U.S. war on deflation threatens global economy
yomiuri.co.jp
Jesper Koll Special to The Daily Yomiuri
Around the world, a growing number of economists are trying to forecast movements in financial markets on the basis of predictions about what will happen to economies. Unfortunately, much of this may be a waste of time. More often than not, the financial markets determine the future course of economies.
Given the dramatic decline in global stock markets and the relentless drop in interest rates during 2002, this should make economic forecasting for this year easy: The world economy may be headed toward a deflationary decompression. The good news is that central banks around the world are on to this and are beginning to mobilize for a fight against it. The prospects for a real fight are serious because the war is being led by the U.S. Federal Reserve--the very center of the global financial system.
On Nov. 21, Ben Bernanke, who was appointed to the U.S. Federal Reserve Board in August, made an extraordinary speech titled "Deflation--making sure it does not happen here." Bernanke made it very clear that the Fed would not hesitate to implement radical and unorthodox policy to ensure that "any deflation would be mild and brief."
Bernanke stated that the Fed would not hesitate to buy corporate bonds or make zero-rate loans to banks against corporate commercial paper collateral, in addition to being ready to buy foreign government debt.
These are important policy statements that mark a true regime shift. The U.S.-centered war against deflation is starting. Global central bankers will have no choice but to follow.
For Japan, the key implication could be negative. There is no historic precedent of an economy pulling out of deflation, however mild, without a currency depreciation. So the greater the risk of deflation in the United States, the harder it will be for Japan to prevent an appreciation of the yen. The coming U.S.-centered war against deflation may very well force a sharp acceleration in deflation in both Japan and Europe.
Downward pressure on the dollar is indeed mounting. For years, global investors put their trust in the United States' future. They regarded the United States as the best bet for a combination of new technology, new entrepreneurs and solid policymaking to pull off a super productivity and growth cycle. They regarded it as the world's largest and richest developing economy and emerging market.
Think about it: The U.S. economy has low savings and lots of potentially profitable investment opportunities. Return on capital must thus be high to attract this investment. In contrast, Japan and Europe are mature developed economies ensnared in a combination of high savings, excessive domestic investment and inflexible labor markets.
As a result, Japan and Europe offer a relatively low rate of return on capital. In the real world, surplus savings thus flow from where returns are low to where they are high. This was the fundamental bullish case for the dollar.
Whether a strong dollar is in the best interests of the United States or not is debatable, but a strong dollar certainly reflects global confidence in U.S. economic leadership.
However, before long, the dollar may become an overvalued currency, with an unsustainably large current account deficit and falling import prices fueling deflation. Thinking the unthinkable, the real concern for the global economy at the start of 2003 is that the United States will be the last and largest economy to suffer an emerging market crisis, in which foreign capital inflows become outflows and the dollar collapses. To defend the currency, Fed Chairman Alan Greenspan would have to raise rates, causing Wall Street to crash and the property bubble to burst, and other negative side effects.
One prescription for such a U.S. crisis would be an International Monetary Fund-style package. The IMF approach to crisis-hit developing economies says that the elimination of a current account deficit must be achieved through deflation rather than through devaluation. The IMF would almost certainly mandate that the Fed raise interest rates even further, and the budget deficit be cut to reduce excessive domestic demand.
In reality, of course, the opposite is poised to happen. This is because the Fed's primary focus is the opposite of the IMF prescription. It wants to inflate and will do so in a clear, decisive and ruthless manner. Too much has been learned about the collapse of asset bubbles and the threat they pose in destabilizing the financial system and unleashing unpredictable forces of deflation through negative wealth effects.
No, the most likely response to a crash on Wall Street is that rates will be slashed even further and the world will be flooded with U.S. dollars. The yen could shoot to 80 yen to the dollar or even higher. This really would kill any hopes of a global recovery.
Clearly, the United States will not lift a finger itself to stop the dollar's fall. It has not got sufficient foreign currency reserves to do so. If private borrowers of nondollar currencies go bankrupt, the U.S. government will not take responsibility for these private foreign liabilities--it will simply allow them to default.
Unlike poorer and smaller developing countries such as Thailand, South Korea or Russia, the United States as the world's largest developing debtor country can and will force its creditors to deal with the problem. Specifically, if default causes problems for Japanese banks and life insurers, the Japanese will have to bail them out. If the yen gets too strong, the Japanese will have to intervene to support the dollar. The United States will not borrow from the IMF or deflate domestic demand to bail out foreign lenders. Instead, the United States will force creditor countries to reflate demand.
Already over the past few months, the global decline of the dollar may be signaling that Japan and Europe will be forced to shrink their trade surpluses--exporting less and importing more--while the United States exports more and imports less.
To make up for their loss of exports, both Japan and Europe will have to reflate domestic demand. In other words, right now the world economy is under the threat of major deflation risk stemming from the U.S.-centered war on deflation.
Of course, none of this will happen as long as global and U.S. investors are willing to finance the dream of the United States' superior entrepreneurs, relentless technological innovation and outstanding policy leadership.
However, if the enthusiasm stops--and history suggests that the higher the expectations, the greater the room for disappointment--the world's central bankers and policymakers will have a real policy coordination problem to deal with.
The best safety net for both Japan and Europe is to speed up deregulation and foster an entrepreneurial revolution that creates jobs, wealth and the dream of a productivity explosion. Japan and Europe must start beating the Americans at their own game and become emerging markets offering high prospective returns. The more Tokyo and Brussels do to create domestic growth opportunities, the less they have to fear from U.S. growth sputtering--and the dollar falling.
Koll is chief economist of Merrill Lynch Japan Securities Co. |
