2002 September 25 Wednesday
Deflation everywhere

The Financial Times reports Germany sits on the brink of deflation:

The bursting of the bubble in US equity prices, particularly for technology, media and telecommunications stocks, has led some commentators to draw parallels with the Japanese situation at the end of the 1980s. The US may suffer a decade of lost growth, just as Japan did during the 1990s, they argue. But when looking for a country most likely to be sucked into a deflationary trap, people should focus on Germany, not the US.

The article then goes on to catalog parallels between Germany's and Japan's economies. Meanwhile the Bank Of Japan continues to do too little too late:

But analysts doubted the BOJ would adopt any effective new monetary tools, despite increasing government pressure to do so.

The BOJ has left its monetary policy unchanged since February 28, when it pledged to lift liquidity in the financial system by raising outright purchases of government bonds by a quarter to one trillion yen.

The gap between the actual and potential output of the US has widened and that is creating deflationary pressures:

These deflationary elements are now reinforced by the growing gap between the economy’s actual production and its potential. Our current total GDP is 3 percent to 4 percent less than what it would have been had the economy produced up to its potential over the last two years. (The difference adds up to $3,000 per American household.) According to the conventional model, when the economy’s actual production is one percentage point less than its potential, inflation will fall one-quarter percentage point. And using this model, Krugman recently forecast that the U.S. economy could experience actual deflation by 2004; other economists think it could arrive in 2003.

As the previous article points out, consumer debt in the US as a percentage of GDP is at a record high. Consumers can't spend and since business has lots of capital operating at less than full utilization. So there is no incentive for business to increase capital spending.

Stephen King points out that an asset bubble's after effects can cause conventional monetary policy to cease to be capable of maintaining price stability. Once prices start falling then real interest rates can be high even if there nominal interest rates are reduced to zero:

Second, and more importantly, asset prices can play havoc with the ability of a central bank to hit its inflation target over time. There is clearly no one-for-one relationship between asset price inflation and inflation of the price level. So, if in the short-term, inflation of the price level is close to target, it might be reasonable to ignore asset price inflation. Let's say, though, that, later on, the asset price bubble bursts, leaving people with unwanted amounts of debt (which, in a low inflation environment, tend to hang around for a long time). The process of debt consolidation could then lead to significant downward pressure on demand and inflation – so much so, in fact, that deflation becomes a possibility. Under these circumstances, real interest rates are in danger of rising – the opposite effect of that seen in the 1970s.

The Bank Of Japan's announcement last week that it was going to buy stock from banks while probably necessary was probably the minimum they had to do to allow banks to meet capital requirements:

The BOJ's move is meant to clear up the problem of the bank's problem portfolios, which in turn could put banks in a better position to deal with their problem loans. The plan also is meant to allay the fear that falling share prices could put some banks below minimum capital requirements -- which could put them in the same fix as George Bailey before Mr. Potter got foiled.

The Japanese government and BOJ just never seem to be able to bring themselves to take steps that are large enough.

Of course, at least the First World nations can service their sovereign debt. The dramatic increase in sovereign debt defaults is an indicator of financial troubles in Latin America.

Joseph Stiglitz reminds us that the US can't continue to run a huge trade deficit to provide sufficient demand for faltering economies.

The system has behaved perhaps better than might be expected because the US has acted as the deficit-of-last-resort. But for how much longer can the richest country continue to borrow from the rest? How long will the appetite of the rest of the world for American bonds and equities continue?

Last time I saw figures for it the US was running a trade deficit of over 4% of GDP. On top of that American consumers are now carrying a historically record high amount of debt. The US is not going to be able to serve as the demand engine to pull the rest of the world away from a deflationary recession or depression.

Share |      By Randall Parker at 2002 September 25 12:06 AM  Economics Political


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