the key element was how investors could learn from the financial system disaster in Japan in defending themselves against potential problems -- particularly in Europe. Indeed, one Europe specialist likened investment in European insurers to playing Russian roulette with five bullets -- a sentiment very familiar to those who have invested in hopes of recovery of Japanese financial institutions. Asset mismatch, the pension hole, and poor accounting practices -- all themes familiar in Japan -- were trotted forth. For investors in Japanese assets, the question is whether emerging problems in Europe will have direct effects on Japan. While recognizing the interconnections of all financial institutions, it seems that Japan is probably not nearly as exposed as in earlier years. Japanese financial institutions have been reducing foreign involvement for some time.
Source: Morgan Stanley Global Economic Forum

And now, today, the Financial Times brings to our attention the fact that business sentiment is, guess what, gloomy. Now the income that isn't consumed is saved. And the income that is saved, and isn't spent by others buying property, needs, in the final analysis, to be invested, because if not...........The only way out of all this is an investment lead boom, but making that investment a reality depends on whether winning the peace is going to be easier than winning the war. Meantime I guess we'd all better become experts in that little known variable, the velocity of circulation of money. Because if, in the worst case scenario, consumption falters, and investment doesn't materialise, then deflation and declining velocity of circulation are waiting, johnny, just around the corner for you. Beware the ides of March!

While stock markets have pitched queasily with the shifts in sentiment over the war in Iraq, businesses have continued to watch and wait, much as they have done for the past few months. The word from corporate leaders is that while the long hoped-for recovery in business investment may have been set back by the war, an end to the war may be a necessary condition for an upturn, but it is not sufficient in itself. Last year there was clear evidence from the US, Japan and Germany, as well as hints from the UK and France, that the decline in investment that began in 2001 was starting to slow. As war approached, those hopeful signs faded; and many businesses have linked the two developments. In the UK, the Engineering Employers' Federation, which represents many capital equipment manufacturers, has revised sharply downwards its growth forecasts for 2003 from its expectations of three months ago, attributing the change to political uncertainty. Two thirds of chief financial officers polled last week by Financial Executives International, the US lobby group, and Duke University's Fuqua School of Business, claimed they were spending cautiously or delaying investment because of geopolitical concerns. The worry now is that the uncertainty is unlikely to be dispelled very soon.

Fears that the war will drag on may or may not turn out to be justified but businesses are concerned that the broader tensions will persist after the war is over. As Pehr Gyllenhammar, chairman of Aviva, Britain's biggest insurer, puts it: "Some more stability will make a difference but will that necessarily come after the war is over? That can also take time." More fundamentally, many economists warn that economic conditions unrelated to the war have had and will continue to have a more significant influence. Ken Goldstein of the Conference Board, a New York-based business research group, would rank Iraq no higher than third as a concern for companies: behind the lack of pricing power that is squeezing corporate profitability, and the persistent overcapacity that is a legacy of the investment boom of the 1990s."There has been an awful lot of talk on Wall Street about the end of the uncertainty once the war is over, but not on Main Street," he says. "The idea that an end to war would ever have caused a big recovery in investment was putting too much emphasis on it." In the motor industry, for example, there has been short-term crisis planning. Some have stockpiled parts to guard against disruption to supplies while others, including Honda and Toyota in the US, cut advertising as soon as war broke out. But longer-term decisions seem to be based more on generally negative assessments of the economy. Ford cut production plans for April, May and June by 17 per cent before the invasion while General Motors, the biggest carmaker, will produce 10 per cent fewer vehicles. The financial position of companies has improved worldwide: in the US, for example, a financial deficit (negative cash flow) of about 4 per cent of gross domestic product at its peak has fallen to less than 1 per cent. That should signal that the outlook for investment has improved. But Binit Patel of Goldman Sachs expects that corporations will still be reluctant to spend. "If you look at any capital spending model, the key driver has been consumer spending, and we expect consumer spending to slow. When capacity utilisation is already low, companies are just not going to get the feeling that they need to invest."
Source: Financial Times

Japan Deflation Continues

Despite the recent oil price rise, Japan just registered its 23 consecutive month of retail sales decline.

Japan's nationwide retail sales have fallen 0.2 percent in February from a year ago, their 23rd straight month of decline. The drop compares with 2.6 percent fall in January and a 3.4 percent decline in December, the Ministry of Economy, Trade and Industry (METI). A record high jobless rate and falling incomes have made consumers reluctant to spend, with war in Iraq adding to uncertainty.Sales at large retail stores in February rose 0.2 percent from a year earlier after falling a revised 2.2 percent in January. Department store sales were flat in February while supermarket sales grew 0.3 percent year-on-year, METI said. The ministry said sales of automobiles and oil-related products had supported overall sales, while those of clothes and personal computers declined.
Source: Channel News Asia

Oh, Oh: This Doesn't Look too Good

The rise in credit card bad-debt may be only a reflection of the wider use of the cards. The question is: if the lenders start to turn down the spiggots of consumer credit, what happens to US consumption? If the data keeps coming in as it has been the last few days, then I'd say a US recession this year (the infamous double dip) is looking more and more like a done deal, whatever happens on the Iraq front.

Mounting U.S. job losses pushed up credit card delinquencies in the fourth quarter of 2002 to the highest level since the American Bankers Association began tracking the data in 1990, the group said on Wednesday. Credit card delinquencies climbed to 4.07 percent of all accounts in the quarter, up from 4 percent in the third quarter of 2002, which was the previous high, the American Bankers Association said in a statement. "The rise in delinquencies is not surprising given the cumulative weight of layoffs and the poor prospect for reemployment in the face of anemic job growth," said James Chessen, chief economist for the ABA. Analysts said the bump in late payments reflects loans to a broader pool of borrowers rather than wider troubles with U.S. consumer credit. "Banks have now made credit available to a larger number of people at the low end of the income scale, so it's not a big shock that when the economy slows down and unemployment is high that these people get into trouble," said Douglas Lee, president of Economics from Washington.

Consumers tend to rely on savings and credit cards to get through financially tough times, and the final quarter of 2002 was such a period, the ABA's Chessen said. A composite index of consumer loans including auto and home equity loans rose to 2.16 percent of all accounts from 2.06 percent in the third quarter, the ABA said. Delinquencies on home equity loans rose to 1.64 percent. Rising consumer debt delinquencies add to signs that the U.S. economic recession of 2001 and its uncertain recovery have strained the finances of many Americans. Bankruptcies were at a record level last year. Mortgages in foreclosure also reached a record high in the last quarter of 2002, although mortgage bankers say the data shows the number of people unable to meet home loan payments may have peaked.
Source: Yahoo News

Italy Implements It's Own Tax Cut

The Italian government just implemented its own version of the tax cut. It is difficult to see the logic behind this when Italian growth is faltering (only 0.4% growth last year, and most probably negative growth this one).

Italy's parliament Wednesday gave final approval to a wide-ranging tax cut plan through which the centre-right government hopes to give the economy a boost before its term expires in 2006. Prime Minister Silvio Berlusconi's government has already started to implement some tax cuts with its 2003 budget, which has raised concerns at the European Union that Italy will run a higher-than-expected deficit. The 2003 budget focused on cuts to low-income families that will cost the state around EUR5.5 billion. The corporate tax rate was trimmed to 34% from 36%, costing the state some EUR2.0 billion. With the reform approved Wednesday, the government aims to cut and simplify the income tax regime to include just two brackets by 2006 - at 23% for families earning up to EUR100,000 and 33% for those on a higher income. Currently, the income tax brackets are set at 23% on income below EUR15,000; 29% on income between EUR15,000 and EUR29,000; 31% between EUR29,000 and EUR33,000; 39% between EUR33,000 and EUR70,000; and 45% above EUR70,000. The corporate tax rate will be trimmed another percentage point to 33% by 2006. The government has said the speed of the tax cuts will depend on how the economy is performing. Growth in Italy, the euro-zone's third-largest economy behind Germany and France, is stagnant. Gross domestic product expanded a meager 0.4% in 2002, the slowest for nearly a decade. Through its 2003 budget, which relies heavily on one-off measures such as tax amnesties to raise money, the government is hoping to cut the deficit to 1.5% of GDP from 2.3% last year.
Source: Yahoo News

Such cuts are very perplexing when the long term budgetary outlook in Italy looks so preoccupying. The parlous state of Italian finances has been highlighted several times by the European Commission, who also continuously complain about the poor quality of the information received from the Italian government. Italy has, in fact, one of the highest debt/GDP ratios outside Japan (over 100%) and one of the most complicated demographic panoramas in the developed world. For the last two years they have only avoided exceeding the 3% stability pact limit through the use of one-off measures (including the securitisation of public buildings). In a recent study of economic vulnerability to ageing Italy came in eleventh out of the twelve countries studied (the last place being awarded to Spain, which was described as 'Italy without the reforms'). With large reductions in benefits now built in, and little accumulated private wealth available as a fall-back position for large parts of the population, an important section of Italian society surely faces mid-term impoverishment. The absence of extensive public care for the aged, and the strength of family ties, mean that most of the burden will fall on the long-suffering Italian houswife, thus making an increase in female participation rates virtually a non-starter. This is going to be the symmetrical equivalent of getting young mothers out to work when there were no creche or child care facilities available. And in the midst of all this it's hard to see Italy boosting the Total Factor Productivity element by motivating a dynamic intellectual-capital growth push based on the few young people Italian society will have at its disposal. With the problem in such an advanced state maybe there is now not a lot that can be done, but living in the clouds is surely not one of the more recomendable therapies.

By 2040, Italy will have one elder for every working-age adult—putting it in a dead heat with Japan and Spain for the developed world’s worst demographics. On top of that, Italy’s pension spending as a share GDP is the highest in the Index countries, and the Italian elderly are among the least likely to be employed or to receive a private pension. Moreover, Italy’s overall eleventh-place ranking in the Index comes despite a series of pension reforms enacted in the 1990s (the “Amato” and “Dini” reforms) that are scheduled to make steep cuts in future benefits. Without these reforms, Italy would surely be in last place. The open question is whether Italy is likely to make good on its reform promises. Its second place ranking in the benefitdependence category (with family ties second only to Japan) gives some hope. Yet Italy comes in last in the elder-affluence category, a reflection of how seriously these future benefit cuts threaten elder living standards.
Source: Global Ageing Initiative Vulnerability Index

Wednesday, March 26, 2003

Germany: As Expected the Bad News Continues

The latest ifo survey confirms what is, unfortunately, only the expected.

Germany's closely-watched Ifo business confidence index fell in March, reflecting the fragility of the country's economy and worries about the fallout from the military action in Iraq. The headline index produced by the Munich-based institute fell to 88.1 in March from 88.9 in February, below analysts' expectations, as sentiment for the next six months deteriorated. "Signs in the last two months of an upturn in the business climate have not been confirmed for the time being," said Hans-Werner Sinn, Ifo president. Economists had forecast that the index, which is also seen as a barometer of eurozone growth prospects, would stay at around the same level as in February, after two successive months of rises and an interest rate decrease by the European Central Bank had prompted tentative forecasts of an end to stagnation in Europe's largest economy. Wednesday's index is one of the first sentiment indicators released since the start of the war in Iraq last week, though some 80 per cent of the 7,000 companies that take part in the monthly review were surveyed before the US-led military action started.
Source: Financial Times

Is the Housing Bubble Over?

The numbers coming in are certainly preliminary, but the tendency is clear: first it was the UK now the US. I am convinced that the mechanism wherby consumption was sustained while all else failed passed through a housing market on the rise. This bear market in property, which was aftert all is said and done a world wide phenomenon, with Australia, the UK and Spain leading the way, needs to be understood as a knock-on effect of the crack in equity markets. With interest rates at rock bottom, a housing market which only seemed to go up-and-up appeared to be the best protection for savings. The emphasis here, of course, has to be on the word 'seemed'. Now the market 'seems' to be stalling, and it could be all over bar the shouting. If this is confirmed, then the next knock-on effect will be on consumption. Watch-out below!

New home sales in the US have plunged this year at the fastest pace in two decades, and the average home price is below what it was a year ago, according to an official report released on Wednesday that provided the latest, preliminary evidence the US housing market has peaked. The Commerce Department said sales fell to a seasonally adjusted annual rate of 854,000 in February - the lowest level since August 2000. The decline over the past two months is the biggest of any two-month period since February 1982.

The report showed the median home price had fallen 4 per cent over the past year - the biggest 12-month decline since the aftermath of the 1990-91 recession. Analaysts have blamed war and terrorism jitters, the weak economy and last month's unually bad weather for much of the weakness. But the report showed declines across most major regions.The housing market has been a rare bastion of growth for more than three years, but the past few months have seen slowdowns in the rise of home values, the pace of housing construction and a sharp decline in builder optimism, despite declines in mortgage rates to new lows. The FT reported last summer that homebuilder executives, apparently fearful of a future slowdown, had unloaded their own shares of company stock at a record pace through the second quarter of 2002.
Source Financial Times

The Fortunes of War

It's one of the enduring ironies of life that as some get blasted others get rich. Today it's the turn of the stock markets to rise. This, I feel, is what is known as volatility, although it terrifies me to think about the kind of mediatic impact this must be having across the third world, and what they must think of us. Is this a case of hostages of fortune, or fortunes for the hostages. I don't know. But what is clear is that, on all fronts, we are going to have to wait for the dust to settle to see what is really happening.

Stocks climbed on Tuesday as reports of an uprising against Saddam Hussein's forces buoyed investor sentiment a day after the market posted the year's biggest losses on worries over the war's progress.Reports an uprising may have started in the southern Iraqi city of Basra sparked a rally shortly after midday. Iraq's information minister denied the reports, but a British military official said early signs suggest an uprising may be under way. "We will be very keen to capitalize on it," he added. "The news in Basra that there had been a revolt against the Iraq forces there really cheered people a lot," said Brian Pears, head of equity trading at Victory Capital Management. "It definitely brought things back more to a middle ground in terms of our feelings about the war."

The market rally lost some of its luster later after the U.S. Senate, driven by concerns about the cost of war, unexpectedly reversed course and voted to cut President Bush's proposed $726 billion tax cut plan to about $350 billion. The blue-chip Dow Jones industrials ended up 65.55 points, or 0.80 percent, at 8,280.23, after jumping almost 1.5 percent earlier. The tech-laced Nasdaq Composite (^IXIC - news) was up 21.23 points, or 1.55 percent, at 1,391.01, after an earlier rise of more than 2.2 percent. The broad Standard and Poor's 500 added 10.51 points, or 1.22 percent, to 874.74. "We are a headline-driven market," said Arthur Hogan, chief market analyst at Jefferies & Co, as the market bounced throughout the session. Investors are scouring headlines out of Iraq on how and when the U.S.-led war will end. Stocks sank more than 3 percent on Monday, snapping an eight-day streak of gains that pushed the Dow 13 percent higher as grim footage over the weekend reminded investors the war may be longer than some had hoped.
Source: Yahoo News

The Curse of the Twin Deficits

The Economist neatly divides economists into two camps: those who believe that the fundamental problem is uncertainty generated by the war, and those who foresee more fundamental problems. The former group seem to believe that once the war is over the US economy will pick up again quickly and the bad times will become history. This view seems horrendously naieve on two counts: firstly it seems to lack any depth analysis of the current US and global economic situation, and secondly it seems to conveniently forget that the kind of geopolitical uncertainty which Greenspan among others has been referring to extends well beyond the borders of Iraq. Which is only another way of saying that even if the fundamental problem were only confidence and security, this problem is likely to continue long after open hostilities in Iraq come to an end.

The second group is preoccupied by structural imbalances. Clearly the leading voice here is that of Stephen Roach, although recently Alan Greenspan has seemed to be moving more in this direction (there are of course plenty of other 'academic' economists who share this view but they attract far less media attention). This group seem to be concerned by three things: the ongoing impact of a debt-deflation shock following the bursting of the asset bubble, the structural imbalance represented by the US current account deficit, and the growing problem of the US government budget deficit.

To this second group I would like to add a third sub-group. Those economists who are worried by all three previously mentioned factors, but who feel that the killer-app that really settles it is the demographic one. The structural problems of the US economy would, in my view, be serious but containable were this 1973 and not 2003. Were we now back in 1973 the war and all its attendant problems (oil price hike, consumer confidence, dislocation in global markets, declining dollar, rising deficit) would (as it did) bring inflation, but that this inflation would then be containable. (You see I am a good Keynesian at heart, and in any event I do believe the argument that we have become much better at containing inflation's 'ills'. With deflation it is another matter!). It would be containable because there would be large younger generations with the capacity to borrow heavily from the future to buoy up the economy of the present. But this is not the situation today. The younger generations are smaller, and their forward looking credit reduced, especially if what we have lying out there in front of us is growth slowdown and deflation. This is the big liquidity constraint our economies face. The theory available to us for understanding this process may still be weak, but the evidence and the facts are not. Japan has been mired in an 'unexplicable' deflation trap for over a decade now, Germany seems well on the way to entering, and, if my analysis is correct, we should see Italy joining the club in the not too distant future. Stephen Roach pleads, hope against hope, for alternative global engines. But none emerge (except, of course China and India, but that is another story, for another day - although clearly both of these factors may be jobs-negative for the US, in China for manufacturing, and in India for services). It is simply not credible to imagine that (with the possible exception of the UK) structural reform in the EU and Japan will produce a major growth spurt. If they can hold the boat together rather than watching it fall steadily apart then in my book they will be doing well. Bottom line: even giving some ground to the most bullish accounts of the current US prospects it is hard to see strong growth emerging in an increasingly arthritic global economy.

In spite of everything, the American economy has been growing somewhat faster than most of the big industrial economies, and most forecasters still reckon on a reasonably healthy pace of expansion this year. There are now two risks threatening these optimistic assessments, though. One is a difficult, lengthy war which could damage morale at home. Some sectors of the economy—particularly those, like airlines, involving foreign travel—are already braced for more trouble as nervous Americans stay at home. Business investment has yet to recover from the aftermath of the dotcom bubble. Another spectacular terrorist attack on American soil would also knock domestic confidence.

The other risk facing America is one that divides economists into two clear camps. Some argue that the uncertainties caused first by the prospect of war and now by the conflict itself are the only obstacle to a sustained recovery. They believe that once the fighting is finally over, growth will quickly pick up. But another group believes that the American economy is plagued by structural imbalances which could continue to constrain growth even after the war is over. The current-account deficit, now around 5% of GDP, is a key factor: if capital flows into America slowed even more sharply, or dried up, the adjustment involved in reducing the current-account deficit could be painful both for America and the rest of the world.

The other imbalance that troubles economists is the American government’s deficit. Under the Bush administration, large projected surpluses have turned rapidly into deficits as far as the eye can see. The huge $726 billion tax cut which President George Bush has been seeking—the second since he took office just over two years ago—has pushed off into the far distance any serious prospect of moving back into surplus.

Among those who have expressed concern about this is the influential chairman of the Federal Reserve, Alan Greenspan. He worries that such large deficits could crowd out private-sector investment and push up interest rates in the longer term. While on balance Mr Greenspan is optimistic about America’s economic prospects once the current geopolitical uncertainties have ended, assuming they do, he has also raised the possibility that other measures will be needed to stimulate the economy. But Mr Greenspan cautioned against the president’s latest stimulus package because he thinks it is too soon to know what measures might be needed, and because he is no fan of large government deficits.
Source: The Economist

Tuesday, March 25, 2003

UK House Prices Begin to Wobble

It's too early yet to say whether or not this is the begining of the break in the run, but certainly for the time being the UK housing market has run out of steam. This is one to watch closely. One small detail of interest here for the connoiseur of 'panics, manias and crashes': it is often said that one of the prepcipitating factors which may burst a bubble is a tightening in the lending conditions, well this is what seems to be happening. And when lenders refuse to continue to fuel the run, well the run screaches to a halt.

UK house price growth slowed to zero this month, as nervous home buyers put off purchases because of uncertainty over Iraq, according to Hometrack, the residential property company.Its March survey of 4000 estate agents showed house price inflation fell to zero for the month, following a steady decline from a peak of 2 per cent last May.

Hometrack said the slowdown had been particularly marked in London and the south east, where price falls were widespread.The largest drops were registered in central London and the City, which fell 0.4 per cent; Berkshire, which slipped by 0.4 per cent; and Wiltshire and Surrey, where prices fell by 0.3 per cent. House prices continued to rise in the north. The highest increases were recorded in Cumbria, with 0.8 per cent; the East Riding of Yorkshire at 0.4 per cent; Mid Wales with 0.3 per cent; North Lincolnshire at 0.3 per cent and Dorset with 0.2 per cent.

Hometrack said it was taking an average of five weeks to sell a home, compared to 2.8 weeks recorded at the height of the boom last May. It said the average house price in the UK in March stood at £135,500. John Wrigglesworth, Hometrack's housing economist said house price stagnation looked "set to continue", led by the marked slowdown in activity in London and the south-east. "Despite low interest rates, high employment and growing income, the heat has definitely left the market," Mr Wriglesworth said. "Prospective home hunters are holding back from buying, not least due to worries and insecurity over the consequences of the war with Iraq. Fear dissuades people from moving and they stay put."Hometrack said that while mortgage repayments as a percentage of income were relatively low, most lenders were limiting mortgage offers to 3.5 times income. It said this appeared to be "putting a ceiling" on house price affordability, particularly at the top end of the market. Mr Wriglesworth said: "It appears that the prudence of lenders is helping put the brakes on house price rises. While they were happy to lend three times income when mortgage rates were 12 per cent ten years ago, they are reluctant to lend more than 3.5 times income, even though mortgage rates are currently lower than 5 per cent. This is effectively putting a ceiling on the level of house prices."
Source: Financial Times

Markets Take a Turn for the Downside

If ever we had any doubts what the term 'volatility' really meant, the events of the last seven days must have served to put an end to them. Last week, as the global equity markets apparently 'factored-in' a short war in Iraq, substantial gains were registered all round. This week, on the back of negative images from the Iraq front, it seems the process may be reversed. And long run prospects? These, surely, are impossible to forsee. 'Poor visibility' can never have been a better applied than as a description for what we currently face. Even on the best case war scenario, the future certainly looks a good deal more complicated than it did a week ago, and downside risks stronger than ever.

Fears of a prolonged, messy war in Iraq (news - web sites) swept financial markets for a second day in a row on Tuesday, knocking stocks, boosting oil prices and hitting the dollar. Gold was up $3 an ounce and bond prices climbed, pushing down their yields sharply, as investors sought safe havens. Governments across the world were also beginning to count the cost of the war. President Bush was seeking $75 billion in emergency funding. Investors' hopes for a quick end to the war have been sinking fast amid graphic pictures of captured and dead U.S. soldiers, fierce resistance from Iraqi troops, and a tough battle for Baghdad looming. The mood is a complete about-face from the past few weeks when stock markets rallied and safe-haven positions were dropped in a "relief rally" over the end of uncertainty about the start of the war and a view it would be over swiftly.

European shares added to losses of as much as 5.5 percent on Monday, although they were off their Tuesday lows. The FTSE Eurotop 300 index was down 1.11 percent and the narrower DJ Euro Stoxx 50 shed 1.05 percent. Both had earlier fallen by more than two percent. Dealers were also braced for more losses on Wall Street to add to the Dow Jones industrial average's 3.6 percent sell off on Monday. "The news coming out of Iraq hasn't improved and with the dollar weak and oil prices rising, the two or three elements that supported us last week are turning in the opposite direction," said Gert de Mesure of Delta Lloyd Securities. Japanese stocks earlier ended down by over two percent. The benchmark Nikkei average fell 2.33 percent or 196.31 points to 8,238.76, wiping out most of a 2.93 percent rally in the previous session. The broader TOPIX fell 2.30 percent to 812.29.

Oil prices built on Monday's gains and last week's four- month lows, although they were still well off recent near $40- a-barrel highs. Prices were also driven up by tribal violence in Nigeria which has cut that country's crude output by 40 percent. The price of oil has been of particular concern to markets in the run up to war because of the damaging effect increases can have on the stuttering global economy. U.S. light crude was up 73 cents to $29.39 a barrel, extending Monday's $1.75 jump. London's Brent crude climbed 64 cents to $26.73 a barrel.

Concerns the war could last longer than initially expected boosted traditional safe-haven investments like government bonds and gold for a second straight day. The two year Schatz yield was 2.5 basis points lower at 2.54 percent, while benchmark 10-year Bund yields were 4.1 basis points down at 4.16 percent. Yields on the 10-year U.S. Treasury fell 3.7 basis points to 3.93 percent. Spot gold traded at $332.50/333.50 an ounce, up from $329.50/0.25 at Monday's close in New York. It had earlier risen as much as $4.50 an ounce.

On the foreign exchange market, the dollar fell to its lowest level on the euro and other major currencies since the start of the war. The dollar was down more than half a percent on the day against the euro at $1.0705 and the Swiss franc at 1.3745 francs . It was down nearly one percent against the yen, below 120 yen, after yen bears were disappointed the Bank of Japan took no radical steps to tackle deflation and weaken the Japanese currency at an emergency meeting on Tuesday.
Source: Yahoo News

BoJ Emergency Meeting Disappoints

The Bank of Japan, which met earlier today for an emergency session, voted to increase the purchase of shares from Japan's struggling banks, but stopped well short of taking the radical anti-deflation measures some had expected. The measures agreed upon fall far short of the 'unorthodox' measures that many have been calling for, and seem to cast rather a long shadow over the speculation that Fukui would be more radical than expected.

The central bank voted 7-2 to expand a scheme to buy shares from commercial banks to Y3,000bn from the previous Y2,000bn limit. It also said it would provide as much liquidity as the markets needed to counter any turbulence generated by the war in Iraq. Markets, which had stayed relatively firm in the morning session in spite of falls on Wall Street overnight, were disappointed. The Nikkei stock average, which has rallied over recent days, fell sharply on the BoJ announcement, closing down 2.3 per cent to close at 8,238.76. "These are just small steps within the current monetary framework," said Nobuyuki Nakahara, a former BoJ board member who advocates more radical anti-deflationary measures. "They do not represent the fundamental changes of policy that Japan needs."

The board meeting, convened by Toshihiko Fukui, who became governor last week, was the first emergency gathering to be called since the BoJ became independent in 1998. This had led to speculation that Mr Fukui might be preparing to take bold action against deflation, which has been plaguing the economy since 1995. Some economists had predicted the bank would start buying exchange-traded funds, a proxy for the stock market, or foreign bonds, which could result in what many economists believe is a much-needed weakening of the yen. There was also a suggestion that the BoJ might take action to make the market in small- and medium-sized company debt more liquid, another request by politicians anxious to shore up the economy.Jesper Koll, chief economist at Merrill Lynch, said the new BoJ governor had raised expectations in parliamentary testimony of bolder action. "You cannot make these sort of statements, call an emergency meeting and then do nothing. It's just not good enough."

In September, the BoJ broke a long-standing taboo by saying it would buy Y2,000bn of shares from banks. On Tuesday, in addition to raising that limit to Y3,000bn, it increased maximum purchases from individual banks from Y500bn to Y750bn. Although the bank stopped short of radical action, it said it would examine the effectiveness of the current policy framework in time for its regular policy board meeting on April 7-8.Many analysts wondered what there was left to talk about. "We've had asset deflation for 12 years and price deflation for six years," said Mr Koll. "We don't need discussion. We don't need debate. We need action."
Source: Financial Times

The Future of EMU

Even while the war rages around us in all its bloody reality, it is still important to try to take stock of some of its likely economic consequences as and when they become a little clearer. Today it is the turn of Morgan Stanley's Joachim Fels to start to ask some of the pertinent questions. Whatever the final outcome it is clear that the post-Iraq war EU will look somewhat different to the pre-war one. In the first place everything is happening against the backdrop of an important structural change: the entry of ten new members into the community. In and of itself this will produce changes, and some of the possible lines of evolution of those changes are already discernable. Firstly there will be a political re-alignment. Those with long enough memories cannot fail to remember that one of the main backers of the EU enlargement process was in fact Mrs Thatcher. The then British prime minister, in my opinion, took this view for two reasons. Firstly in an attempt to make any move towards European political union (and the creation of a Euro super state) much less likely, and secondly to break the back of the Franco-German axis by creating the possibility for new political alignments.

Regardless of whether one considers this a good or bad thing, it is impossible for the thoughtful observer of the European scene today not to have the feeling that Mrs Thatcher was the most prescient of the then politicians. The enlargement seems now destined to take place without the political reforms which were widely regarded as being indispensible (not tackling the veto situation, as we have just seen in the UN case, might be considered as something of a 'lethal dose'). At the same time Jaques Chirac's recent outburst against the new Eastern members should not be regarded as anecdotal, but rather as an indication of what may well be to come. If, from the time of De Gaulle, rough and ready anti-Americanism has been the handmaiden of French foreign and domestic economic policy, with the EU as a political structure being merely an extension of this policy by other means, then this bubble has now, suddenly, burst. The political divisions which have emerged around the Iraq war only serve to underline this new reality. Perhaps the only really surprising thing, and I, like almost everyone else here in Spain, am having great difficulty in interpreting this, is the political stance of the present Spanish government.

Europe really is divided into four components: a South (Greece, Portugal, Italy and Spain), a North (UK, Sweden, Finland, Denmark, Holland (?), Ireland (?)), an East (principally the so-called 'transition' economies, and in particular Poland, Hungary, and the Czech Republic), and a central component around the Franco-German axis (France, Germany, Belgium, Luxemburg, Austria). In my view the weakest of these components is the southern group, and this is the component with the most to lose if Joachim Fels is right and the growing political rivalry spills over into increased economic competition. This is especially true for one reason not mentioned by Fels: the principle competitors of the Mediterranean four will be the Eastern group, and these, since they do not belong to the euro group, will have far greater room to manouevre in the newly competitive environment. They are also, if Fels is right in predicting widening yield spreads, the most at risk from negative public debt liabilities given their demographics and lack of adequate pension preparation.

On the other hand the likelihood of UK euro participation seems to have faded considerably, and this may have its own impact on the other principle axis of economic and political competition, the North/Central one. Here, among other factors which should be taken into account, are the different levels of penetration of the English language, and internet take-up and participation rates, both of which could in some ways be seen as proxies for capacities to realise available externalities in the so-called knowledge-based economy.

All-in-all, Not a pretty picture I feel. Perhaps the most ominous of Fels' forecasts: that market participants need to begin to factor-in an EMU break-up probability assessment. As Fels says, this seems extremely unlikely. But the mere fact that he even mentions it, and the fact that the markets may begin to recognise it as a conceivable possibility, this fact in itself means that it is just that little bit more possible today than it was yesterday.

The rift that has emerged within Europe between those countries backing the military intervention in Iraq and those opposing it has made one thing crystal-clear. The idea of an ever-closer political union culminating in the United States of Europe will remain a pipe dream for a very long time, especially now that the European Union (EU) looks set to expand towards Central and Eastern Europe with ten new, self-confident members scheduled to join next year. These developments have some important economic and market ramifications. Markets will have to get used to the notion that national governments will increasingly pull in different directions on important foreign or domestic (economic and non-economic) policy issues. In short, the country factor will loom large for investors, the risk of a break-up of the EU and/or EMU, while small, will be non-negligible, and the ECB could be pressured into producing higher inflation. However, a diverse and diverging EU that moves at different speeds in different policy areas may actually produce better economic outcomes than a monolithic United States of Europe governed by a single government in Brussels ever could. In my view, economic and political diversity, combined with a huge single market for goods, services, capital and people, provides for a healthy competition of national or regional entities for mobile resources. The result would be a less regulated, more dynamic and faster-growing European economy............

Make no mistake: the current and potential future divisions within Europe will make national governments, parliaments and voters less and less likely to cede more sovereignty to Brussels. This has important consequences for the EU Convention, the assembly led by Valerie Giscard d'Estaing which is currently seeking to draft a European constitution to be finalised next year. European federalists will deplore the fact that Europe seems unable to build a political union that can speak with one voice and match the status of the United States. In my view, however, this has been an unrealistic and unworkable vision all along, especially for an enlarged EU comprising 25 or more members....... I rather try to see the positive side of Europe's disunity.....
Yes, this kind of competition may look messy or even chaotic at times, some countries may run in the wrong direction for a while, and internal disagreements and even institutional crises will ebb and flow. However, as long as the common market for goods, services, capital and people rules, this kind of competition should produce better economic outcomes than a single government for the whole union, which would be far detached from its diverse citizens in 25 or more member states. Countries that pursue the right tax, welfare and labour market policies in this set-up will be rewarded with capital inflows, stronger growth and lower unemployment and can serve as a role model for others who are doing less well. Eventually, the process of "dynamic benchmarking" will lift the boat for all members willing and able to play the game and should result in a less regulated and stronger-growing European economy.

Growing divisions on budgetary policy and a possible slow death of the Stability and Growth Pact could lead to a significant widening of government bond yield spreads between the more and the less virtuous countries. Partly, this would reflect the actual fiscal policy divergences and partly it would reflect the fact that a financial bail-out for a member state that runs into serious fiscal difficulties will be less likely in a dis-united Europe. Second, in this changed environment, markets will have to attach a higher probability to a break-up of EMU and/or the EU at some future date. While I believe that the economic benefits from participating in both are sufficiently large to make such an event unlikely, we simply cannot neglect the possibility of fraction and secession. Everything else being equal, this suggests a higher risk premium on European financial assets and the euro. Third, a disunited Europe won't make the ECB’s job any easier. As the ECB has no policy instrument to address economic divergence between the euro participants, a growing divergence of budgetary and general economic policies would likely lead to increased political pressures for an easier monetary policy to grease the wheels. Whether the independent ECB would cave in to such pressures is uncertain. Yet, history shows that even the most independent central banks are not immune to the political environment in which they operate.
Source: Morgan Stanley Global Economic Forum

Monday, March 24, 2003

Markets Trying to Front-Run Themselves?

Morgan Stanley's highly intelligent currency expert Stephen Jen asks the question we are all thinking: are the markets getting ahead of themselves? My own response is that this speeding-up in what is euphemistically known as the 'factoring-in' process could well be another example of Kurzweil's principle of acceleration (of things getting faster, faster) at work. But remember, the quicker the markets internalise what are imagined to be the initial post-war conditions, the quicker we may arrive at the post-honeymoon re-assessment.

This is the first post-war relief rally (RR) in history that began before the first shot was fired, in my opinion. The ‘pre-emptive’ nature of this RR seems remarkable. Further, it is also worth mentioning that this so-called ‘relief rally’ resulted from risk reduction rather than more risk-taking, i.e., there is nothing ‘relief’ about this rally, I believe. Since it is very difficult to navigate through these geopolitical currents, the markets, evidently, have clung to the only benchmark we have: the experience of the last Iraq war, where we saw the USD and equities rally, with a collapse in oil prices. The market is, in a way, trying to front-run itself, in my view. However, I see this just as an unwinding of short-equity and short-USD positions, rather than a genuine change in the trends in these two assets............

The underlying fundamentals of the US and the global economy remain weak. The Fed and many global investors may have put too much blame for weak economic activity on the uncertainty associated with the war and high oil prices. However, it is far from clear that a successful resolution of the situation in Iraq will lead to a meaningful improvement in consumer sentiment or capital expenditures. The fact is that the labour market, the housing sector, and retail sales continue to weaken. With capacity utilisation hovering at only 75.6% so far this year, it does not seem justified to believe that capex will recover all of a sudden. Demand in the US will likely be increasingly reliant on fiscal stimulus. With the ‘twin deficits’ continuing to widen toward the 10% mark (the arithmetic sum of the two deficits in percent of GDP), it is difficult to see how the USD can stop depreciating, in my view.
Source: Morgan Stanley Global Economic Forum

Post War Economics

Interesting piece in the New York Times from David Leonhardt - describing itself as the skeptical economic view - about what there may be waiting for us just around the corner. As he indicates each new month of layoffs and other corporate cost-cutting begins to make what was supposed to be the temporary exception look more like a rule. He asks out loud the question that many more must be asking themselves silently: what if this decade's growth looks different from that of the 90's? In his support he cites productivity heavyweight Dale Jorgenson as saying: "When it all comes out, we're going to have a significantly less sanguine outlook than we did in the late 90's." In particular Jorgenson draws attention to the declining rate of expansion which is to be anticipated for the American workforce, suggesting that the slowing of labor force growth will also slow economic growth. Estimates indicate that the number of hours worked in the United States grew more than 2 percent a year in the late 90's, whilst in the years to come, a best guess is that it will probably grow by only about about 1 percent each year. As Jorgenson says,"that's a huge bite out of growth,"..... "we're not going to have the 4 percent growth rate we had during the boom." What's the betting we may soon all be calling ourselves the 'new skeptics'?

ith the battles having begun in Iraq, the United States economy once again looks as if it might be on the cusp of emerging from its torpor. The Standard & Poor's 500-stock index rose more last week than it did during any week since September 2001, and Wall Street forecasters predict that a quick military victory will reduce economic uncertainty, causing a surge of corporate and consumer spending.

But this has become a familiar refrain. A year and a half ago, many economists said that the country would prosper as soon as it recovered from the Sept. 11 attacks. Early last year, the scandals at Enron, Worldcom and elsewhere were supposed to be all that was preventing a new boom. With each new month of layoffs and other corporate cost-cutting, however, the exceptions begin to look more like a rule. Increasingly, corporate executives and some economists worry that the slow-growth economy of the last three years might in fact be the new reality, one that will bedevil workers and investors for a few more years. "When it all comes out, we're going to have a significantly less sanguine outlook than we did in the late 90's," said Dale W. Jorgenson, an economist at Harvard University and an expert in productivity, widely seen as the most important factor for future growth. "That's something we're just going to have to get used to."

Economic turning points rarely announce themselves clearly, and rapid growth might truly be just around the corner this time, thanks to the Federal Reserve's reduction of short-term interest rates, say, or a technology breakthrough yet to be understood. At the least, a victory in Iraq seems likely to cause a spurt of optimism and economic activity.

But there are tangible reasons to doubt that the United States will soon return to the heady times of the late 1990's. The federal budget deficit is rising, and the aging of the population will slow the growth of the labor force. Consumers will probably not increase their spending as rapidly as they did in recent years, and businesses — having invested so much in the boom years — still have a lot of idle factories and machinery."The effects of the bursting of the stock market bubble have proven to be far more long term and pervasive than expected," William J. McDonough, the president of the Federal Reserve Bank of New York, said in a speech on Thursday. He specifically mentioned continuing doubts about corporate accounting and governance as a drag on growth. The war with Iraq and the occupation that will follow are certain to deepen a budget deficit that without the war would exceed $300 billion next


March 24, 2003
Skeptical Economic View Takes in More Than Iraq

ith the battles having begun in Iraq, the United States economy once again looks as if it might be on the cusp of emerging from its torpor. The Standard & Poor's 500-stock index rose more last week than it did during any week since September 2001, and Wall Street forecasters predict that a quick military victory will reduce economic uncertainty, causing a surge of corporate and consumer spending.

But this has become a familiar refrain. A year and a half ago, many economists said that the country would prosper as soon as it recovered from the Sept. 11 attacks. Early last year, the scandals at Enron, Worldcom and elsewhere were supposed to be all that was preventing a new boom.

With each new month of layoffs and other corporate cost-cutting, however, the exceptions begin to look more like a rule. Increasingly, corporate executives and some economists worry that the slow-growth economy of the last three years might in fact be the new reality, one that will bedevil workers and investors for a few more years.

"When it all comes out, we're going to have a significantly less sanguine outlook than we did in the late 90's," said Dale W. Jorgenson, an economist at Harvard University and an expert in productivity, widely seen as the most important factor for future growth. "That's something we're just going to have to get used to."

Economic turning points rarely announce themselves clearly, and rapid growth might truly be just around the corner this time, thanks to the Federal Reserve's reduction of short-term interest rates, say, or a technology breakthrough yet to be understood. At the least, a victory in Iraq seems likely to cause a spurt of optimism and economic activity.

But there are tangible reasons to doubt that the United States will soon return to the heady times of the late 1990's. The federal budget deficit is rising, and the aging of the population will slow the growth of the labor force. Consumers will probably not increase their spending as rapidly as they did in recent years, and businesses — having invested so much in the boom years — still have a lot of idle factories and machinery.

"The effects of the bursting of the stock market bubble have proven to be far more long term and pervasive than expected," William J. McDonough, the president of the Federal Reserve Bank of New York, said in a speech on Thursday. He specifically mentioned continuing doubts about corporate accounting and governance as a drag on growth.

The war with Iraq and the occupation that will follow are certain to deepen a budget deficit that without the war would exceed $300 billion next year if President Bush's proposed tax cuts were to become law. Mr. Bush's recent statements about North Korea and the scope of the war on terrorism suggest that other conflicts are possible in coming years.

"The U.S. is going to take on quite an economic cost, whether it's successful militarily and politically or not," said Bob McKee, the chief economist at Independent Strategy, a consulting firm in London for large investors. "Nobody is much prepared to help."

Independent Strategy predicts that the war and its aftermath will cost almost $300 billion from now to 2006. William D. Nordhaus, a Yale economist who has analyzed past conflicts, estimates that the United States will have to spend $75 billion to $500 billion occupying Iraq.

Most economists think that higher deficits help cause higher long-term interest rates by increasing competition for savings. Higher rates, in turn, would sharply curtail mortgage refinancing and cool a housing industry that has been among the economy's few strengths. Until growth picks up and private demand for investment capital strengthens, few economists expect interest rates to move significantly higher.

Last year, low interest rates and rising home prices permitted households to take out $700 billion from their homes, through sales, refinancings and home equity loans, up from about $400 billion a year in the late 1990's, according to Economy.com. In a speech this month, Alan Greenspan, the chairman of the Federal Reserve, predicted that the pace of extraction would slow, "possibly notably lessening support to household purchases of goods and services."

Even with mortgage rates still near a three-decade low, the number of houses starting to be built declined 11 percent last month, according to the Census Bureau's seasonally adjusted figures. Cold weather played a role in the decline, but the drop also suggested that after a record surge of house buying in recent years, the number of people looking to buy new homes might not be growing as it once was.

Stocks, meanwhile, remain historically expensive, despite a market correction that recently passed its third birthday. The stocks in the Standard & Poor's 500 are trading at a price equal to about 30 times their earnings per share over the last year. At the end of the 1990-91 recession, that multiple was 18.

If stocks grow only modestly in coming years, consumers — particularly baby boomers, who are approaching retirement — are likely to increase their saving, at the expense of spending, economists say. Now, households are saving about 4 percent of their incomes, up from 2 percent during the boom but still well below their average of around 8 percent in the 70's, 80's and early 90's, according to the Commerce Department. Already, car buyers have shown some recent signs of ending their long shopping spree, and Ford and General Motors have announced that they will cut production. Of course, as the economic pillars of the last couple of years weaken, some rickety parts of the economy will stiffen. Corporate profits have improved somewhat, and executives will eventually start investing in new equipment and technology again. State governments will not be cutting their budgets forever. These are reasons that almost no economists think that the United States will fall into a prolonged and deep slump as Japan has. But there is still a great difference between booming and merely avoiding frequent recessions. Many top executives have focused on this difference, seeing the slow-growth economy as more than a temporary phenomenon. At the end of last year, most chief executives predicted continuing job cuts and economic growth of less than 2 percent this year, according to a survey by the Business Roundtable in Washington. Despite the deep cuts of the last two years, industrial companies are still using just 75 percent of their available capacity, less than they were during most of the 2001 recession. "This is a period of adjustment," said David A. Daberko, chief executive of the National City Corporation, a bank and large mortgage lender based in Cleveland. "We're going to run higher unemployment. We'll have less growth."

"The notion that consumers aren't willing to spend because of a military skirmish with Iraq is simply ludicrous, in our opinion," said Richard Yamarone, an economist at Argus Research in New York. Instead, the slowing of wage growth for most workers to a pace below inflation is leaving people with less money to spend, and the labor market does not appear poised for a quick recovery, he said. As baby boomers begin retiring, leaving the nation with fewer workers, wages could start to rise rapidly again. Over all, though, the slowing of labor force growth will also slow economic growth, economists warn, restricting the resources that the country has to pay for new investments or wars. Professor Jorgenson of Harvard estimated that the number of hours worked in the United States grew more than 2 percent a year in the late 90's. In coming years, it will probably grow about 1 percent each year. "That's a huge bite out of growth," he said. "We're not going to have the 4 percent growth rate we had during the boom."
Source: New York Times

Sunday, March 23, 2003

BoE Paper Gives Thumbs Down to British Deflation

According to the latest paper to come out of the Bank of England, deflation is unlikely to be a major problem in the UK. Unless, of course, there's a housing crash. We'll see.

A general price deflation in which interest rates fall to zero is 'highly unlikely' to hit Britain, according to a paper published by the Bank of England today. Interest rates at historically low levels around the world and a troubled economic outlook have prompted central banks to start worrying about deflation. Japan, where prices are falling and the economy is stagnating even though the Bank of Japan has, in effect, cut rates to zero, is an example nobody wants to follow. But an article by one of the Bank of England's economists in its latest quarterly bulletin says economic models suggest that for an economy such as Britain's, which is aiming for an inflation target of 2.5 per cent, the risk of a deflationary spiral is "very small indeed". In part that is because if the Bank saw a risk of deflation it could, and would, cut interest rates aggressively to head off the threat.

However, the article also argues that central banks should in normal times try to move interest rates only gradually, to reassure the markets that any change was likely to stick. If the preventive policy fails and deflation does persist, and interest rates have been cut to zero, the Bank paper considers possible policies for breaking out of the trap. Such policies would include tax and spending decisions, buying shares or bonds, devaluing the exchange rate and printing money to pay for a tax cut. But it concludes that many of these policies are "untried and untested", and prevention is likely to be better than cure. With underlying inflation at 3 per cent, and expected to go higher, deflation seems like the least of the Bank's problems. A house price crash, likely to be accompanied by a slump in consumer demand, could resurrect deflation as a significant threat.
Source: Financial Times

Give That Tax Cut a Closer Look

One of the principles of economic (or any other) policy analysis here at Bonobo Land is : look not at what they say, look at what they do. I have started to push this argument hard recently in the context of the declining dollar. Despite denials to the contrary, I remain convinced that US treasury policy is to allow the dollar to slide down, and that when the war is over we will see another wave of dollar selling as this becomes apparent. The objective: to correct the structural problem of the trade deficit, and to ward off any threat of deflation in the US. The practicalities of this seem to be a tacit agreement with the Japanese to allow them to break the rise in the yen, and leave the euro to do the heavy lifting. Policy response to changing economic circumstances in Europe are so slow, that for the time being all the politicians are basking in the sunlight of the euro's new found wealth. This complacency is reinforced by a faulty appreciation of the global economic slowdown as being simply the by-product of geopolitical instability associated with 09/11 and Iraq. Meanwhile across the Atlantic there is no such complacency, and a good deal of strategic thinking. I am convinced Stephen Roach is right: Greenspan, Bernanke et al take the deflation threat seriously and are working to avoid it. The heightened US sensitivity may also be a product of the fact that the United States has one face looking out over Asia, and policy makers are more aware of the extent of the problem. Be that as it may, I fear that euroland may not see the problem till it strikes.

Another topic where I feel the important point is not what people say but what they are doing, is that of the Bush tax cut. Looking at what is happening in Iraq at the present time I feel it is a mistake to underestimate the intelligence of the Bush administration. If you want the world to believe you are crazy and stupid, then what could be better than having a president who is prepared to act as if he were a war-crazed cowboy with sub-normal intelligence. But remember this is theatre. Behind the act there is some hard thinking going on. I therefore suggest that it may be a mistake to become so obsessed with the Bush theatre roadshow as to miss what may, in fact, be important policy changes. Firstly, as I have already indicated, there is the appointment of Greg Mankiw as economic adviser: not the most obvious Bush "Mark 1" style yes-man. (This is obviously coupled with the exit-stage-left of Glenn Hubbard, who, frankly my dear, didn't have a clue). Then we have the notorious tax cut. I don't want to enter into the ins-and-outs of whether this was a responsible policy in the first instance (in all probability it wasn't, but then the reality in which it was formulated has long since disappeared into the past). What interests me more is the way the tax cut can in fact be hijacked and converted into an SPV (special purposes vehicle). The job, right now, of the American president is to convince the markets and the American consumer that there is going to be inflation: this remember is to escape from the zero bound trap. But not inflation right now, since everyone believes that the Fed being the serious entity it is, this would soon be brought back under control. No, what they have to do is convince everyone that there is going to be serious long-term inflation. If I am right, in doing this they hope to avoid short-term deflation (remember we have serious papers knocking around out there with titles like "On the Responsibility of Being Irresponsible"). So what better way to convince everyone that this is going to happen than sell the image of your 'polyvalent loony', the president whose only interest is to keep his rich friends happy, and use it to ram home the point - inflation is on the way. And it seems to be working: Certainly an economist as prestigious as Paul Krugman is convinced there is going to be serious inflation in ten years time, and to put his money where his mouth is he has taken out a fixed rate mortgage. And if Paul Krugman is convinced, then so too are a lot of readers of the NYT, etc etc. What I would like to believe, since I have always respected Krugman as an economic thinker, is that he is as recursively aware of his own part in the theatre as Bush possibly is. Of course, once everyone is suitably convinced, and deflation is avoided (this, of course, on the conventional view of the deflation problem which I personally don't accept!!) then we might find them saying, aha, caught you, only kidding. This would be a much more convincing act than the Svenssen scenario of the sombre central banker (Greenspan?) trying to convince everyone that he's going to be irresponsible, but only for two or three years. No, the vaudeville is much better if the central bank character is seen to come out publicly and criticise the 'irresponsible' president.

Well, I'll leave you all to make up your own minds. But just in case you think it's only me who could think of this, I'll leave you with a quote from the Bank of England paper:

Another policy that has been proposed is to print more money and to transfer it to the private sector. To recap, normal open market operations involve the central bank and the private sector exchanging cash for bonds, making mirror-image changes in the public and private sector portfolio of assets. However, a money transfer
would involve printing money and giving it to the private sector, taking nothing in exchange. If this money were valued by those that received it, they would feel wealthier, and their spending would rise.There are many difficulties that a money transfer of this kind would entail. Literally distributing money among the population in a way that does not impose costs on the economy by affecting the current distribution of income and wealth is likely to be administratively infeasible. One possibility is that money is printed to finance a tax cut, given some level of governmentexpenditure.
Source Bank of England Quarterly Review

When Money is No Longer Liquid

I have spent part of this morning reading the latest Bank of England 'deflation watch' piece published in the latest edition of the quarterly review. In the midst of a relatively serious summary of the recent debate I find the following quote which really has set me thinking: "when we say that cash is more liquid than other assets we mean that it can, for example, be more readily transformed into something else that the owner wants". This seems innocuous enough doesn't it? It is probably after all a central tenet of all known monetary theory. But what happens when there is nothing else that the owner of a liquid asset wants than to hold the asset? Here I think we have the heart of the current debate and widespread misunderstanding about what is happening in Japan. There is in fact no charge for holding money. Now when interest rates are zero and deflation is running at two per cent, holding cash also attracts a positive real rate of some two percent, and apparently with no risk. In times of deep financial crisis (like the one which currently afflicts the Japanese banking system) the asset may even be considered by some to be safer under the bed than in a current account deposit where certain kinds of transaction may even attract charges. So the most liquid of assets ceases to be as liquid as it was (viscous perhaps, sticky money, etc, etc?), and herein lies the problem: everyone will accept cash, but not everyone is so willing to part with it. Oh, and just one more thing, printing money to acquire assets whose value may decline without provoking inflation (ie failing to provoke inflation) could be considered a cure worse than the problem if it only served to detriorate an already serious debt liability situation.

Goodfriend has suggested that the central bank could stimulate the economy by buying assets less similar to cash than normal: illiquid assets like infrequently traded bonds, or even claims on the private sector like shares or corporate bonds. An exchange like this would involve the private sector giving up an illiquid asset and taking a more liquid one, cash, in return. When we say that cash is more liquid than other assets we mean that it can, for example, be more readily transformed into something else that the owner wants. Money can be swapped for goods directly: other assets generally cannot. Having something that is more readily (more cheaply) turned into a good that can be consumed is valuable. Following an exchange of cash for illiquid bonds or shares the private sector would have more ‘liquidity’ and would therefore be better off. This would stimulate spending. By announcing that the central bank is prepared to engage in operations in formerly illiquid assets, these assets would themselves become more liquid. That would cause their prices to rise, make private sector holders of those assets better off, and increase demand. Higher levels of spending would raise expected inflation and lower real rates, stimulating demand further, and so on, until a point was reached when normal interest rate policy could be effective again.
Source: Bank of England Quarterly Review