Japan

/ / , , , , /

Deflation and Wages

It’s a rare moment when Paul Krugman agrees with someone like Martin Feldstein, they represent very different parts of the political and economic spectrum. But agree they do. What is the miracle factor that binds them? Their fear of deflation. Nothing is as threatening to the way in which we all conduct business in the modern economy as a bout of deflation.
How real is the risk?

Well Feldstein was prompted to write about deflation by the appearance of an Economist magazine survey in which forecasters from around the world predicted that consumer prices in the US and Japan may actually fall in 2009. That sets the stage for a possible period of deflation, especially when we add in the factor that started Krugman writing: wages are falling in many parts of the US.

Consumer prices are bound to fall for a while during a recession if they are already fairly stable at its beginning. The drop in demand alone takes pressure off of commodity prices – things like oil and raw materials – which subsequently feeds through to the consumer as lower retail prices. If the fall in demand is sharp enough, as it has been this time, prices in stores will also be driven down by retailers and manufacturers use of discounts and incentive pricing. Before long, as the contraction gathers pace, this downward pressure becomes self-fulfilling as consumers start to bargain hunt and avoid anything that appears ‘fully priced’. This is exactly what we have seen so far in this recession. The modest pick up in sales volumes reported back earlier this year were largely a result of discounts encouraging spending.

The fact that fears of unemployment are so rampant that workers are now accepting pay cuts in order top retain their jobs exacerbates this trend even further.

As workers wages start to drop the potential for a vicious downward spiral rises. Lower wages create particular difficulty for anyone with fixed expenses. The relative cost of those fixed expenses goes up. Put another way: the number of hours work it takes to pay the mortgage is higher. This is exactly equivalent to a rise in the cost of debt. Which, as Krugman points out, is something Keynes spoke about during the Great Depression.

One possible reaction that policy makers can have is to stoke up inflation. Which is what the authorities in the US, the UK and Japan have been doing. In all three countries the central banks have been printing money furiously to offset any deflationary tendencies. Here in the US the result has been a very modest rise in the inflationary expectations embedded in long term interest rates.

Nonetheless deflation lurks as a major threat.

An extended period, say several years, of deflation could undermine our economy as no other factor could. Business investment would become unattractive; debts would slowly increase in their burden and stifle consumption; and the mentality of the economy would slowly shift towards a defensive posture: the attractiveness of credit disappears and prevents growth in major sectors of the economy such as housing and auto manufacturing.

In short, deflation sucks.

We all appear to want to try all the wrong options before we are forced, at great cost, to try the right ones. This is truly perverse behavior.

Oddly, we have a very recent historical example to study: Japan during the 1990’s. That example is salutary because it also includes a major bank crisis. As we look back on Japan’s experience three things strike me as relevant:

  1. The Japanese failed to deal with their banking crisis quickly enough. It took the best part of a decade for the government to ‘do the right thing’ and demand that the banks take government bailout money. It also finally forcibly reorganized the weaker of its banks.
  2. But the cost of delay was huge. Japanese wealth was no greater at the end of the decade than it was at the beginning. So the timidity of the Japanese government cost its population a vast amount of lost opportunity. Things may have felt relatively stable, but they should have been so much better.
  3. Deflation is extraordinarily pernicious. In the end Japan only started to recover because the worldwide growth in trade created export markets for Japanese goods. Domestic growth remained weak and savings far too high.

    Since this evidence is easily at hand, and since we also have the benefit of Keynes analysis from the Great Depression I find it strange that practically every government in a major country now affected by the recession, and that means just about everyone, is behaving exactly the same as the Japanese did early in their ‘lost decade’. In fact judging by the policy options taken here in the US and in Europe on both fiscal stimulus and banking issues we all seem hell bent on avoiding learning anything from Japan. We all appear to want to try all the wrong options before we are forced, at great cost, to try the right ones. This is truly perverse behavior.

    Nonetheless that’s what we’re doing.

    And one consequence of timidity is the ugly possibility of deflation which is scary enough to get folks like Krugman and Feldstein to agree.

    That alone should jolt the administration from its tentative ways. Should it not?

    / / , , , , , , /

    Forget Exports as Our Next Big Thing

    The recently published IMF report on the state of the world economy is a very sobering [and very long!] read. It predicts that, for the first time in decades, the world’s economy will shrink. Normally a recession in one area is offset by continuing growth elsewhere, so the global economy keeps on expanding as a whole. Not this time. The recession, that started here and is now infecting everyone else will cause the world’s economy to shrink by as much as 1.3% this year. The report notes that this is, by far, the worst global downturn since the Great Depression. The outlook for 2010 has been revised sharply downward too, with a meagre growth of 1.9% predicted.

    This somber outlook provides a cautionary tale for those who argue that the US can lift itself out of its own malaise by constraining domestic consumption – a worthy goal if we want to reduce our reliance on debt, which I think we do – while, at the same time relying on exports from a reinvigorated American manufacturing sector.

    The problem can be expressed simply as this: who do export to?

    The two industrial countries with the most severe contraction to deal with are Japan and Germany. They both have very similar economic models. They rely heavily on exports of manufactured goods to support a their economies and both have a much more modest level of domestic consumption than the US.

    The news for both Japan and Germany is getting much worse.

    Several economic think tanks in Germany are now predicting that GDP there will shrink by as much as 6% this year largely due to the collapse of trade. Also today, Japan is set to announce its first trade deficit in thirty years, also a result of trade market for its exports drying up.

    The experience of Japan and Germany suggests that, apparently, the global nature of this downturn has taken away an export led recovery as one policy option we can consider.

    The lesson is best learned by looking at the japanese experience. There has been much play made of the economic problems Japan had during the 1990’s: they were the most recent to experience the ‘zombie’ bank phenomenon we fear so much here. Their economy languished at close to zero growth for a decade because they made policy mistakes early on in the crisis, failed to inject a large enough stimulus, and were tentative in dealing with failed banks.

    Sound familiar?

    The Japanese economy revived largely because world demand sucked in Japanese products in sufficient volume to offset very low growth in domestic spending. So successful was this strategy that it has become the normal Japanese method for maintaining a rising standard of living. It is a model for economic management that works well as long as there is always somewhere in the rest of the world with a growing market for Japanese goods. It doesn’t work too well when the entire world goes down together as we now are.

    Which brings us back home: if an export led boom is not a viable option for us, we have to rely on getting our own domestic house in order. Indeed, since America has become the world’s consumer sucking on goods from places like Japan and Germany, there must be plenty of foreign policy makers hoping we get our house in order too.

    And we do that by pumping up demand and keeping savings low in the short run. Oh, and we have to fix the banking system … did I mention that?

    So our recovery relies on the same tricks that got us into this mess: low savings and high consumption. Which is already presenting policy makers with a difficult, or should I say more layered, problem. The near term remedy is exactly the wrong medium term policy. Longer term we want to convert our economy by achieving a more balanced mix of savings and consumption. We want to re-establish the kind of structure it had back in the immediate post World War II decades.

    Interestingly an economy built around a higher savings rate is one that can pay down government debt at a more rapid rate than one built around borrowing: those savings can be channelled into Treasuries. This is one, but not the only, reason why all the hue and cry about running up massive future debt loads is misplaced. As long as we are careful and construct a more fiscally balanced economy in the medium term, let’s say by 2015, then our ability to recover and return to relatively low and sustainable levels of national debt is assured. Those same post-war years provide a good example: US national debt at the end of World War II was very high, but within a decade it was returned to pre-war levels.

    So: exports are not our answer. And we have a very delicate balancing act between the near and medium terms.

    This really is quite a mess we got ourselves into.

    1 2