Stephen Roach (from Milano)
The global deflation battle has at long last been joined. Once labeled remote, deflation risks are now the defining force shaping macro stabilization policies around the world. Japan, of course, led the way in this assault, followed by massive monetary and fiscal policy stimulus in America. And now the European Central Bank has finally jumped into the fray. This massive policy stimulus is good news for those of us who have long worried about the perils of deflation. At least the authorities have finally smelled the coffee. But, in retrospect, that was the easy skirmish in this battle. The big question remains: Will these reflationary efforts work?
As I speak with investors around the world, I find few who are willing to doubt the reflationary endgame. After all, goes the logic, never before has the modern-day global economy received such a massive dose of stimulus. Policy interest rates have been slashed to near-historic lows — zero in the case of Japan — and budget deficits are high and rising in all the major economies of the world. Most presume that it’s only a matter of when, not if, these actions boost aggregate demand and bring the deflation nightmare scenario to an end. Global equity markets are rallying in anticipation of just such an outcome in the next 6–12 months. And global bond markets are taking heart in the possibility that central banks will do everything in their power to insure such a result by remaining accommodative for an indefinite period of time. Policy traction is widely thought to be a foregone conclusion.
But is it? The Japanese experience should caution us in rendering a quick verdict on matters of policy traction in a world fraught with deflationary perils. The lessons of Japan’s post-bubble liquidity trap are particularly appropriate. It’s not that the United States and Germany, to pick the most likely suspects, are following the Japanese script to a tee. The path in all three instances has been very different. In Japan, the interplay between the property bubble and the banking system was unique. In America, the equity bubble infected the real economy, taking both consumption and capital spending to excess — setting the stage for an outsize gap between aggregate supply and demand. In Germany, it’s more a case of chronic structural rigidities and an abrogation of policy remedies to pan-European authorities. But in all of these cases, the means matter far less than the potential end. The world’s three largest economies — collectively accounting for nearly 50% of global GDP on a purchasing-power parity basis — are either in deflation or very close to the brink of such an outcome. And if there’s one lesson of history that screams out for attention it’s the lack of policy traction that typically occurs in such a climate. Central banks, in particular, have had a terrible track record in curing deflation. The world in the 1930s and Japan in the 1990s are grim reminders of what happens when the authorities end up pushing on that proverbial string.
That very risk is being overlooked today, in my view. The monetarist diagnosis has become accepted wisdom — that fluctuations in the price level are first and foremost a monetary phenomenon. America’s Federal Reserve is now leading the campaign in extolling the virtues of the printing press as an anti-deflationary cure. Fed Chairman Greenspan and Governor Bernanke have gone out of their way to stress the unlimited potential that central banks have to flood the system with liquidity — liquidity that can only raise the aggregate price level. This belief resonates in the hallowed halls of the ECB, especially in Germany, where I have just completed a two-day, three-city swing. As one leading German economist put it to me recently in commenting on his country’s near universal acceptance of monetarism, “…it's in the German genes.” Never mind monetarism’s terrible track record — especially Milton Friedman’s vocal and public call for renewed double-digit inflation in the US by the end of 1984. It just doesn’t seem to matter that surging US money growth in 1983 — M-2 up by 13% — was followed by a dramatic slowing of inflation from 6.2% in 1982 to 3.7% over the 1983–85 period (see my 21 May dispatch, “This Deflation is Not a Monetary Phenomenon”). Never mind the results of the Bank of Japan’s massive liquidity injections since early 1997. There just doesn’t seem to be any concern that Japan’s 84% expansion of the monetary base over the 1997 to 2002 interval was accompanied by a 6% decline in nominal GDP (see my 30 May dispatch, “The Lessons of Japan”). Notwithstanding these extraordinary miscues, monetarism is widely given the benefit of the doubt as the surefire cure to all that ails a potentially deflationary world.
In my view, the so-called monetarist cure begs the basic question of policy traction — the means by which central bank stimulus boosts aggregate demand. For the record, I feel just as strongly about supply-side fiscal remedies that are the rage once again in Washington in offering “trickle-down” remedies to Main Street consumers. Dogmatic to the end, both monetarists and supply-siders pay little attention to the hows and wheres of their stimulative prescriptions.
Consider the case of the United States: Decades of business cycle experience have taught us that there are three sectors of the real economy that are always most sensitive to policy stimulus: consumer durables, residential constructions, and, with a lag, business capital spending. Recessions typically crush demand in the first two sectors — cars and housing, for short. Policy stimulus then unleashes pent-up demand and the recovery typically springs to life. In the current cycle, cars and housing never fell and actually rose to records in the early stages of an anemic recovery. In short, there is no pent-up demand in the United States that will now get traction in an era of policy stimulus. That leaves business capital spending as the only real hope. But with companies lacking in pricing leverage and therefore awash in excess supply, I am hard-pressed to believe that this sector will draw support from reflationary policy efforts — even from the temporary tax incentives that the Bush Administration has just enacted. In an era of global capacity bloat, cost-of-capital considerations — the means by which policies can influence the investment decision — just don’t matter that much at all. In a post-bubble era, the policy responsiveness of the US economy bears little or no resemblance to that of the more traditional cyclical climate.
The story in Germany is different but ends up at basically the same point, leaving us with good reasons to question the likelihood of policy traction. With record-high and still rising unemployment, the German consumer is all but dead in the water. Will lower interest rates really make a difference? That question is especially relevant since German core inflation of 0.8% is running about one-third that in the rest of Euroland — 2.4% by my reckoning. That means ECB monetary accommodation will not provide the real interest rate relief that Germany so desperately needs. At the same time, the recent and prospective appreciation of the euro should act to impair external demand, the economy’s only real source of growth these days. While one day hardly makes a trend, the initial response of foreign exchange markets to bid up the euro in the aftermath of the ECB’s 50 bp easing of 5 June is disconcerting, to say the least. Constrained by the pan-regional framework of EMU-based policies, Germany is not getting the stimulus it needs. And I continue to believe that few in Europe could avoid the contagion brought about by an asymmetrical shock that takes Germany into deflation.
As a deflationist, I do draw some comfort from the reflationary response of the Authorities. But the risk is that the response is late and not bold enough — especially in the case of Europe. Macro policies are very blunt instruments. In a typical business cycle, counter-cyclical remedies work like a charm — economies are ripe for stimulus. But this is a post-bubble world, where the traditional business cycle has been turned inside out. In this climate, there are no guarantees of traction. |
