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Friday, May 23, 2003

China, Internal Demand and Job Security

I'm having an interesting exchange with T-Salon at the moment. Basically I'm arguing my 'China is Going to be Like Nothing You've Ever Seen Argument'. T-Salon says yes, and no. The reasons are interesting (there's commenting so go on over and join in).

Yes, you are quite right that China has an important economic and political role to play in the world. Indeed, it is already playing an important role in both economic and political realms. Andy Xie, Stephen Roach and mainstream American media have described China's enormous economic role in the global economy quite well. In terms of politics, what is seldom mentioned in the media, other than international security, is that China has an important role to play in global issues such as climate change, natural resource management, public health, etc due to China's gigantic population. The dual realities in China, recent success in becoming more OECD like on coastal area while large part of its hinterland remains underdeveloped indifferent from many Africa nations, made it a leader in both "developed" and the "developing" world. China is also on its way to become a very powerful political broker between "developed" countries and the "developing" countries.

What I am not sure is whether China will become the sole world leader as in the case of the UK at the beginning of 19th century or in the case of the US in 20th century. There are far too many complicated and interwoved problems that have been accumulated over time. Any one of them may prop up and have a devastating effect on the entire system.

The chinese economy is very perception (not fundamental) driven, in my view. There is still no sizable and sustainable internal demand. FDI and confidence are keys that are making it looked as if it is well. I have a feeling that the foriegners and bankers (like Stephen Roach for example) are not frank enough about the ground reality. I suspect they all paint a rosy picture for people outside China in a hope that more foriegn money will flow in, so that the problems would wane away by itself. The ground reality I saw, as of end of 2002 in Hangzhou (2nd tier city), Shanghai (1st class chinese city) and around Zhejiang province (relatively well-off coastal province), is that export sector was great. Other businesses are quiet. Consumer price deflation is a norm for most consumer products, food including. There is also excessive capacity (many high tech parks, 16 lanes roads & highways in the middle of nowhere are empty.) and many people don't feel job security...
Source: T-Salon

Internal Clocks Which Help US Stay On Course

I'm reading Strogatz on Sync at the moment, and I couldn't help notice this interesting little piece on how the Monarch butterfly navigates. Might there be lessons for the rest of us here?

During their winter migration to Mexico, monarch butterflies depend on an internal clock to help them navigate in relation to the sun, scientists have found. By studying monarchs inside a specially designed flight simulator, the researchers have gathered what they believe is the first direct evidence of the essential role of the circadian clock in celestial navigation. The study appears in the journal Science, published by the American Association for the Advancement of Science (AAAS). In the fall, monarch butterflies journey from central and eastern North America to a small region in central Mexico. Only every fourth or fifth generation makes the trip, indicating that the urge to migrate is instinctive, rather than learned. "Monarchs have a genetic program to undergo this marvelous long term flight in the fall…. They are essentially hell-bent on making it to their over-wintering grounds," said Science author Steven Reppert of the University of Massachusetts Medical School.

While scientists are fairly certain that monarchs use the sun to navigate, they know less about how the butterflies adjust their direction each day, as the sun's position in the sky changes. It has long been suspected that monarchs use their internal, "circadian" clock as part of their sun compass. "We have shown the requirement of the circadian clock for monarch butterfly migration," said Reppert. "When the clock is disrupted, monarchs are unable to orient toward Mexico. Without proper navigation, their migration to the south wouldn't occur, and that generation of butterflies would not survive." Reppert chose monarchs for the study in part because they don't learn their route, as honeybees foraging for nectar do, for example. "Monarch butterfly navigation seems to involve the interaction between a clock and a compass. This makes monarch navigation a bit simpler than navigation in foraging insects where each new route has to be learned," Reppert said.

Understanding how the circadian clock assists the sun compass in the relatively simple navigation by monarchs could provide a model for studying navigation by other animals, Reppert said, citing both foragers such as honeybees and desert ants, as well as long distance migrators such as songbirds. "We would like to know how the circadian clock functions in four dimensions – not only how the clock functions to keep time, but also how time regulates spatial information," he said. "Increasing knowledge of the genetic makeup of the monarch circadian clock will help tease apart the entire migratory process, a process that remains one of the great mysteries of biology." Research in other animals has been turning up a number of genes that make up the circadian clock, as their expression oscillates in a daily cycle. The clock is "entrained" to the daily light cycle via specialized by special light-sensitive cells, called photoreceptors. The researchers found that a common clock gene, known as per, is also part of the monarch circadian clock. Constant light disrupted the cycling of this gene's expression. It also affected the time of day butterflies emerged from their chrysalises, known to be a marker of circadian time-keeping in other insects.

Reppert and his colleagues then studied the effects of manipulating the daily light and dark cycles on monarchs inside a specially designed flight simulator, with a video camera and computer that record the flight direction. After being housed under a light/dark cycle in the laboratory that was close to the fall outdoor lighting cycle (light from 7:00 a.m. to 7:00 p.m.) migrant butterflies exposed to outdoor sun oriented to the southwest, toward Mexico. Butterflies housed under an earlier cycle (light from 1:00 a.m. to 1:00 p.m.) flew to the southeast. When the butterflies were exposed to constant light, they flew directly toward the sun, presumably having lost their sense of time. Reppert's team also found that, while UV light is required for sun compass navigation, some other wavelength of light was required for entraining the butterflies' clocks. This difference may provide a means for untangling the two biological processes. "The light input pathways are quite distinct, so tracking those pathways in may eventually lead us to the cellular level where this clock-compass interaction is occurring," Reppert said.
Source: Science Daily

Japan, Hong Kong, Taiwan: Indefinite Deflation

Obviously things look pretty different in Hong Kong to the way they seem in New York, Washington, Brussels and Frankfurt. Andy Xie again:

Excess supplies of labor and capital continue to exert powerful deflationary pressure on East Asia. Export performance or the credit cycle may give the appearance for short periods that inflation is returning. When cycles peak, inflation tends to disappear quickly and deflation either gets under way or resumes. Korea’s inflation in 2002 was largely due to its rapid credit growth. The high oil price nudged inflation higher in the first quarter of 2003. It is now trending down and is likely to reach new lows. China is experiencing some inflation because of the increase in its raw material costs. The surge in investment demand is the main cause. As we have observed previously, deflation usually follows investment driven-inflation. A high savings rate, surplus labor, and lack of entry barriers always allow the benefits from productivity gains to be passed on to consumers in China. Japan, Hong Kong, and Taiwan seem to be in deflation almost indefinitely. Their interest rates are already near zero. They do not appear to have income drivers to solve their demand problems. It is difficult to visualize any scenario under which deflation in these economies would end. East Asia must resist currency revaluation. There are no obvious policy tools for combating its contractionary effect. Interest rates are close to zero except in Korea. Fiscal deficits are quite large already. A major revaluation would just crush the economies in the region, in our view.
Source: Morgan Stanley Global Economic Forum

A Treatise on Political Monetarism

Morgan Stanley's Robert Alan Feldman gives a quick runaround on the four standard approaches to deflation. Needless to say there is a fifth institutionalist (demographic) one, but, well never mind. Brad certainly gets a look in though:

The monetarist school of deflation relies on Irving Fisher's equation of exchange, MV=PY - money x velocity = prices x output. The simple application of this theory suggests that if you raise M, then P will rise too. Thus, to end deflation, just raise money. Simple.

Or is it? What measure of money are we talking about? And what measure of prices? At a more subtle level, there are some hidden assumptions here. How do we know that P will go up, and not Y? (Higher Y is not a bad thing -- but the purpose here is to discuss deflation, not real growth. Would the problem of deflation be solved if real growth were 10% and deflation 5%? Not necessarily.) Most important, the “M up leads to P up” view assumes that velocity is constant. Old Chicago Monetarism “did not believe that the velocity of money was stable and did not believe that control of the money supply was straightforward and easy.” (See J. Bradford DeLong, “The Triumph of Monetarism?” Journal of Economic Perspectives, Winter 2000.) Rather, it was “political monetarism” (DeLong’s term) which argued “not that velocity could be made stable if monetary shocks were avoided, but rather that velocity was stable.”

Is this model “relevant to the contemporary world”? It all comes down to the stability of velocity. At least in the case of Japan, velocity has been horribly UNstable. Mere instability is one thing, but in fact, in Japan’s case, velocity has been endogenously unstable. Every time the Bank of Japan has printed more money, people just stick the money under their mattresses. In short, M up leads only to V down. The key reasons are worry about the solvency of the financial system, and poor returns in the real economy. Until confidence in financial institutions can be restored, and until resource allocation in the real economy improves enough to pay interest, raising M will not help. This is not to deny that monetarism has its times and places. However, to the extent that other countries suffer from weak financial systems (the US not so much, Europe rather more), monetarism will not work. To the extent that other countries suffer from poor resource allocation (the US to some extent, Europe much more), monetarism will not work. In my view, the monetarist approach is not “relevant to the contemporary world” in the sense that Keynes used this phrase.
Source: Morgan Stanley Global Economic Forum

Why I Think Information Costs Just Came Down

Some may think my argument that the arrival of the internet invalidates the old Paul Romer model of high front-end research costs is somewhat tendencious. I beg to disagree. Exchanging information has never been cheaper, and those of us who share, well we're going to win-out in the end, now aren't we. We have, my friends, the evolutionary advantage. Some of you may recall, that three weeks ago I posted about my concern for Bulgarian immigrants here in Spain. Today I received this from Margarita in Bulgaria. Long live the information revolution!

Dear Prof. Hugh,
I've just found your web-page and I'm really impressed! My name is Margarita Karamihova. I am an ethnologist, recently working on emigration from Rhodope Mountains, Bulgaria. One point of my research is related to emigration of Bulgarian-Muslims /Pomacs/ to Spain. Here you find enclosed an example in one municipality . My previous contacts with colleges from Spain have shown than there are no researches on Bulgarian immigrants there. I'll high appreciate to have any of your articles on Bulgarian immigrants in Spain.

Any other interested parties out there, please feel free to join in.

Thursday, May 22, 2003

Firm Size and Growth Revisited

Some of you may remember that a while back I posted over some misconceptions, which I associate with the euro urge, about the inevitability of growth being associated with big. In fact the evidence is completely inconclusive, and the situation may at best be a random walk, or even a power law relation (the so-called Gibrat's law). In which case the old Coase-ian argument about the internalisation of information costs may be greatly over-stated in the world of distributed networks and ambiguity. Now Frans has picked me up on this, and with good reason. (Incidentally Frans' page, although still largely in Dutch, is now rife with references to Brad Delong, Paul Krugman and a certain fat man with a good word for no-one, as well of course as to the inevitable Bonobo). Frans has a page - in English - devoted to a proposal for the limiting of the size of firms which I must say makes a lot of sense. My arguments would perhaps be a little less on the side of a preoccupation with the US (the EU has more than it's share of intrenational corporations) and more on the side of encouraging growth, change and diversity. We have, after all, existing anti monopoly regulations, I don't think there's necessarily anything anti-market at all in tilting the rules a little more in the direction of favouring those who would unseat the incumbents. Microsoft is a case which comes to mind immediately. Well done Frans!

Rules should be made on the level of the European Union declaring an upper limit to the size of all enterprises that (want to) do business within the Union. If one of the boundaries, mentioned below, is exceeded the company will have to split up itself or stop doing business within the Union:

25.000 workers
€ 2.500.000.000 returns
€ assets
€ 250.000.000 profit

Introducing these rules of course need transitional arrangements (a transitional period to be more specific). "Doing business" stands for selling products and services as well as starting or maintaining local establishments.

The intention of this proposal is nothing more and nothing less than restricting the power of the biggest enterprises. Aiming at the European Union to take the initiative is obvious. Countries like the Netherlands, India or even France do not stand a chance: they would simply encounter the power of the transnational corporations that this proposal is confronting. The economic importance of the EU is enough to face this confrontation. Even after the ENRON- and WORLDCOM-scandals there little can be expected from the USA in decades ahead. Some sympathy can be expected from the UN but the UN itself lacks the power. It's hardly necessary to elucidate on the reasons behind this proposal. The power of the transnational corporations, that are still growing in size and economic impact, is simply to big. Especially the poorer countries are powerless vis-à-vis the transnational companies, assuming that their government are interested in the well-being of the poor. The size of the biggest corporations serves no positive goal whatsoever. To prevent any misunderstanding I like to emphasise that it is not my opinion that bigger corporations are more likely to misconduct. If a correlation exists between size of the corporation and the norms of their behaviour I would rather expect an inverse relation. The temptation of misuse of power however, -both in domination of markets and in confronting governments and organisations of workers -, simply lies in another order when it concerns the corporations of extreme size.

Curiously enough implementation of these rules has no disadvantages !! Opposition can only be expected from people with pathological wealth or power.
Sufficient evidence exists that the best economic achievements do not emanate from the biggest corporations of all. That should be no surprise: the size does provide well for giant (investing) possibilities but for bureaucracy and sycophancy as well. Above that the centrally decreed strategy makes the divisions and branches operate below the optimum: because of the notorious "internal standard prices" and the related phenomenon of "tommy". A real nice aspect of this proposal is the fact that debating it can stimulate powers that will work in favour of its realisation: in the second rank of corporation-management ambitious people are going to realise that this proposal creates chances to add lustre to their careers and start acting in favour of it.

Not Completely Alone

I'm not completely alone, there is, after all, Eddie, our 'man in Singapore'. And before you all take pity on us old-fashioned interventionists, I'd like to point out that I wouldn't want to bet that we'll see the same 'nothing to be done' argument continuing when the money starts to spill out of the euro again. The US may be a weakened growth engine, but it is, as Stephen Roach never tires of reminding us, the only one the world has right now, so if there are such things as 'fundamentals', then this is the one which should be reflected in the respective currency valuations. (Incidentally, Singapore is listed by the IMF as being at moderate' risk of deflation).

I’m also partly here at the local papers because I want to say some things that are not said here in Singapore. For example, the reaction of the local biz paper (“Business Times”) to the fall in the USD. “The knee-jerk reaction in some circles has been to lobby for a weaker Singapore dollar, but it's not entirely clear that such an over-hasty response is necessary, or even appropriate.”

It is a reaction that I expected. Yet in the same article, they note that: “The sharply higher euro has aggravated matters by effectively tightening monetary policy ........monetary policy has been tightened by the surging euro at a time when it needs to be loosened.” Spore is a much more open economy that the EU. I think the central bank here should try all it can to curb the rise of the local currency, hard as it is in practice. But we can only seriously attempt to do that by starting to run down some of the massive fiscal reserves I mentioned earlier. Don’t know if you believe this, but Spore has a current account surplus of almost 20% of GDP. People here think it’s a good thing. There can be such a thing as too much of a good thing. Nobody’s listening. It’s frustrating when you can see an accident but can’t do anything to stop it.

Another point about Spore (and SEAsia). There are no benefits system that’s dedicated to the unemployed. The unemployed can only get assistance via existing
schemes to help the destitute. So they have to prove that they are unable to work and have no means of subsistence, as well as no one to depend upon. So if
you have rich relatives, sorry mate. Better get your relatives to help. The scheme is administered strictly, and only on 1 –3 months basis. After putting yourself through the humiliation, what do you get? About US$300 a month for a household of 2 adults and 2 children. The average monthly wage here is US$1700. If you happen to earn more before you got retrenched, and ran down all your savings. Sorry again mate. Live on US$300 and go get a job. And better live in public housing because, at least, you can a waiver on your utilities bill. According to a household survey done a few years back, the lowest 20% of household expenditure was US$560. If this country doesn’t shake off the recession, you can feel an implosion.

Singapore's economy grew at a 1.1 percent annual rate in the first quarter of 2003, against an earlier official estimate of 0.7 percent, the government said Monday. The economy was boosted by strength in chemical and electronics exports, it said. The twin engines from Singapore's export sector overcame the ongoing contraction in the construction industry and weakness in the service sector. The government said it was maintaining a growth forecast of 0.5 to 2.5 percent for 2003, but would revise the target if the SARS outbreak changed significantly. Gross domestic product -- the total value of all goods and services -- grew 1.6 percent from the year-earlier and against the government's earlier estimate of 1.5 percent year-on-year. "This is in line with market expectations, no one was looking for a downward revision," said Joseph Tan, economist at Standard Chartered Bank Consumer price inflation jumped by 0.7 percent in the first quarter from 0.2 percent in the previous three months due to higher costs of healthcare and clothing.
Source: CNN Business

Eurozone Average Inflation Could Fall Below Zero Warning

The UK's NIESR has been running some numbers, and a further appreciation of the euro/dollar by 20% would push the entire eurozone average inflation below zero. Back to Gerard Baker, if this is a market valuation, there is nothing we can do, right. Wrong. And the sooner the finance ministers pack their bags and get bag to Deauville, and some hard thinking, the better. Or is it, after the pain will come the pleasure?

The eurozone's economy is likely to fall into deflation if the euro returns to its equivalent peak levels of the mid-1990s, according to one of Britain's most respected economic forecasters.Simulations by the National Institute of Economic and Social Research, prepared for European central banks and finance ministries that use them for comparison with their own models, suggest that if the euro rises by about another 20 per cent, there is a roughly two in three chance that it will push average inflation for the eurozone below zero.Such a move would not be unprecedented: the dollar has fallen 29 per cent against the euro since its peak in 2000. In 1985-87, it fell by 54 per cent against the D-Mark.The fall of the dollar has been gathering momentum, and international investors seem increasingly concerned by the US combination of a vast current account deficit and low interest rates. A rise from the euro's current level of about $1.17 back to 1995 levels, equivalent to about $1.40, seems far from impossible.

Ray Barrell of the NIESR said: "At the moment, the chances of inflation falling below zero in the eurozone as a whole are quite low: perhaps 5 per cent. But if the euro were to rise to those 1995 peaks, then the chance of deflation in the eurozone is better than even." It would also take up to 1.8 per cent off the eurozone's gross domestic product, he said, threatening to push it into recession, or at least a further period of slow growth. A rise in the euro against the dollar is also likely to be bad for global growth as a whole, because it hurts the eurozone more than it benefits the US. "Because the eurozone economy is nowhere near as flexible as the US, eurozone output will fall more than US output rises," Mr Barrell said. The impact would depend on how the euro moved against other currencies apart from the dollar: if other currencies are also rising, the effect would be less. Most economists do not currently see deflation as an imminent threat to the eurozone. "I don't think it is just around the corner, except in Germany," said Robert Barrie of Credit Suisse First Boston. "But there are problems there, and policy isn't doing much about them. You can bet that interest rates are not as low as they would be if they were being set for Germany alone."

On Monday Gerhard Schröder, Germany's chancellor, said he did not see "any danger of deflation in Germany", rejecting the warning from the International Monetary Fund that "mild deflation is fairly likely to take hold even though the risks of pernicious deflation are low". But the rise in the euro threatens to kick away the support from a relatively strong trade position that has supported the German economy in the last few years. Reinhard Kudiss, economist at the BDI industry federation, said German companies were less well-placed to withstand a strong exchange rate than in the mid-1990s. "Many companies are very worried," he said. "For many, the domestic German market has been a challenge for some time. If, in such an environment, the export side also comes under pressure, the situation becomes even more difficult." With German inflation typically running at about 1 percentage point below the eurozone average, even a move towards zero inflation in the eurozone would be likely to mean deflation for Germany.
Source: Financial Times

Deflation: Stephen Roach is Barking Up the Right Tree

Well Stephen Roach says it loud and clear, and he is right: deflation is not a monetary phenomenon. My difference with Stephen: I would put a fourth leg to the stool, ageing. Ageing and declining labour forces attack both the demand and the supply side. The supply side since there are less entrants for the labour force, and even as you struggle to maintain participation rates the quality inevitably goes down. On the demand side (actually the demand and the supply side are at bottom the same, but, well, oh never mind......) with less young people and lower growth expectations there is less borrowing (unless of course the government does it, hence all the fiscal deficit arguments) and hence it is more difficult for growth to hit those critical take-off levels. But apart from this (perhaps important quibble) chapeau. For once I am agreeing with someone: deflation is not a monetary phenomenon.

Don’t listen to the monetarists. They would lead you to believe that both inflation and its diabolical mutation — deflation — are simply monetary phenomena. As long as central banks have control over the printing press, goes the logic, rest assured — they will never abdicate control over the aggregate price level. I would argue, instead, that the current perils of deflation have little or nothing to do with your favorite monetary aggregate. Today’s strain of deflation risk is first and foremost a story of the cyclical imbalances and structural flaws in real economies — problems that are far from amenable to the so-called monetary fix. That’s especially the case in the United States, where the deflation debate now rages.

As most of the world has finally caught on to the risk of deflation, it’s worth reviewing why. It’s not just that America’s price statistics are now flashing ominous warning signs. It’s that the analytical underpinnings to the case for deflation suggest there could well be more to come. As I see it, there are three powerful forces at work — the first being the business cycle. Recessions, by definition, are deflationary events. So, too, are subpar recoveries. A cyclical downturn opens up a gap between aggregate supply and demand that alleviates pressure in labor and product markets. In a subpar recovery — defined as growth in aggregate demand that falls short of the potential gains on the supply side of the equation — that gap remains wide. Basic economics tells us that a cyclical overhang of aggregate supply reduces pricing leverage.

That’s precisely the case today. America’s most recent recession has been followed by an anemic recovery. As a result, unemployment has continued to drift up, and capacity utilization rates have continued to fall. But there’s an important twist: The recession of 2001 commenced at an exceedingly low inflation rate — 2.3% inflation as measured by the GDP price index in late 2000. That means the US economy entered a period of cyclical distress very close to the hallowed ground of price stability. In that context, the implications of a recession and its subsequent subpar recovery entail a far closer brush with deflation than would have been the case had the US been running a higher pre-recession inflation rate.

The bubble — and the post-bubble shakeout that has ensued — is the second key macro underpinning to the case for deflation. The bubble led to bloat on the supply side of the equation — fostering excessive hiring and capital formation. Tantalized by the allure of skyrocketing Nasdaq multiples, US businesses went for scale and scope — just what the apostles of the New Economy were urging. The bubble popped and yet the legacy of excess supply lingers — precisely the point underscored by an unusually low capacity utilization rate. At the same time, there has been a post-bubble compression of aggregate demand growth, as the wealth effect now works in reverse. In the three years since the bubble popped in early 2000, growth in personal consumption has averaged 2.7% — 40% slower than the 4.4% pace recorded over the 1996–99 period. The legacy of the bubble — subpar growth in aggregate demand in the context of lingering excess supply — reinforces the cyclical pressures on pricing leverage.

Globalization is the third leg of the stool. Not only has trade liberalization expanded aggregate supply in tradable goods markets, but there has been a comparable development in the once-non-tradable services sector. The globalization of services — the newest and potentially the most powerful piece in this equation — reflects three developments: global deregulation, which transforms administered pricing into market-determined prices; surging cross-border M&A activity that has led to the creation of huge multinational service providers; and the Internet, which has facilitated the growth of IT-enabled service exports (i.e., software programming, consulting, design, engineering, etc.) from places like India. In the long run, the supply-led impetus of globalization generates incremental income that supports increased aggregate demand. But today’s world is far from that long run. Instead, it is coping with the impacts of the first-round effects of globalization on the supply side, which further exacerbate the global imbalance between supply and demand.
Source: Morgan Stanley Global Economic Forum

US Treasury Secretaries Do Have Dollar Policy: Even When They Blow Their Nose

Gerard baker has a piece in the FT which is turning my hair whiter than it already is. His argument: the whole notion of a dollar policy is a piece of fiction. (And the notion of monetary policy too, I imagine, because all the same arguments could be made about the powerless of Greenspan and co to set interest rates long term, but that doesn't prevent them trying to have a monetary policy).

It is not just that the formal ending of the strong dollar policy had been prefigured by a succession of clumsy attempts at clarification by Mr Snow and Paul O'Neill, his policymaking Doppelgaenger. It is that the whole notion of a dollar policy is a piece of fiction that should have been abandoned years ago. Policymakers can set interest rates, tax rates and public spending levels. They can no more set the price of a nation's currency than they can set the price of an apple or a company's stock.... Before Mr Snow spoke, the dollar had been falling for two years - by more than 25 per cent against the euro, somewhat less against other currencies - because it was bound to.... And it will surely fall further. Mr Snow and his colleagues for once deserve some credit for belatedly simply trying to get out of its way.
Source: Financial Times

Brad buys this in part, but can see problems.

Gerard Baker is largely right, but I see two problems with his analysis:

1/. You can fix the price of your currency--if you have the enthusiastic cooperation of your central bank and the government's budget masters. It's called a fixed exchange rate system. You can do it. You just don't want to: exchange-rate stability is not worth what you have to sacrifice to get it.

2/. This is not an argument a U.S. Treasury Secretary can win--given the mapping that foreign exchange traders believe holds between his statements and U.S. government policy--and it is a costly argument for a U.S. Treasury Secretary to try to make. This is one that you make your underlings wage with the press, on background.
Source: Semi Daily Journal

Now I'm afraid I don't agree with Brad here. There are not only two possible alternatives (fixed or free-floating: see eg my brother . A dollar policy is possible, indeed my argument is that this is what we have. In the world of policy by 'expectations' even the treasury secretary blowing his nose is part of policy. The present policy is being used by the US to try and force Europe and Japan to mend their ways at gunpoint. (But since the analysis of the problem is wrong, forgive me if I beg to doubt the efficacy of the remedy). This is the real result of the Iraq war, no cooperation, no consensus, and we'll see what happens next. But the euro won't hold this value, ie this is NOT a reflection of a market valuation, but the result of expectations being 'steered'.

Movements of this violence in currency markets cannot be good for business. Why make a low return investment in a world of xcess capacity when you can turn 20% this year buying euro-bonds, and maybe another 20% next year buying US treasuries on the ride back up. In theory governments exist to prevent this type of thing, but I know, I am a lone voice here......

Wednesday, May 21, 2003

China and the G8

Many thanks to Andrea for forwarding me this link on the confirmation of China's presence at the G8.

Long claiming to be a champion of the developing world, China is making its first appearance at the meeting of the G8 industrialized nations in June - a sign of a shift in its foreign policy from being a revolutionary power to a major world player. China's need to repair the international damage caused by its initial mishandling of the Severe Acute Respiratory Syndrome (SARS) outbreak provides the immediate background for President Hu Jintao's meeting with the leaders of G-8 countries. But experts say the real motive behind China's acceptance of the invitation to a meeting of developing countries on the sidelines of the G-8 annual summit is that it needs an alternative platform to the U.N. Security Council, where it holds a permanent seat. "It is obvious that acting solely from the position of a UN Security Council member, China can no longer make its voice heard to the best of its interests," observed Zheng Yu, international relations expert with the Chinese Academy of Social Sciences.

"The functions of the U.N. Security Council have been continuously restrained. The Group of Eight is now the international arena where all matters of economic, political and security importance are decided," he pointed out. Three years ago, China rejected an invitation from Germany to attend the G-8 annual summit as an observer, maintaining its communist stance that the group is a "club of the rich." But since 2001, a series of subtle political moves have highlighted how China is shaping a new image of itself--no longer as a communist power supportive of guerrilla movements but as an emerging world player wishing to converge with other world powers. Launching a charm offensive as Asian neighbors harbored suspicions of its rising clout, China in November 2002 signed an agreement that would create a free trade zone by 2010 with the 10-member Association of South-east Asian Nations (ASEAN). The agreement puts China at the forefront of a zone that would be the third largest in the world after the European Union (news - web sites) and the North American Free Trade Agreement.

Beijing has also abandoned its once-virulent anti-U.S. rhetoric, joining forces with the United States in its global 'war against terrorism'. While opposing the U.S.-led war against Iraq (news - web sites), China is now actively trying to participate in the rebuilding of the oil-rich country and has dispatched a special Middle East envoy as a sign of its intention to expand its influence in the region. "China has been on the rise for more than twenty years. But what makes these three years special is a combination of economic and military power that has given the country a new confidence," said Robert Ross, a political scientist from Boston College. "China's self-assessment is undergoing a change and Chinese leaders are getting briefings on China being a rising power," Ross told a meeting of the foreign press in Beijing.
Source: Yahoo News

Why the US Government Should Be Doing This is a Mystery

Brad is also worried about the dollar and what John Snow may (or may not) be doing:

The problem is that for decades the Treasury Secretary's words on the dollar have been taken at an extreme discount. So whenever the Treasury Secretary says, "It is the policy of the U.S. government to drive up the dollar," markets say, "Ho, hum." But whenever the Treasury Secretary says something other than, "it is the policy of the U.S. government to drive up the dollar," markets say, "Good God! The U.S. government is trying to drive down the value of the dollar!! Sell!!! Sell!!!! Sell!!!!!"

Why financial markets do this is a mystery. But they do. And the result is that--whatever else the Treasury Secretary says--he must precede and follow it by a declaration that a strong dollar is in America's interest and is the policy of the United States. And whatever else the Treasury Secretary says must not contain any quotable sound bites that undermine the "strong dollar" quotes.

Many Treasury Secretaries resist taking on this formal, hieratic role. They think it makes them look like idiots. They would rather be coherent, and appear to be intelligent people with a grasp of economic issues, rather than mere parrots that repeat, "A strong dollar is in America's interest! Squawk! A strong dollar is in America's interest!" Tough. They need to learn to deal with it.
Source: Semi Daily Journal

Trouble is, I think that what Brad is arguing was more or less true in the era of the managed float, but I suspect the rules of the game have changed. The US is trying to force the Europeans and the Japanese to reform at gunpoint (not of course using 'the big hammer', but certainly metaphorically speaking see my Advantages of Being Close to Death post). In order to do this it is trying to 'manage expectations', thus I suspect Snow's words (unlike Duisenberg's) were well chosen. All of this may really be dicing with something not too far from death (certainly for Germany, and who knows what will be the consequences for Japan: I don't). Now earlier today I referred to the fact that there was one other 'crazy' member of my family: my brother, the anarchist banker. In response to my request for advice and help with the arguments from Joerg and Richard Duncan he has just sent me a mail. Now the damn thing is so long I've had to open a dedicated page on my website just to accommodate it.

How it takes me back! It was one of the scariest and most exhilarating times of my life at the beginning of the 1970s, when things started to happen in the currency markets. I was running the currency payments desk in Water Street, Liverpool which being the old Martins Head Office Branch was frenetic with all the trading and shipping companies in the old port. With the markets being in flux you had several places to deal, dependant on currency, amount, type of payment, and destination or where it was being received from. France for example was operating a two tier currency system (commercial and financial), there were Exchange Controls and a separate Investment Currency Market, various types of currency cocktails which had all the attributes of Molotov Cocktails, things called B units, another type of light blue touch paper cocktail, the farmers were stupidly borrowing Swiss Francs because of the low interest rate and having no matched funding, nobody apart from a junior official at the Bank of England understood the Forward Market, the green pound was an enigma which people seemed to use more like a fictitious unicorn except it was real, most of the Dealers were dealing themselves in unbeknown to their employers, some dealers doing a Leeson avant le nom (Lloyds Lugano). I was only lucky, my mistakes turning into profits mostly. The partner of my first London solicitor scarpered to Marbella where he lived surrounded by gun toting body guards. He had done the Bank of England for millions on the Investment currency market but he did not consider it against the Code Napoleon so he did not come back to face the music. Rather like Wittgenstein going to the cinema to watch Betty Grable's legs, I used to go to places like the Rumford Coach House to watch topless go go dancers (new at that time, sort of 70’s lap dancing clubs and highly embarrasing because I seemed to have worked with most of the girls on stage who tended to be ex bank employees). Ah joy it was to be alive! And some Johnnies want to go back to this sort of chaos! Leave it out! ...................

But the main point I want to make is that the situation is more complex that Duncan or Joerg make out and that an essential key is the role of the dollar in World Trade. One needs to look at its use as a reserve asset and indeed as reserve assets in general as % of World Trade. And look to the future requirements. I know that the West may be hitting a recession but this calculation is made including GDP figures which include Domestic Economic Performance. What% of GDP is foreign trade related and what is the prognosis for this trade element. In globalisation Domestic economies are meant to suffer by the import of cheaper foreign goods. Thus the trading element may be less affected as regards its requirement in% terms for the trading currency. And as China, Russia, and the Indian sub continent come more into the trading fold what currency will they trade in. Remember before the fall of the Wall trade with the Eastern Bloc was done under Countertrade terms, ie Bata and Vienna was the Centre (We were swapping Xerox machines for football players!) The engine of growth before the wall was trade (Cotta used to produce interesting graphs when he gave us lectures at Bad Homburg showing the lack of importance of the Eastern Bloc in World Trade). Now all these new players will need some currency to trade in. It may well be that the dollar is needed to provide liquidity............... continued ............

I hope this overview may help but my thought is that over the long term there has to be reserve currency, this needs to be decided by the market and the dollar seems to be the only game in town. World Trade will pick up and as History has shown this problem is a part of the system, and comes and goes as the need for liquidity comes and goes. It is all part of the trading cycle. Every market needs liquidity. And in times of trouble the Europeans only exacerbate the situation when they don’t back the US. They cut off their nose to spite their face. France and Germany mark well. The Gods also punish people by making their wishes come true. Those who want the Euro as a Reserve Currency beware!

Now to get back to the real world. On Monday I gave a very badly attended talk trying to show that the key to Duchamp’s revolution in Concept Art was the alternative Geometry of Lorbachevsky and Riemann, more particularly how the questioning of Euclid’s 2 and 5th postulate fed into Einstein’s Theories of Relativity and the effects of gravity. I am at present out on the Care in the Community Programme…..

Fine Words or Empty Rhetoric?

The Economist muses on the state of the global economy and, for once, comes to the right conclusion (well nearly, since recently they seem to have an almost pathological inhibition against spelling anything out clearly). I am one of those who hankers back to the 'good old days', which maybe were never really so good, but were probably a damn site better than what we seem to have waiting round the corner. This euro run cannot hold: got that, cannot hold.

For those who have long predicted the dollar’s collapse, the recent currency-market volatility must seem like vindication. America’s current-account deficit is now more than 5% of GDP, and few economists believe that the capital inflows needed to finance such a large deficit are sustainable. A weaker dollar is a key element in the adjustment needed to bring that deficit down.

But if Mr Snow and his colleagues are relaxed about the dollar’s drop—even if they claim not to be trying to engineer it deliberately—the consequences elsewhere in the world are potentially painful. European politicians were upset when the fledgling euro sank after its launch in 1999, and many of them have been embarrassed by its persistent weakness. National pride in a strong currency is not necessarily rational, however, and the surge in the euro’s value this year has come at a difficult time for economies in the euro area.

Germany, the euro area’s dominant member, is now technically in recession. Official figures published last week show that the German economy contracted in the first three months of the year, the second consecutive quarterly fall...............Perhaps surprisingly, the ECB does not appear to be alarmed by the experience in Japan, where the authorities have failed to make any headway in curbing deflation. Prices in Japan have been falling for more than three years now, and the IMF is worried that the problem could get worse. As its report points out, deflation is hardly ever benign, and the Japanese experience bears this out: the economy is shrinking once again. Tokyo’s failure to grapple with long-term structural problems has led to a succession of crises in the banking sector. While the G7 finance ministers were meeting at the weekend, a giant rescue of Japan’s fifth-largest bank, Resona, was under way. The bank failed to meet new, tougher capital requirements—so it has been saved by an injection of taxpayers’ money, possibly more than $17 billion. It is still unclear whether the rescue signals more of the same old patching up or a new, more radical approach to clearing up the banking sector’s mess. ......The Japanese government is clear that a weaker dollar spells trouble for hopes of an economic revival, and has reportedly been trying to halt the appreciation of the yen. Such efforts, against a background of what used to be called “benign neglect” in Washington, are unlikely to have much impact in the currency markets. If traders think the American government wants to see a cheaper dollar, they are likely to go on selling. For those who hanker after the old days of greater global co-operation, such policy confusion is depressing to watch. What’s happened, they ask, to the idea that countries would agree to monitor currency movements and co-ordinate intervention to prevent misalignments? They forget the world has changed. Greater capital mobility makes it much more difficult—though admittedly not impossible, as recent research has shown—for the authorities to influence currency fluctuations.
Source: The Economist

For those who hanker.......difficult but not impossible. Ay, mi madre, ohalá.

Putting the G Back in Global

Bonobos aren't 'hard-liners' about many topics. By our very nature we are playful and non-agressive, and, oh, we don't bite. But we would just like to take the time out to welcome our 'almost a bonobo' relatives , and celebrate the day with a world first that is really worth the effort - and express the hope that this is a pointer of the way forward for Global Solutions Inc. Now let's make it stick shall we.

The World Health Organization (WHO) has unanimously adopted an anti-smoking treaty - the first global public health measure ever approved. The aim of the Framework Convention on Tobacco Control is to reduce an estimated five million smoking-related deaths each year. All 192 member states are now committed to strict curbs on the advertising, marketing and sale of tobacco products within five years. At least one third of the space on cigarette packets will have to be devoted to health warnings, including pictures of diseased lungs.

The adoption of the treaty is a triumph for the outgoing director general of the WHO, Gro Harlem Brundtland, who made tackling tobacco-related deaths a key issue during her time in office. "Today we are acting to save billions of lives and protect people's health for generations to come. This is an historic moment," she said. The BBC's Imogen Foulkes, at WHO headquarters in the Swiss city of Geneva, says the vote ends four years of sometimes acrimonious wrangling. During this period, she says, countries with large tobacco industries - including the United States and Germany - initially opposed the treaty but finally gave their approval under strong pressure from developing nations.

The WHO, a United Nations agency, says that some 4.9 million people die each year from cancer, cardiovascular disease and other conditions linked to smoking. If countries fail to adopt the measures of the convention, it says, the death toll is likely to exceed 10 million by 2020, with 70% of the victims in the developing world. Many new smokers are young girls in the developing world, where levels of tobacco consumption are rising - in contrast to trends in some industrialised nations. The convention will come into force once it is ratified by 40 countries.
Source: BBC

Deflation Alert: Taiwan

Morgan Stanley's Denise Yam with some disturbing details about the SARS impact in Taiwan. Remember the IMF just rated Taiwan as at relatively high risk of deflation.

Taiwan has been hard hit by the spread of severe acute respiratory syndrome (SARS). Following the last revision to our forecast for the Taiwan economy in early April, we have reassessed the impact of the SARS crisis. We believe that private consumption may post an unprecedented YoY decline in real terms in 2Q03, while exports may fall YoY for 2-3 months in mid-year. International travel will likely take an extended period to recover, while SARS may also slow investment in and manufacturing relocation to Mainland China in the short term as entrepreneurs reassess their future business expansion plans. Although GDP growth was still respectable at 3.2% YoY in 1Q03, we expect the economy to weaken substantially in 2Q and have further cut our full-year GDP growth forecast to 2%, from 2.3%.

While Hong Kong and Singapore appear to be bringing SARS under control, Taiwan is still struggling to limit its spread. The disease has so far infected 274 people and caused 35 deaths on the island, with the number of new cases averaging 18 per day in the past week. Individuals under quarantine orders totaled 12,440 on May 13. Increased awareness, stricter enforcement of quarantine orders, improved hygiene standards, and the hotter weather in the summer months should help contain the disease. Nevertheless, while there has been a sharp rebound in shoppers and diners in Hong Kong, Taiwan households are still stocking up on groceries to stay at home, and consumer sentiment is plunging as fear invades daily life.

Although official macroeconomic data will be available only with a time lag, recent anecdotal evidence and independent surveys suggest a sharp downturn in consumption. Shoppers have disappeared from department stores. Local transport operators have seen a drop in passenger flows. The majority of retailers, restaurants and amusement parks are geared up for a cut in revenue in 2Q, although the crisis has so far benefited online shopping and outlets of medical and health supplies as well as home entertainment products.

Taiwan consumers have always shown remarkable resilience; private consumption in real terms has never posted a YoY decline since the data have been available. This reflects how Taiwanese accumulate savings during an upturn to maintain a high level of wealth. It has enabled a smooth consumption pattern even through the country’s worst recession ever in 2001 and the sharp surge in unemployment. Nevertheless, we believe it is possible that consumption will fall YoY in 2Q03 because people are staying at home to prevent infection from SARS, rather than due to a drop in income or wealth.

Unemployment failed to ease in the last cyclical upturn following a surge in 2001, as the Taiwan economy continued to hollow out and restructuring pressure persisted. Joblessness has hovered above 5% for 18 months, and the average unemployment period has lengthened, while a broader definition of joblessness, which includes those wishing to work but not actively seeking employment, has remained above 7%. The SARS outbreak will likely trigger another round of layoffs, while controversies over unpaid leave and how employees under quarantine orders should be paid may heighten labor disputes and strain employment relationships. The government’s recommendation that corporations maintain the payment of salaries to employees will need to be accompanied by substantial assistance (low interest loans or subsidies) should the business environment deteriorate much further. As for government relief measures so far, the Legislative Yuan has approved a NT$50 billion (US$1.4 billion, 0.5% of GDP) SARS fund aimed at alleviating business and household setbacks from the SARS outbreak. Of that fund, 40% (NT$20.21 billion) is aimed at supporting local industries.

Source: Morgan Stanley Global Economic Forum

News From the Eastern Front

It may come as no surprise, but I'm not the only crazy member of our family. I have a son. He is a medic, currently doing complementary studies into health system administration (you might be able to discern where all this is leading, MSF, WHO???). Well as part of the course they have to do a health system evaluation in a foreign clime using a pre-prepared 'toolkit'. So where does the clever guy choose to go: Georgia. But not the one with Atlanta at its heart, oh no, that would be to easy. He had to choose the one right next to Chechenya. (Don't worry another day I'll introduce my brother, and you'll get to see what 'crazy' really is). Apart from all the guns and alchohol, perhaps the most noteworthy thing is the difficulty he had in finding an intenet connection.

The flight was to Yerevan in Armenia, and was full of young men, most of whom were flying on to Tashkent. They all had a kind of 'eastern' look about them, apart from the fact they were messing around with loads of brand new camcorders and other gadgets. There seemed to have been a shit load of shopping going on in Harrods by these guys and they were all determined to bring it on as hand luggage, much to the stewardesses consternation. Ha ha.

Anyway, we arrived in Armenia a few hours later (about 00.00 local time). We'd befriended an old american guy working over there (on some agriculture project... and yes pig farming was a big part of the equation) on the plane, and after messing around with some very bureaucratic (but good looking) officials in the airport and sorting out visas we eventually set foot on foreign soil. The army dudes in the airport were NOT to be messed with. This American was meeting some interpreters so they helped us with sorting out taxis for our 6hr trip by car to Tiblisi... which was damn lucky really. Anyway, $100 between 5 of us wasn't a bad price, considerring that there was always the possibility of a bit of bullet dodging somewhere along the way. The night journey began.

Armenia is amazing. Its high and very cold at night. The towns we saw at dawn were the most macarbe place you will ever go. Truly strange. We found ourselves driving through these incredibly steep craggy gorges and eventually comng across factory towns like no other i have ever seen. The side of the mountains steeped in the greenest grass i have ever seen, but then there would be these ginormous factories, with smokestacks pouring forth and rivers of what looked like the most rancid and caustic effluent imaginable. Terrifying. Factories lying like rotting grey skeletons in the middle of stunning backdrops.The roads were shit but our driver (Tico) was pleasant enough. Happy for the cash.

We arrived in Tiblisi monday morning. Slept all afternoon after arriving at our pad and then met a rather interesting chap called UKA. He's a manager at the local health clinic. about 25 yrs old. Georgia is notably better off than Armenia. You can see it as soon as you cross the border... almost immediately. Before i go on let me say two things.I have never seen so much alcohol drunk in all my life. All these people are alcoholics. Secondly, I have been eating the BEST food of my LIFE for the past two weeks.UKA took us out by way of introduction on mon night. He was what they call the tamada (basically the drinking boss for the night) and he made us drink the most incredible amount of booze. That night, i was interviewed by georgian television (and on tv the next day), offered a couple of whores by Uka (its only polite), drove around in numerous ladas, met a lot of good looking women and a lot more whih i won't go into.

Tuesday.... well a bad day for the brain. We met more contacts and settled in. The health system is in a state and basically there is a huge informal economy in health over here. Things work better than you would imagine but obviously the main issue is financing. They still use much of the same organisational structure that was established in the soviet period, and it seems to me that they recognise how valuable aspects of it were. However they are in the process of reforming a large part of primary vare which i will tell you more about in another email. We have met some very interesting people.

The next few days were spent interviewing people and gathering data, workjing on the toolkit and implementing it. They have loads too many doctors over here (it is very popular) and so they have a pretty inefficient health system. They spend only around 1.5% of gdp on health care as well. The weekend was great. Fri... more drinking and eating, some dancing, we met guys with guns and gangsters, raced around the pothole infested roads of Tiblisi in souped up ladas and bmw's played footy, met ex-secret service, engaged in some more street racing, went out to the countryside and saw some old churches from the 6th century, sang with the georgian equivalent of andrew llyod weber, were offered more hookers. ALL georgians are alcoholics.I shall leave it there and be in touch again soon... there is a lot more to tell, especially about the health system. (the computer place is now shutting. I It was an hours walk to this place and its getting late).

And the Devil Take the Hindmost

Hans-Werner Sinn, President of Germany's IFO Institute of Economic research, arguing for the toleration of a higher aggregate inflation level in the euro zone. The argument used is essentially a Harrod-Balassa-Samuelson one that the current price 'correction' in the mediterranean 'fringe' countries is benign since it forms part of an inevitable price adjustment. Among several difficulties I have with this argument is knowing how to separate what is genuinely a 'coupling' effect from what is normal, garden variety 'bad' inflation driven by monetary conditions which are ridiculously loose in the countries affected (remember interest rates are below the rate of inflation, so real rates are effectively negative). So I would not be so complacent with this situation, as I fear it may eventually provoke recession in these (by pricing 'home' activities out of a job), a recession which - absent the capacity to practice currency devaluation - could only be remedied by continuing relative price deflation. That is why, unlike the IMF, I do not consider Spain to be at extremely low risk of experiencing deflation over the coming years. That having been said I am in agreement with Sinn's conclusion, that a looser monetary policy should have long been pursued in the eurozone, but for the 'lesser evil' argument that saving Germany from deflation should have been the number one priority - and if this implies throwing some of the smaller economies to the wolves, well, I'm afraid this problem was structurally inbuilt from the start. I say a looser monetary policy should have been pursued, since I fear the deed may well now have been done.

This month's long-awaited revision of the European Central Bank's inflation target was a disappointment. Although the ECB paid lip-service to greater tolerance of inflation, nothing has really changed. The ceiling for eurozone inflation will remain at 2 per cent. This is bad news for eurozone countries, because they need a dose of inflation to get moving again.

Controlling the average inflation rate alone makes no sense as long as the span in national eurozone inflation rates, which averaged 2.7 per cent over the first four years of the euro, remains as large as it is. This divergence has systemic causes that are likely to persist for the foreseeable future. Although member countries already have very similar prices for traded goods, great differences prevail in prices for non-traded goods such as services, rents, building materials and catering. This is because of different wage levels, which in turn reflect differences in development. In the course of the economic convergence that will take place over the next two decades, wages as well as prices for non-traded goods and services will converge in all eurozone countries.

This adjustment in relative prices is a natural and desirable process that the ECB's monetary policy should tolerate, especially as it is advanced by the euro. The euro led to a convergence of interest rates in Europe and has lowered the real cost of capital in soft-currency countries that previously had to pay high risk premiums with their interest rates. For this reason the euro is stimulating investment in these countries, supporting real growth, boosting wages and increasing the rate at which prices are converging.

If the ECB tries to curb this transitional inflation with a restrictive monetary policy based on an ambitious inflation target, it will adversely affect the more developed countries, which will be forced towards too low a rate of inflation. Since nominal wages and prices in the core eurozone economies tend to be resistant to decline, some inflation is always advisable because it facilitates real wage and price cuts in weak sectors. If inflation is too low, real wages and prices in these sectors will remain too high, triggering bankruptcies and job losses. The German and French economies are the main victims, because they have high wages and high prices for non-traded goods. Moreover, both countries have lost the interest rate advantage they enjoyed when they had their own currencies. Aggravating this is the possibility that the euro may have been introduced too early, before the D-Mark and the French franc were able fully to realign after the 1992 currency crisis.

The real wage restraint necessary for restoring competitiveness in Germany and France could be more easily accomplished if the ECB had a higher inflation ceiling. This would enable Germany and France to become more competitive by just waiting for inflation in other countries where price levels are currently too low. With separate currencies, they could induce the same effect with an open devaluation. Unless monetary policy is loosened, such a level of competitiveness could take a decade to attain.

It is sometimes argued that the ECB should not consider country-specific inflation rates because the US Federal Reserve looks only at the US average. That argument is not convincing. First, unlike the dollar, the euro is young. Currently, Europe is undergoing a real convergence process with huge differences in inflation rates; this problem has long since been overcome in the US. Second, unlike Europe, the US has no extended social welfare net that prevents nominal wages from falling. European states offer unemployment benefits that depend on previous wages and welfare payments that are defined in nominal terms. These high replacement incomes keep a floor under nominal wages. Even if unions are willing to accept - or are unable to prevent - real wage cuts, real wages cannot fall unless there is inflation. Yes, political reforms that cut unemployment and welfare benefits are also a possibility but such reforms are very tricky.For this reason the ECB should set an inflation ceiling of 2.5 per cent until eurozone convergence is concluded, at the same time ensuring that no country falls to very low inflation levels, say, below 1.5 per cent. It should pay particular attention to the inflation floor, because deflation or low inflation in single countries would pose great dangers to the stability of the European economy.
Source: Financial Times

Tuesday, May 20, 2003

We're All Bonobos Now

From Pan Paniscus to the rest of you, welcome to the club.

The latest twist in the debate over how much DNA separates humans from chimpanzees suggests we are so closely related that chimps should not only be part of the same taxonomic family, but also the same genus.The new study found that 99.4 percent of the most critical DNA sites are identical in the corresponding human and chimp genes. With that close a relationship, the two living chimp species belong in the genus Homo, says Morris Goodman of Wayne State University in Detroit. The closeness of relationship between chimps and humans has become an important issue outside taxonomy, becoming part of the debate over the use of chimps in laboratory experiments and over their conservation in the wild.Traditionally chimps are classified with the other great apes, gorillas and orangutans, in the family Pongidae, separated from the human family Hominidae. Within Hominidae, most paleoanthropologists now class virtually all hominid fossils in three genera, Homo, Australopithecus, or Ardipithecus.On the basis of the new study, Goodman would not only put modern humans and all fossils back to the human-chimp divergence into Homo, but would also include the common chimp (Pan troglodytes) and the bonobo (Pan paniscus).

It is not the first time such a suggestion has been made - in 1991 physiologist and ecologist Jared Diamond called humans "the third chimpanzee". But subsequent genetic comparisons have yielded varying results, depending on how the genotypes are compared. Goodman compared published sequences of 97 genes on six species, including humans, chimps, gorillas, orangutans, and Old World monkeys. He looked only at what he considered the most functional DNA, bases which cannot be changed without a consequent change in the amino acid coded for by the gene. Among these, he found that 99.4 percent were identical in humans and chimps. He found a lower correspondence for bases that could be changed without affecting the amino acid, with 98.4 percent identical for chimps and humans and the same for the "junk" DNA outside coding regions. Goodman believes the differences are larger for non-coding DNA because their sequences are not biologically critical.

His correlations are much higher than the 95 per cent similarity reported in 2002 by Roy Britten of the California Institute of Technology. Goodman does not disagree with those results, he told New Scientist, but points out that the differences analysed by Britten are not important to gene function because 98 percent of the DNA did not code for proteins. The small difference between genotypes reflects the recent split between chimps and humans, says Goodman, who dates the divergence to between five and six million years ago.But Sandy Harcourt, an anthropologist at the University of California at Davis, believes chimps and humans split six to 10 million years ago. "That's an awful long time to be in the same genus," he told New Scientist. Classifying chimps as human might raise their conservation profile, but Harcourt hopes that is not the only way to get people to worry about them. "I'd prefer to go the other way, and consider more things that aren't human" as important for conservation, he says.
Source: New Scientist

On the 'Correctness' of Currency Policy

I'm catching a lot of flack at the moment for my attempts to put a different 'spin' on the dollar decline situation, and on the inactivity of the G7. Today it's Joerg's turn to try to wrong foot me:

regarding the "argument about the absence of a currency policy instrument": Please explain what you consider to be the correct stance for a central bank to take. The Mexicans are selling incoming dollars off at a daily auction. They are playing the game according to the rules of a true floating-exchange-rate regime. In my view, they are the "best practices"-model of behavior the larger banks need to ultimately emulate. If they do not, a well-managed fixed-rate regime would be preferable to what might ensue from attempts at running a "beggar-thy-neighbour-strategy" with manipulated, flexible pseudo-floating rates. Note also that the choice the central banks are confronted with is structurally similar to the menu of options available during the 1920s and 1930s in regard to the maintenance of the gold standard. The rules for that game had been laid down by Ricardo, but they were not fully implemented at the time. There was a tendency to add to the gold reserves - which lengthened the list of causes contributing to the plunge into and the persistence of the depression. It may seem to be difficult to mismanage all four variables - trade, money, taxes and budgets - that were apparently misadjusted at one point or another of the evolving Great Depression, but considering the fact that there is no need to get them all wrong at the same time I would think there is a a fair chance of history repeating itself.

..............I cannot see how this points in any other direction but that of a repeat performance of historical mistakes. I would also like to point out that it is not "money" itself that is at fault here. Money is a technology that comes with a users´ manual. Unfortunately, central banks currently seem to use a new release of the tool - the floating-exchange-rate version originally launched by Milton Friedman many decades ago and now in widespread use all over the world - in conjunction with the old manuals that are detailing how to operate a fixed- or semi-fixed exchange-rate system. If the instructions in the new manuals were already being followed, it would be clear to everybody that the monetary instrument does not allow for such a thing as a currency policy. Playing an updated game according to the old rules, however, will certainly wreak havoc. There is always the option to return to the older system - which we can be sure will ultimately not be exercised -, but unfortunately a mix-and-match style of operation is a recipe for disaster.

My first observation is that I am not especially comfortable in the role of having to try and explain a 'correct' central bank strategy since I do not consider myself to be in any way qualified to set myself up as a 'currency theorist'. I find myself being lead into this minefield by the need to try and make some coherent sense out of what is happening on the global economy front, and finding that in order to do this I need to take account of the strategy being adopted by the US treasury. Also, by way of parenthesis, I should note that in principal I have difficulty with the term 'correct' here, and would prefer to speak of 'possible' strategies. One of the great problems with being pragmatic is that the simplicity of the extremes is not available, and at the same time it is often difficult to give the kind of clear and precise answers which may be offered by the more dogmatic orthodoxies. So I can say quite happily that I think neither fixed nor floating exchange rates, offer, in and of themselves, a way forward. This is like asking if you believe in free markets, well yes, and no. I believe in regulated 'free' markets. And I believe in 'regulated' floating exchange rates - and in no case fixed rates (this explains my reasoning on the Euro, and I guess I'm going to have to explain this more another day, since Frans, at least, is still waiting for an explanation). Of course, in both cases, the issue turns on what you mean by 'regulated'.

In the modern world things aren't so simple as when Friedman started writing. In particular we've discovered 'expectations', and this means that the principal players are constantly 'intervening' in the markets by what they do and say, whether or not this is supported by any classic currency measures. In other words I am saying that absence of intervention (or saying you are comfortable with a process) is itself a form of intervention. Currency strategy is a game of constant guessing. The question is to know whether anyone is about to get the 'big hammer' out. So the central banks - or the Treasury Departments according to country - try to ride the wave. They try to steer the markets by the use of gesture and intonation, politics is, after all the pursuit of war by other means, and non-intervention is the pursuit of intervention by other means.

So my starting point here is that I am comfortable with this tendency to 'guide' and 'steer' the markets. Where I am not comfortable, is with the kind of guidance that is currently being given. Perhaps part of the problem is that I am not happy with the point of departure: I am not convinced that the dollar was anything like as over-valued as was being suggested. Over-valued, implies that something else is under-valued. So over-valued with respect to what? And what exactly was undervalued - the euro, the yen - I am not convinced? My fear is that the dollar is being allowed to fall to pursue two objectives (and yes, this is currency policy at work). Firstly to try to put a gun to the heads of the Europeans and the Japanese, to try to force through reforms by placing survival in danger: a very dangerous game this one. And, secondly, in case the first ploy doesn't work, to try and buy some anti-deflation insurance for the US. I am not convinced on either count. I think what is needed is a change of course, globally. Back to the days of Plaza and Louvre, to a more managed world where we tried to work in cooperative fashion to resolve our collective problems. In economics one winner doesn't need another loser: we could all sink or swim together.

The circumstances now confronting the US economy are unique in the modern era. The Federal Reserve has warned about the risk of deflation after a year in which the US dollar has fallen by nearly 30 per cent against many leading currencies. Despite the weakness of the currency, US Treasury bond yields have fallen to 45-year lows and are 37 basis points under the yields of German government debt. The dollar's decline has been painless for US financial markets because investors are complacent about inflation. The failure of bond yields to rise has also produced a policy of benign neglect in Washington. Federal Reserve officials say the falling dollar is a European problem, not a US one. John Snow, the US Treasury secretary, effectively abandoned the previous administration's strong dollar policy over the weekend by issuing his own definition of what constitutes a strong currency. It does not include market prices.

The dollar began to weaken more than a year ago but its decline has accelerated during recent weeks for three reasons. First, the markets are concerned that the Bush administration's fiscal policy could boost the federal budget deficit to $400bn-$500bn and create a domestic savings imbalance that will expand the current account deficit to $600bn. Second, the markets are alarmed that the US is embarking upon an imperialist foreign policy that will have unknown consequences for its fiscal position, foreign trade and relationships with other countries. In the heyday of empire, the UK ran large current account surpluses. There is no precedent for a country playing the role of global superpower with a large external payments deficit. During the cold war, the US was able to finance its defence spending in part through offset programmes with other countries. The Bundesbank, for example, stockpiled dollars as a quid pro quo for US defence spending in Germany. During the 1991 Gulf war the US received large subsidies from Japan, Saudi Arabia and other countries. With the US pursuing a more unilateralist foreign policy it will have to absorb all of the costs without help from traditional allies.

Last, the markets perceive a vacuum at the centre of US economic policymaking. In this administration power is highly centralised at the White House. The only highly visible cabinet ministers are at the departments of state and defence. The Treasury's stature and influence declined during the tenure of Paul O'Neill because of his caustic comments about many issues and his poor relationship with Congress. Mr Snow has worked hard to improve ties with Congress but the markets see him as a salesman, not an architect of policy. Larry Lindsey and Glenn Hubbard, the people who created the administration's economic policy, have resigned. The other institutions of economic policy are also weak. The new director of the national economic policy council is focused on internal administration rather than influencing markets. Mitch Daniels, director of the Office of Management and Budget, is leaving to pursue a political career in Indiana. The Council of Economic Advisors is being evicted from the White House. Economic policy appears to be under the control of White House political advisers, not the traditional institutions of government. In fact, the White House will not be able to encourage a dollar rally until Karl Rove holds a press conference on the subject.

As Mr Snow's recent comments have made clear, Washington will do nothing to stabilise the dollar until there is a big correction in bond prices that might jeopardise the boom in the US housing market. But in the absence of a threat to the US housing market, the burden of adjustment will fall elsewhere. Asia will resist dollar depreciation through large-scale market intervention. China's foreign exchange reserves will expand from $280bn to $330bn this year. Japan's foreign exchange reserves will mushroom from $500bn to $600bn this year and reach $1,000bn by 2008. If Asia is able to stabilise its exchange rates, the US will have to reduce its current account deficit through larger devaluations against other currencies. This pressure for devaluation will set in motion a process of competitive monetary reflation with the eurozone, Britain, Canada, South Africa and other countries with variable exchange rates. These countries will be compelled to cut interest rates to prevent their currencies from appreciating against the dollar.

The Bush administration is prepared to pursue aggressive fiscal and monetary policies to ensure a healthy recovery in the run-up to the 2004 presidential election. Its new weak dollar policy is designed to put pressure on other countries to reinforce this domestic growth agenda. During the late 1980s Japan created a bubble economy with rocketing prices for land and equities by pursuing a monetary policy designed to stabilise the dollar. The coming round of competitive monetary reflation is also likely to force central banks to pursue far more aggressive interest rate cuts than they expect. If it does, President George W. Bush will not win re-election. There could be Bush bubbles in many asset markets during late 2004 and 2005.
Source: Financial Times

Japan's Crisis Revisited

Stephen Roach again. Yesterday he informed us concerning Japan that "one of these days the logjam was destined to be broken. It's just a question of when - and under what circumstances. That day could well be at hand." Now I have learnt with the passage of time that forecasting when 'endgame day' might finally come in the case of Japan is an extremly hazardous business. Back in October (when few of you were reading me!) I posted a piece comparing Takenaka to Yamomoto (the reference being to the financial carnage that any Japanese 'hard landing' might cause over on Wall Street) which, apart from the theatricality, I would willingly post again if I thought Roach was right. Right, I mean, in the sense that 'high noon' is coming. Having burned my fingers by being precipitate first time round, I'm adopting a more cautious 'wait and see' approach. In particular in the meantime I've read Karel van Wolferen's The Enigma of Japanese Power which I highly recommend to anyone wanting to understand what is happening in Japan. Among other jems you can find there is the idea that Japan, in some ways is a non-geographical federal state, power in this case being distributed not between the regions, but between the competing power centres situated in the various ministries. The notion of a Japan which speaks with a single voice is therefore something of a contradiction in terms. However the current power battle between 'reformers' and 'non-reformers' plays out in practice, you can bet your life the path will be 'non-linear'.

Returning to the more substantial point, for once I am in complete disagreement with Stephen. Playing Russian roulette with the Japanese body politic will not give the desired result. First, it is a risk averse society and will never be persuaded to volunteer to press the trigger (but then I guess that is another dimension of the weak dollar policy, to try and leave them - and the Europeans - no alternative). But, secondly, what if - as I've being arguing here at Bonobo Land - the 'reforms' as they're presently conceived are a remedy worse than the disease. What if there is no growth 'recovery' as Stephen understands it, waiting just round the corner for Japan, and if all those government bonds which the BoJ is quietly accumulating will one day be virtually worthless - for if deflation accelerates, and the debt continues to grow, there will be no way to pay it off, ever, and one day the world will wake up to this unpleasant reality. What if the reform that is really needed is a complete change of mindset, a 'cultural' revolution which opens to the world, and at the same time opens the doors wide to immigration as the only short term stop-gap for an ageing and declining population. And what if Japan is only the first, and what if we are addicted to growth in a world where - like 'good lovin' - it proves hard to find. These are difficult and deep questions, and the answers won't be coming out of my keyboard in a rat-tat-tat fashion. Looking for solutions is going to be difficult, but the first step is to find the problem.

In that vein, it is critical to ponder the broad outlines of Japan’s potential endgame. There can be no mistaking the near-term implications of legitimate reform initiatives for the Japanese economy: Initially, reform-driven restructuring of the financial system and nonfinancial corporations will be extremely tough medicine to take. Unemployment will undoubtedly rise a good deal further from its near record level of 5.4%, as will the risks of renewed recession and intensified deflation. There is also the related risk that the pain of restructuring could lead to a financial crisis that obviously would have a more pervasive impact on the Japanese and world financial system. But with possession of the world’s largest reservoir of saving and currency reserves, Japan can afford to take these risks. In the end, there is no alternative to additional cyclical distress if, in fact, Japan is finally serious about the heavy lifting of reforms. What Japan cannot afford to do is strangle its economy. And at this late date, that remains the most realistic alternative to reform.

These developments could have equally important implications for the rest of Asia and the broader global economy. More than a decade of near stagnation in Japan has all but neutralized its role as an engine of Asian growth. Whereas Japan accounted for approximately 10% of pan-Asian GDP growth over the 1985–94 period (on a purchasing power parity basis), our estimates suggest the share fell to a mere 4% in the 1995 to 2002 interval. Successful reforms will not change the balance of Asian growth over night. But as Japan comes out the other side, an externally-driven Asian economy will re-acquire an autonomous source of domestic demand. Today’s Japanese consumer probably has the greatest pent-up demand potential of any major economy in the modern era. As reform-induced layoffs mount, an increasingly saving-short Japanese consumer will undoubtedly exert even more restraint. But when there is a sense that the worst of the headcount carnage may be nearing an end — possibly 2–3 years down the road — a sharp rebound in private consumption is likely and Japan will then be in a good position to reclaim its role as the growth engine of Asia. The Japanese reform story is also critical for the world economy — especially the global rebalancing that a lopsided, US-centric world so desperately needs. The burden of this realignment must be shared by all. Just as a saving-short US economy must rein in the excesses of domestic demand, the structurally-impaired economies of Japan and Europe must unlock stagnant domestic demand by implementing long overdue reforms. Given America’s massive and ever-widening current-account deficit, I continue to believe that a sustained and significant weakening of the dollar will put increasingly greater pressure on Japan and Europe to shift the mix of economic growth away from currency-sensitive external demand. The recent weakening of the dollar lends credence to just such a possibility. Mounting pressures on the Japanese banking system only add to the tension, underscoring the perils of inaction. In the end, reforms are the only way to a successful global rebalancing. And wouldn’t you know it? Just when the world had written Japan off, the world’s second-largest economy may be starting to deliver.
Source: Morgan Stanley Global Economic Forum

Resona Resonates

The world is gradually waking up to the significance of the timing and scale of the Japanese government intervention in Resona, the country's fifth largest bank. First Stephen Roach:

The just-announced injection of 2 trillion yen ($17 billion) of public funds into the Resona Bank may well be the functional equivalent of a de facto nationalization of Japan's fifth largest bank. Unlike most of Japan's banking reform initiatives, this action was not focused directly on the write-offs and disposal of nonperforming loans (NPLs). Instead, it was aimed at restoring the NPL-impaired capital base of this troubled institution to international standards. In doing so, it appears that the government will effectively own approximately 80% of Resona’s total capital — at least, that’s the inference that can be taken from a statement by Prime Minister Koizumi, who implied that the bank’s capital adequacy would rise from around 2% to about 10%. The magnitude and scope of this action are without precedent in the recent history of Japanese banking reform; the bailout is equal to a little more than 20% of all funds previously injected into the banking system, or the equivalent of 0.4% of total Japanese GDP. Moreover, Japanese press reports suggest that Resona’s president and four other senior executives will resign, presenting the government with an opportunity to install a new reform-minded leadership. As such, this initiative hints that the heavy lifting of Japanese financial sector reform could at long last be under way. If that’s the case — and it remains a big “if” — we then need to look at Japan in an entirely different light.
Source: Morgan Stanley Global Economic Forum

No the big question is how much significance can we put on this intervention. Reading the tea leaves is a difficult job here. The key problem is whether the authorities acted as part of a concerted policy, or whether they had no alternative. Over to David Pilling, our 'man in Tokyo':

The Financial Services Agency yesterday insisted that the first it had heard of Resona's difficulties was on Saturday, the very day it agreed to inject about Y2,000bn ($17bn) into Japan's fifth-largest bank. If that is true, then the FSA's assurances that it was "not aware" of any other large Japanese bank being in trouble was not exactly reassuring. Yet the FSA was adamant yesterday that the decision to rescue Resona had been an auditing, and not a regulatory, one. "This is a matter between the bank and its auditor," an agency official said. "On 17 May, Resona reported formally that their capital adequacy ratio was going to be below [the required] 4 per cent . . . and we took reasonable action."

The word "formally" possibly sheds light on what happened. What seems most likely is that the regulator, at least informally, had known very well what was happening for weeks and had been discussing the issue with Resona behind the scenes. An associate of Heizo Takenaka, financial services minister, yesterday said that the agency had been fully aware that Resona had potential problems with its auditor since mid-April. The confusion over what the FSA knew, and when, begs the most fundamental question of the whole episode. Did the FSA decide that it was time to make an example of one bank by forcing it to accept capital? Or did it desperately try to salvage Resona, before reluctantly bowing to the inevitable and agreeing to provide fresh funds? According to Jean-Francois Minier, managing director of Dresdner Kleinwort Wasserstein, the decision must have come from the government. "At the end of the day it would be hard for the auditor to get tougher on its own," he said. "I'd be surprised if they were to do this independently." Mr Minier said that, if the government wanted to make an example of one bank, Resona was the one to go for.

First, it was purely domestic, having ditched its international businesses in the run-up to merger. That meant the government did not have any international repercussions to worry about, particularly in dealing with counterparties. Second, Resona, being so heavily dependent on deferred tax assets to pad its capital base, was in no position to object. There were suggestions that some Resona executives were furious at the government yesterday. But, officially, they asked the state for money and fell on their swords. That saved any messy recriminations linked to enforced nationalisation, which some senior executives at bigger banks have vowed to fight in court. That is the positive spin on events. But what if what the FSA said is taken at face value? What if it really did not know that Resona was about to be declared dangerously undercapitalised?

The ramifications of that are even more startling. To begin with, it would mean that Japan's financial regulator was woefully in the dark about the state of the institutions it is entrusted to monitor. For months now, senior FSA officials have been denying that the financial system had any problems that could not be solved through existing policies. But if the agency got Resona so wrong, it is possible that it is also misinformed about the real financial health of other Japanese banks, national and regional. Even more worrying, if the decision to pull the veil off Resona was really an auditing one, then auditors are now arguably the most powerful force in Japan. Because there is not, as yet, any clearly defined political decision on how to deal with tax deferred assets, a policy void has opened up. It is now apparently up to auditors to interpret current guidelines. In other words, as talk of bank nationalisation grows, the real decisions about what to do about Japan's shaky financial system may just have been privatised.
Source: Financial Times

Monday, May 19, 2003

IMF Deflation Revisited

The new IMF publication Deflation: Determinants, Risks and Policy Options is, like many documents of its type, something of a mixed bag. What I think is important is that they're getting the discussion up and running, this should at least be a wake-up call for Brussels and Frankfurt, and the debate can become more 'refined' as we move down the road a little. One BIG complaint is the fact that demographic changes don't seem to get a look in anywhere! Now I may be willing to grant that I'm overstating the case (I'm not convinced that I am, but it's important always to accept the possibility that you may be mistaken), but that it has no part to play in explaining the big picture (in understanding why, for example, Germany is so 'boxed-in' fiscally) this is surely impossible to accept. So why the distinguished absence. Really I am at a loss to understand this. This absence isn't the only major gaffe however, try this one for size. Speaking of economic growth and deflation in the 19th century, it says the following:

Prices declined in large part because of the constraints imposed by the Gold Standard in an environment in which there was a significant excess demand for gold. Increasing demand for money was being driven by technological change and population growth. At the same time, the supply of gold was largely fixed. The constraints imposed by the limited supply of gold manifested in part in the deflationary episodes and relatively weak growth: despite the extraordinary technological revolution, annual U.S. real GDP growth per capita was just above 1½ percent over the entire century; in the U. K. it was just under 1 percent.

Now this argument is really lamentable. By what standard is it possible to talk of overall growth in the 19th century as 'weak'. In comparison with any other known period of human history it was stunning. It is only by looking at the 19th century in comparison with the 20th century that we can look negatively on the 19c, and it only by looking back from the 1990's that we can talk about 20th century growth as 'moderate'. The question is (and it is, as we'll see as our investigations advance, an important one) can this process be sustained. Further, we should try and avoid falling into the trap of assessing all of human history using the yardstick of what just happened, we can gets things seriously out of perspective. Anyway I'll let Brad make the point:

.........the twentieth century is unique. Such rapid growth in standards of living has never been seen before, anywhere, anywhen. The nineteenth century saw perhaps a a tripling or quadrupling real growth und proper account is taken of the impact of new technologies like the railroad and the telegraph, and the expanded range of technological capabilities. And nineteenth century growth was itself fast compared to what had come before: people called it the "industrial revolution" for a reason.

Before the nineteenth century growth was even slower. The standard of living in the Netherlands, probably the richest economy in the world at the end of the eighteenth century, might (or might not) have been some fifty percent higher than it had been three centuries before, at the time of the Renaissance. And before that? Upper classes certainly lived better on the eve of the industrial revolution than they had beforehand, but for the average guy? Was it better to be a slave of the Roman politician Marcus Tullius Cicero or an enserfed peasant under the Han dynasty in the first century B.C., or was it better to be a slave of the American politician Thomas Jefferson or a casual laborer working the Canton docks in the late eighteenth century? As best we can tell, it is very close to being a tossup.
Source: Brad Delong: How Fast is Modern Economic Growth

That having been said the document is, as I've already indicated, interesting. They do, after all, distinguish between deflation in the late 19th century - which if not entirely benign, was at least not lethal - and deflation 1930's style. This contrast is also reflected in the classification of contemporary Chinese (non-disastrous) and Japanese (lethal dose stuff) deflation. From their analysis the economists at the IMF derive four sets of indicators: (i) aggregate prices; (ii) measures of excess capacity, or output gap (iii) asset markets; and (iv) credit market and monetary indicators. In addition, they mention structural characteristics, and the room for maneuver on the policy front as having a role to play in the overall assessment. Clearly I disagree with non of these as pointers to watch, but could it not be that some of them, at least, have demographically related roots: for example the relation between aggregate demand and the supply of savings? And still we are left with no mechanism to explain why all this should be happening now. I think it goes without saying that I do not accept the simple business cycle plus shocks version.

On the German front the document doesn't mince its words:

With broadly stable prices over the past six months, the German economy faces substantial demand driven drag to growth. Credit growth, production, and incomes weakened considerably during 2001 and 2002, and the labor market has been coming under pressure. House prices have been falling; equity markets have adjusted more than in the other advanced economies (Charts 12a and 12b); and corporate balance sheet adjustments still have some way to go. Furthermore, banks and insurance companies are, by their own admission, undergoing the most challenging period since World War II. Thus the near-term outlook for a recovery in investment remains more clouded than in the other advanced economies. The Phillips curve analysis for Germany suggests that for mild deflation to take hold, the output gap would need to rise 1 to 2 percentage points. At the same time, the unemployment gap would have to increase by 2 percentage points. For persistent deflation, the output and employment gaps would have to increase by 2½ to 3½ percentage points. The staff’s central projection sees a widening of the output gap on the order of 1 percentage point this year because real GDP growth would remain around ½ percent. However, the unemployment rate would increase relatively modestly.

Accordingly, the probability of mild deflation taking hold over the next year is considerable. Of course, as prices in Germany decline relative to its trading partners, particularly in the euro area, the improvement in its competitiveness will stimulate exports and investment. This may prevent expectations of falling prices from becoming entrenched. However, this mechanism is likely to operate only slowly, and can do little to remedy difficulties in financial intermediation that could develop rapidly in a deflationary environment. Unlike in other economies, the room for policy maneuver is constrained, if not absent altogether. Fiscal policy is set to become restrictive (cutting the cyclically adjusted deficit by ¾ percent of GDP this year)––in support of Germany’s commitments under the Maastricht Treaty. While monetary conditions have tightened given the euro appreciation, monetary policy may not ease significantly because of greater price pressures in Germany’s euro-area partners.