Mike
any thoughts on Roach today?
Global: The Lessons of Japan
Stephen Roach (New York)
The deflation debate is finally out in the open. As well it should be, in my view. But there is one key aspect of this argument that is still considered verboten -- the Japan precedent. The Japanese experience with deflation over the past seven years is widely viewed as a unique outgrowth of the world’s most dysfunctional major economy. As I travel the world in my role as a deflation provocateur, the most common refrain is “We’re not Japan -- so it can’t happen here.” I hear that these days in Germany and, of course, in the United States. It’s hard to argue with one aspect of that that assertion -- no two countries are alike. But does that mean we should ignore the lessons of the Japanese experience?
I would argue that the answer to that question is an emphatic “no.” First of all, Japan does not have a monopoly on the case for deflation. To the extent that deflation arises from policy blunders and/or from prolonged disparities between aggregate supply and demand, there’s more than one way to fall into this trap. Second, I would heed the warnings of America’s Federal Reserve. Sure, the public utterances of senior Fed officials about deflation all contain the codeword “remote” in assessing the likelihood of such an outcome. But they have no choice in their spin -- the authorities want to convince the public that the odds of deflation are extremely low. To do otherwise would strike fear into the hearts of the masses, reinforcing the very expectations they are trying to quash. My advice: Listen less to the rhetoric of a public relations campaign and pay more attention to the Fed’s role in providing legitimacy to the deflation debate. The Fed’s policy statement after its 6 May meeting dispels any lingering doubts -- it states explicitly that the risks are now skewed more to deflation than inflation. In that same vein, a research paper published nearly a year ago couldn’t be clearer -- the lessons of Japan are not to be taken lightly (see Alan Ahearne, et. al., “Preventing Deflation: Lessons From Japan's Experience in the 1990s,” Federal Reserve International Finance Discussion Paper 729, June 2002).
Those lessons are especially appropriate for financial markets. Interestingly enough, for all this talk about deflation, financial markets are not priced for such an outcome. Inflation-indexed bond markets tell us that long-term inflationary expectations remain stuck in the 1.5% to 2.0% range. And rebounding equity markets speak of an earnings optimism that all but dismisses deflationary perils. Some fascinating work by our US equity strategist, Steve Galbraith, bears directly on this point, suggesting that the US stock market may even be discounting rising inflation -- from 2% to 3% -- over the next six months. Steve gleans that insight by looking at the recently improved price action of a basket of around 100 stocks that have the tightest historical correlation with inflation. The bottom line: Investors are all fascinated with the great inflation debate. But when push comes to shove, the broad consensus is still leaning the other way when putting real money to work. Should the case for deflation gain greater mindshare in shaping actionable investment conclusions, financial markets could be in for a rude awakening.
In that regard, it’s worth pondering the experience in Japanese financial markets, as deflation went from being a bad dream to reality. The behavior of Japanese government bonds (JGBs) is especially noteworthy. Back in early 1995, on the cusp of Japanese deflation, 10-year JGBs were yielding 3.4% (on 31 March 1995). At that point, the so-called smart money widely considered JGBs the greatest “short” in the world -- the bubble to end all bubbles. For the record, as deflation has taken hold in Japan, there has been a steady, unrelenting rally in JGBs over the ensuing seven and a half years that has taken yields down to a mere 0.5%. Fast forward to the United States and you now hear similar claims of a bubble in Treasuries. With an astonishing 3.3% yield on the 10-year (as of the close on 29 May), such perceptions are understandable. But the lessons of Japan should caution us from concluding that it’s now time to short Treasuries -- especially, as noted above, with so little deflation risk embedded at the long end of the yield curve. If the fear of deflation intensifies in the US, the Japanese experience tells us there’s still plenty of room for Treasuries to rally further.
There’s an equally relevant lesson to take from currency markets. Back in the spring of 1995, the yen/dollar exchange rate briefly hit a record high of ¥80. It then entered a protracted period of depreciation, ultimately falling by 45% by the summer of 1998. Conventional macro suggests that such an outcome would have been accompanied by rising interest rates and accelerating inflation -- with the latter development especially likely for a trade-sensitive economy such as Japan. Of course, neither outcome transpired, as JGB yields plunged and Japan tipped into deflation. The lesson from Japan: Deflation turns time-honored macro relationships inside out. Inasmuch as I continue to believe that the US dollar is in the early stages of a secular downtrend, the Japanese experience certainly intrigues me. In a climate rife with deflationary risk, there are no guarantees that a falling dollar will lead to higher inflation and/or higher long-term inflation rates.
Invariably, the relevance of the Japan experience is drawn into greatest question when the banking comparisons are made. Deflation is widely and correctly regarded as being most dangerous when it is accompanied by distress in the financial system. Since Japan’s banks are in much worse shape than those elsewhere in the world, many believe that other countries need not worry. Here as well, I have my doubts. Germany, for example, already has a very vulnerable financial system -- banks and life insurance companies, alike. By contrast, US banks are in good shape at the moment, having gone through a serious shakeout in the early 1990s. But America has record debt loads, especially the household sector, where debt-to-GDP currently stands at a record 80% -- fully 15 percentage points above the ratio prevailing in the recession of the 1990s. The US also has flexible labor markets and a relatively flexible wage-setting mechanism. Should deflationary risks get to the point where Corporate America needs to slash labor costs more aggressively -- both headcount and compensation -- that would severely impair the household sector’s debt-servicing capacity. The result would be a sharp increase in nonperforming loans and a concomitant outbreak of distress in the American banking system. Debt deflation is the most lethal strain of deflation. America’s record private sector debt loads are hardly comforting in that regard. While any progression of debt-related dislocations in the US would undoubtedly be different than it was in Japan, the endgame could be comparable.
The monetarist cure is a final comparison worth making -- especially in light of the debate now raging in the US over the efficacy of the Fed’s coming assault on deflation. The monetarist diagnosis and prescription is straight-forward: Inasmuch as fluctuations in the price level are believed to be first and foremost a monetary phenomenon, an injection of massive liquidity should stop deflation dead in its tracks. Yet if it was all that simple, it’s hard to believe that the Bank of Japan wouldn’t have tried this recipe some time ago. In fact, that’s exactly what happened. Since early 1997, Japan’s broad money has increased by about 20%, its monetary base has surged by 84%, and the BOJ’s balance sheet has expanded by 122%. Yet over that same six-year period, Japanese nominal GDP has actually contracted by 6%. In other words the monetarist prescription has failed miserably in Japan -- hardly a comforting result for other central banks as they now face the perils of deflation.
America is not Japan -- nor is Germany. But each of these countries faces its own unique strain of deflationary risks. The Federal Reserve is telling us that now is the time to heed those risks. I suspect the ECB will eventually and grudgingly send a similar message. That leads me to believe that there could well be a good deal more to come in the “deflation play” in financial markets -- especially since investors have largely been reluctant to discount such a possibility. Financial markets, of course, are often driven more by the fear of an extreme development than the outcome itself. In other words, the world doesn’t have to topple into a destructive deflation for markets to react. All that has to happen is that the risks of deflation rise. I continue to believe that’s a distinct possibility. And if that’s the case, then the lessons of Japan could end up having a great deal more relevance than most suspect. |
