Roach Global: A Conversation with Franco Modigliani
Stephen Roach (New York)
There are always great imponderables in the macro outlook. But today the questions seem to loom larger than ever. At the top of my list are two burning issues -- the prognosis for the American consumer and the risk of a US deflation. Nobel laureate Franco Modigliani has long been noted for his path-breaking work on these very issues. He was in town in couple of weeks ago, and we had the chance to sit down for a most engaging discussion. An edited version of our conversation follows.
Stephen Roach (SR)
Let’s start out with the burning issue of the day -- the American consumer. Franco, as a pioneer in the macro of consumer behavior, what is your assessment of the outlook for this key sector of the US economy?
Franco Modigliani (FM)
The consumer is at risk. Having said that, I must confess to being surprised about the resilience of consumption after the stock market bubble popped. I would have expected some retrenchment. I would have also expected some related damage in the real estate market and the dollar. I still believe at some point there must be some repercussions.
SR
What gives you such conviction?
FM
The key for the consumer response is not the immediate situation. Too much is made of the day-to-day developments, such as mortgage refinancing. My work shows that consumers frame decisions in the context of their life-cycle considerations. It is an intertemporal theory, whereby decisions in any period have implications for adjustments in the future. That’s why the wealth effect can be important. If the popping of the equity bubble results in a reduction of longer-term return expectations on an important asset, that has important implications for life-cycle saving and spending patterns.
SR
But there is more to household wealth than stocks. Hasn’t the property market saved the day?
FM
While it may seem that way right now, I have my doubts. I am suspicious of those studies that find the wealth effect is larger from real estate than equities. Theory tells me it should actually be the opposite. That’s because the house in part, produces a consumer good -- housing services, which we consume. When the value of the house I inhabit goes up, its implied rental value increases. But that does not significantly improve my spending power, because my imputed rent has gone up as much. Any wealth effect on individually-owned property must net out the consumption of the service we derive from living in our homes. Those adjustments need not be made for stock portfolios. It is possible that new refinancing instruments, such as home equity loans may have temporarily distorted this relationship. But I would view this as a one-time shift, not as a permanent realignment of the link between wealth and consumption.
SR
So how does it all end for the American consumer?
FM
A negative wealth effect tells me it can’t go on forever. And that’s when I revert to the life-cycle theory. Sadly, the large cohort of aging baby boomers is not adequately prepared for old age. The personal saving rate is too low. It has been depleted by individuals betting on asset markets. Life-cycle theory suggests that the saving rate should have gone up by now. Obviously, it hasn’t -- at least, not yet. While that puzzles me, it doesn’t dissuade me from the basic view that the balance between consumption and saving will have to adjust. It’s just a matter of when. That leads me to conclude that that the American consumer is the most dangerous portion of the picture.
SR
Let’s turn to another key issue being debated in financial markets -- deflation. I find myself more worried about deflation than at any point in my professional career. Are you at all concerned about the possibility of deflation?
FM
I was surprised when I first heard of the extent of your concerns. They come across as very strong, very scary. I think you are probably exaggerating.
SR
I have been known to do that.
FM
Does Byron agree with you?
SR
No, nobody does. And that is one of the reasons why I am trying to argue the case -- to give some legitimacy to the deflation debate. These days, when you merely utter the word "deflation," you get strange looks like you’re crazy.
FM
Well, let me start by saying one thing at the outset: It really depends on how much deflation we are speaking about. I would say that deflation is something to worry about, only if is going to be large. If it’s just a temporary blip down in the price level, it wouldn’t worry me. It has to have both depth and duration to be a serious concern. But so far, we really haven’t had any deflation at all in the United States. Isn’t that right?
SR
So far, you are absolutely right. But the GDP price index is now increasing by just 1.1%. That’s the lowest rate of aggregate inflation in the US economy in 48 years. So we’re not that far away from the hallowed ground of price stability, to say nothing of the deflation that lurks on the other side of this threshold. But it’s not just the data. I worry about deflation for both cyclical and structural reasons.
FM
In other words, you are not just worried about the existence of deflation. You are more worried about it having bad effects.
SR
Yes.
FM
Well, that takes us to a consideration of debt deflation. Essentially you will agree that inflation or deflation has an effect both on creditors and debtors. In that sense it is a zero-sum game -- whatever is gained is lost and vice versa. But the private sector as a whole gains because it is the net creditor of the Great Debtor, namely the government. In practice, firms are also net debtors and creditors are mainly (older) individuals. So from the household’s point of view, you might argue that deflation is good. However, I think it is a very important thing to remember is that deflation is bad for the government -- as a net debtor; in effect, it increase the real national debt. On balance, that is good for the current generation that owns the claim on government indebtedness but bad for future generations that will have to pay higher real taxes to finance that claim.
SR
Can I just ask you to clear up one thing: Are you saying that creditors gain because deflation effectively expands their purchasing power?
FM
Yes, it’s both the purchasing power with respect to the flow -- debt service -- and the purchasing power of the stock of assets. While retired people lose out from the standpoint of interest earnings in a deflationary period, when they liquidate their capital, they can exchange the proceeds for more goods. In that respect, the stock effect works to their advantage in a deflationary period.
SR
I’m very interested in this differential effect. It seems to unmask some of the tensions that we macro practitioners lose sight of. Can you elaborate on this point?
FM
Yes, your question actually takes me back to a story about a good friend of mine, Harvard economics professor John Kenneth Galbraith. Well, one year, when I was a visiting professor at Harvard, Ken Galbraith invited me for a debate with the students at Lowell House. He decided that we should have a debate about inflation. He made the point that inflation was bad for the poor and good for the rich. And I said, "Ken, you’re way off." [Laughter] The poor, I insisted, are more likely to be debtors. And debtors benefit from inflation because of the reduced real burden of the debt. So I concluded that inflation is good for the poor and not for the rich.
SR
And what did he say?
FM
[Laughter] I think it was at that point that Ken said to the students, "Don’t believe what he says. He’s one of these people who writes textbooks and has to defend what he said in his textbook." But there’s a moral to this story: In assessing the macro impacts of inflation, deflation, or fluctuations in interest rates, the distribution of indebtedness matters. For every borrower who gets a boost in purchasing power, there is a lender who loses. They may be different people, but it is the net effect that matters for the macro economy.
SR
Let me go down a slightly different road. Deflation has an impact, as you just described, on the ability to service debt. But deflation has also become a real wake-up call for companies that are coming to realize that they don’t have any control over pricing leverage. And they’re cutting costs in response. If there comes a point when the cost cutting is aimed at headcount and wage payments, how does an overly indebted society adjust to that?
FM
The answer to that question depends on the causes of the supposed deflation, a subject on which you have not dwelt extensively. I can think of two major causes: The most obvious would be a deep cyclical decline, but this version is most unlikely because of the availability of well known stabilization policies, and because in this century, as a result of wage rigidity, no contraction has ever produced deflation in developed countries, since the Great Depression. The other possibility is dogged foreign competition from countries like China. This type of deflation, within limits, would be good for the consumers and would compensate for any resulting downward pressure on nominal wages.
SR
How might such "good" deflation turn into bad deflation?
FM
The only problem I could see would be the possibility of debtors getting worse off. And even though there may be offset by creditors being better off, that doesn’t help if you have wholesale repossession of houses and other levered assets. You also suggest that the price pressure could reach a point where it could lead to a curtailment of domestic production. However, I doubt that even this kind of deflation could get very far because it probably would be offset by a devaluation of the dollar.
SR
So if it’s debt deflation that has you most concerned, don’t you worry about record levels of household and corporate indebtedness currently existing in the United States?
FM
Macro debt loads have certainly gone up a lot -- it’s hard to deny that. But, here again, I want to look beyond the macro and study the composition of debt. And there are some very recent developments on the scene that give me pause -- namely the home equity loan. I think this new instrument has done some very important things. Suddenly, a house has become a liquid asset.
SR
Do you think that’s good?
FM
Well, from the standpoint of progress, I think it’s good. I have always been in favor of making assets more liquid. In that same vein, I am also in favor of allowing loans on 401(k)s.
SR
But the flip side of that liquidity is debt -- the means by which incremental purchasing power is extracted from these assets. Does this create a new bias toward debt-financed consumption that can only end in tears?
FM
That’s obviously a worry, especially if you are right on deflation. What Americans do now is borrow against future asset values. Deflation would bring down the value of the properties themselves and therefore reduce the ability to borrow. This phenomenon can become very important if deflation deepens and lasts.
SR
I have one last question on the deflation issue: Doesn’t the endgame hinge on wage rigidities, or the lack thereof? If deflation pushes nominal wages down, won’t all bets be off?
FM
As a Keynesian, I believe that macro variables such as employment and prices hinge on wage rigidity. Once you accept that, all the rest follows. Historically the floor for increases in wages is defined by productivity. So as long as productivity growth is maintained, nominal wages are unlikely to fall. It’s a very deep question. Employers simply don’t like the idea of going to workers and telling them they’re going to cut their wages. And because employers rely on the support and loyalty of workers, they can’t afford to alienate them. By and large, prices are linked to such "sticky" wages. In short, Steve, your case for deflation is interesting. But I’m not persuaded that that the wage-setting mechanism is flexible enough to turn this into a serious problem here in America.
SR
Thank you very much, Franco. I certainly share your concerns on the consumer. And I will continue to probe the case for deflation.
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