DeLong: America's Date With Deflation

Charles Jannuzi b_rieux at yahoo.com
Fri Aug 23 06:48:24 PDT 2002


I would have thought this creature slummed it over here to try and get ideas he couldn't get discussing economics with fellow middle of the road economists, but I can't really say this piece reflects any discussion of deflation we've had on here. The most obvious weakness in the piece is that DeLong really hasn't given much of an explanation as to how deflation is going to come about in the US. I think a cheap dollar spells all sorts of other problems, not deflation.

Late last year into early this year, I really thought the US was going to say it supported a strong dollar as a quid pro quo for Koizumi letting American private equity take over the banking sector in Japan, but I was wrong. The Bush regime propped up oil and steel prices instead and let the dollar slide. I think the recent slide on the equity markets, in part, reflects international investors wanting to diversify out of dollars and into euros. Cheapening the dollar is a double edged sword that cuts you both ways of course: once you get burned by a cheap dollar policy, you don't want to buy more if you think the US is going to encourage a cheap currency. And you find other investments in other currencies attractive as you see the value of such investments rise first from a rising currency (which then attracts more investments).

But let's look at some of the article:


>>Two years ago, at the peak of the late-1990s
boom, the US economy was slightly overheated.<<

As far equity markets go, I think slightly is a slightly deficient term.

>>As the unemployment rate fell to 4 per cent and below,<<

BTW, recalling a different thread about US unemployment. Someone with labor statistics in Japan tells me that if the Japanese gov't figured unemployment statistics the way the US does, the unemployment here would be 1% lower, which means Japan's post-war high unemployment level is 'full employment' in US economics.


>> inflation began to creep upwards, rising
by between a quarter and half a percentage point each year. By late 2000 it was clear that America's gross domestic product was 1-2 percentage points above potential output - above that level at which aggregate demand balanced aggregate supply, at least in the sense that there was neither upward nor downward pressure on inflation.<<

Which is why we have imports, right?


>>Today things are very different. America's
level of real GDP is running 2 percentage points higher than it was in the summer of 2000.<<

Even God isn't sure of this.


>> However,
underneath is the extremely strong underlying productivity growth trend driven by technological revolutions in data processing and data communications. These technological revolutions have boosted potential output by perhaps 7 per cent over the past two years. Thus today America's real GDP is not 1-2 per cent above but 3-4 per cent below potential output.<<

Still can't give that up, yet Brad? There is no real way to measure this 'productivity growth thing' since the concept could never be objectively reified, and even if it were, economics could never keep track of it. And a trend implies something other than a one-off, but a one-off might stretch beyond a couple of years and still, ultimately, be a one-off or a blip or an anomaly or just an outright lie (like corporate profits, remember?). US companies probably keep labor costs off books to impress investors as well--like with outsourcing.


>>How do we know this? Simply look at the
unemployment rate: today America is producing 2 per cent more than it did two years ago, and is doing so with an unemployment rate not of 4 per cent but of 6 per cent.<<

Producing more of what?, I'm prompted to ask.

This coincides with my theory of 'productivity growth' all along. Basically, companies restructure and force fewer people to do more. However, much of this proves unsustainable and can actually spell disaster for companies who do not have enough people trained and experienced to handle more business or changes in the business environment. They are just very productive at doing things badly, like churning out more Fords with more defects while alienated consumers switch to Toyota (which is fine by me anyway, if we'd had free trade back in the 1980s, no US car company would even exist, nor would any deserve to).


>> Moreover,
the unemployment rate is more likely to rise than

to fall in the next year and a half. The consensus forecast is that this year US economic growth will be positive, but will be significantly less than the rate of growth of potential output. In 2003, the consensus forecast is for US economic growth to be about 3.5 per cent - equal to the rate of growth of potential output, but not enough even to begin to close the

output gap.<<

If you run a company right now, this is the least of your worries, if you even understand the abstract concepts behind the conclusion.


>>With production substantially below potential
output, there is downward pressure on US inflation. We have already seen the US inflation rate nearly halve in the past two years. This downward

pressure is not expected to lessen for at least the next year and a half. That means that by the summer of 2004 the US will have an inflation rate

- at least as measured by the GDP deflator - that is less than zero. The

US will, if these forecasts come true, have joined Japan in deflation.<<

Why is it economics always sounds like Newtonian physics--or worse yet, plumbing? I agree, there will be less inflation and then less of less inflation.


>>What does this mean? The first implication of
deflation is that the central bank's ability to carry out a stimulative

and expansionary monetary policy is greatly restricted. When inflation is 4 per cent a year, the central bank can provide businesses with powerful incentives to take their spare cash and use it to build factories and buy equipment: if the central bank pushes short-term interest rates

near zero, businesses are faced with the choice between investing in their business or watching the real value of their cash on hand shrink by 4 per cent a year. When there is deflation, the central bank cannot make businesses such offers that they are unlikely to refuse: at a deflation rate of 1 per cent a year, the real value of businesses' cash on hand grows by 1 per cent a year even if the short-term nominal interest rate

is as low as it can go.<<

That's not really how it has worked for most of Japan. This works for the banks' racket of paying .01 percent on accounts and charging 2% for loans. The loans interest rate looks low, but it is a pretty good difference and makes loans profitable--IF YOU CAN GET FIRMS TO TAKE THEM OUT AND PAY THEM BACK. Firms that are unprofitable and whose investments aren't earning anything anywhere are reluctant to expand or take out loans. Companies in Japan, if I can generalize, are reluctant to take out loans to expand business in a flat or contracting economy. Loans might be more dear in a deflationary economy, but if you can't finance your debt, pay off your immediate short term debt, and you have no profits, your company goes bankrupt. Meanwhile assets owned and investment portfolios are not earning anything.

I'm not sure what is the chicken or the egg here. I remember Japan had a pretty buoyant economy into the early 90s. I remember that postal savings and insurance as well as mutual and stock company insurance companies were paying or promising to pay high returns on accounts and policies. I remember that geared debt became problematic because it became more difficult to borrow more to cover what was immediately due. I remember the stock market crashed really hard and about the same time the yen went way way up in value.


>>The consensus forecast for the US economy over
the next two years is not a pleasing one. Few - if any - believe that an unemployment rate of 6 per cent is necessary to avoid upward pressure on inflation. Almost all are looking forward to a period with a substantial output gap: two years of sub-potential output with unemployment at its current level robs American households of $800bn in real production of goods and services.<<

Wouldn't plant utilization rates and sales per store be a better indicator? Also, the federal government is going to be buying 150-200 billion dollars more a year in goods and services--and just the sort of goods and services the US economy is supposed to be so good at producing.


>>More important, deflation rapidly exposes
weaknesses in businesses' and banks' capital structures. If there is the potential for a chain of bankruptcies that will disrupt the flow of funds through financial markets, cripple investment spending and bring on

a deep recession, deflation is the best way to turn that potential into an unpleasant reality.<<

I think when stock markets go down you see the weaknesses in business plans that relied on increases in their own stocks' value as well as the value of all their stock investments and crossholdings. And we sure have seen enough of them. The FT recently had an article about how Japan could be hiding Enrons, but that's ridiculous. Japan has nothing like Enron because it's stock market has been down to 1/4th its historic high for a decade. There are no companies at all in Japan like Enron.

Also, when a domestic economy has a lot of competition, deflation in consumer prices means a loss of profits. We see this in Japan where a handful of companies in each sector, good or service takes the price charged down to the level where everyone claims if prices go any lower they will lose money. It's as if most of what you could sell becomes a loss leader to try and claim market share and wait for better times. This Japanese companies have always done, but they've been waiting 10 years for an expansionary, inflationary economy that produces enough differences to create profits.

Also, for various reasons--the high yen, competition from SE Asia, Korea, Taiwan and China--exports to the US only sporadically offset the lack of profits in the domestic economy. It would seem the yen has to be at around 125 or lower in value to reflate the economy. At 115-118 in the past months, Japan will again deflate.


>>Most important, however, is that two more years

of downward pressure on the rate of inflation will rob the US Federal Reserve of its power to stimulate the economy. Today's GDP-deflator inflation rate is about 1 per cent a year, meaning that today's federal funds rate target of 1.75 per cent per year corresponds to a short-term real interest rate of 0.75 per cent a year. If the US price level in two years is not rising but falling at 1 per cent a year, it will be impossible for the Fed then to pursue a policy as stimulative as the one it is pursuing now.<<

The US is already pursuing an anti-deflation policy: a cheap dollar (and now Asian economies with 'dollar pegs' are finding their exports don't earn so well), artificially high oil prices (for one thing, caused by topping off the strategic reserves to the tune of 250 million barrels), artificially high steel prices (US free trade in strategic action)--and these latter two commodities are THE KEY inputs in any modern economy.


>>It is in this context that the Fed's failure to

cut interest rates so far this year is puzzling. If 1.75 per cent was the appropriate interest rate last winter, when stock indices were 20 per cent higher than they are today, it is hard to see how it can be the appropriate rate today.<<

Well, they were getting to the point where if they cut any further, the psychological effect exaggerates and distorts perspectives. Take the Japanese, they KNOW that their savings are earning nothing and this hardly makes them feel buoyant as consumers. I know the theory about the idea that if you know prices are going to come down, you don't buy now, waiting for a cheaper price. But no one knows the future, and most consumers don't seem that premeditated, more affected by the prices and pictures in advertising than a memory of what they paid for something 3 years ago. More likely they see that their nest eggs are not earning any interest while retail taxes have gone up, so they put more away, trying to get ready for even harder times.

Also, it would seem with everyone watching the US, the potential to make cuts is more important than making them. Greenspan wants a post-attack Iraq option, in the event of an oil spike, panic and speculation on that panic, and a good hard crash of the stock markets (if Japan is any comparison, believe me, the US equity markets haven't seen anything yet--Dow 3600 would be the low, not 8000 something)


>>Furthermore, if 1.75 per cent was the
appropriate interest rate before the shock of revelations about corporate accounting began to drive a larger wedge of uncertain size between the terms on which the government can borrow and the terms on which private businesses can raise capital, it is unlikely to be so today.<<

So make it easier for said corporations to borrow money? Why? Because the government has to be a source of easy money if the 'markets' refuse? I doubt that an interest rate cut is going to make the Europeans or Asians want to buy the next tranche of corporate bonds after having been so badly burned on Enron and Worldcom and many others.

>>And if the Federal Reserve wishes - as it surely does - to preserve its power to offset and neutralise any future contractionary shocks to the economy, the current

inflation rate is already dangerously low and already leaves it with remarkably little room for action.<<

For the US I'm guessing something more like stagflation. That Asians and Arabs want out of US investments has more to do with the cheap and unsupported dollar than anything else, I think. Of course a trillion dollar lawsuit (gosh, the bubble years, everyone forgot how to count billions even) that named me liable would make me look for some pretty good Swiss shelters about now.


>>None of this means the US economy is about to
run aground. But anyone who has sailed a yacht knows that it is not enough to

be sufficiently far from shore to have water under your keel. You have to be able to plot a course that will keep water under your keel. And you have to plot a course that will keep water under your keel even if Mother Nature decides not to co-operate.<<


>From physics and plumbing to Christopher Cross.
Did anyone ever tell you Brad, you look a bit like Chris Cross? Me, I feel like that Morrissey song: Seasick, Still Docked.


>>The first rule of prudence - in yachting and in

monetary policy-setting committees - is to keep away from situations in which one or even two adverse shocks will cause severe difficulties.<<

The first rule of prudence. I'll have to add that one to my list of things etched in stone I read on LBO list. There's still plenty of room for new entries. Thanks.


>>It is thus disturbing that the consensus
forecast seems to paint a picture of the US economy two years hence in which production remains substantially below potential output, and in which slight deflation has taken hold and robbed the Fed of its power to offset adverse shocks. The current course is one that prudent sailors would be scrambling to change.<<

Well, I think our sailors will be to busy refueling 1000-1500 daily fighter sorties over the ME sometime soon. The US has a huge hinterland and a huge natural resource base compared to Japan--and the currency everyone holds-- so I am more inclined to believe in the stagflation picture for the US.

C. Jannuzi

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