Stephen King: It's all very clear how Japan lost a decade, but will others make the same mistake?
Outlook: Unless a decent recovery is already in the bag, the public will have doubts about the potency of policymakers and the tools at their disposal
Tuesday 31 August 2010
If only it were as easy to fix economies as it seems to be to fix cricket matches. Last weekend, the world's central bankers turned up for their annual Jackson Hole jamboree. A year ago, central bankers were mostly feeling rather chirpy. After all, financial markets had rebounded from the lows of spring of 2009, company executives were becoming increasingly optimistic and there were the first signs of a recovery in economic activity. It seemed as though the medicine – in the form of monetary and fiscal stimulus – was working. A year later, the mood in Wyoming was more circumspect. The worst may be over but the expected rebound in economic activity – at least in the Western world – is proving hard to come by. True, the German economy did very well in the second quarter but economies are, for the most part, operating well below their potential.
Even worse (with the notable exception of the UK), inflation is too low. In the US and throughout continental Europe, prices are rising too slowly. Nations are beginning to flirt with deflation. For the masters of price stability, this is not good news.
Deflation doesn't always have to be bad. "Good" deflations are those where prices fall relative to wages and profits because of big improvements in productivity and technology. In "real" terms, households and companies are genuinely better off. Sadly, today's flirtations with deflation are not of this kind. They are mostly "bad" varieties that could easily throw economic recoveries off course.
The nightmare scenario can be simply stated. With debt levels high (a legacy of the last decade of excess) and interest rates at zero or thereabouts, a move into outright deflation where prices, wages and profits are falling in nominal terms would leave the burden of debt rising month by month and year by year. Typically, central banks respond to periods of economic weakness by cutting interest rates, thereby reducing the burden of debt. In a world of falling prices with interest rates already at zero, central banks lose this option. Real interest rates start to rise which is another way of saying the debt burden begins to grow.
Recognising this, people repay debt with greater zeal in the belief that a stitch in time saves nine. It is, however, a self-defeating process. The more debt people repay, the weaker demand becomes, thereby making deflation even worse.
Central bankers have to find a way out of this trap. That is precisely what Ben Bernanke promised in his opening remarks at Jackson Hole on Friday. Offering reassurance by the bucket-load, he said: "Falling into deflation is not a significant risk for the US at this time but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation".
It is an intriguing statement in part because its accuracy or otherwise rests not just on what the Federal Reserve will choose to do but also on the public's understanding of the Fed's decisions. Mr Bernanke is making the rather strong claim that deflation will be avoided not only because the Fed has the tools to prevent deflation but that, in addition, the public believes the Fed has the tools and that the tools work.
This begs obvious questions. What if the Fed has the tools but the public doesn't think so? Might the tools then prove ineffective? After all, most central bankers recognise that monetary policy works increasingly through its effect on people's expectations. Better, in these circumstances, to have a nation of believers rather than agnostics. Already, however, people are expressing doubts. Why else would the price of government bonds, the yen (managed by the ultra-cautious Japanese) and gold be going through the roof? Might it be the case that, without a decent recovery already in the bag, the public is having doubts about policymakers' potency?
Part of the difficulty lies in explaining to the public the various unconventional tools a central bank has at its disposal. Among policies outlined by Mr Bernanke at Jackson Hole were firstly, additional purchases of longer-term securities (most obviously, Treasuries) via a further expansion of the Fed's balance sheet and secondly, a promise to keep short-term interest rates lower for even longer in a bid to push longer-term interest rates down.
Of these, the first is more or less the same as the Bank of England's recent quantitative easing, where heavy purchases of gilts from pension funds, insurance companies and the like left these institutions with excessive cash which was then invested in a range of other assets. Directly or otherwise, this process may have lifted equity and corporate bond prices, kept a lid on sterling and stabilised (or even raised) inflation expectations.
The UK's experience surely emphasises, however, that our understanding of unconventional policies is, at best, shaky (a point Mr Bernanke was quick to acknowledge). Knowing how much quantitative easing to deliver is not much more than guesswork, partly because central bankers have no real sense of how the public's expectations will change. In the UK's case, levels of nominal activity have held up not so much because output is any stronger but because inflation is a lot higher, an outcome which is inevitably leading to a degree of jumpiness at the Bank of England. Could it be that the public regards any form of quantitative easing, whether rightly or wrongly, as an act of alchemy ultimately doomed to failure?
To be fair, Britain is in a better position than many of us feared a year ago, so it may well be that unconventional policies have done some good. But amid all the worthy discussion at Jackson Hole, I also sensed a growing degree of confusion. Western policymakers have, from time to time, been heavily critical of their Japanese counterparts, arguing that Japan's economic failures stemmed partly from the Bank of Japan's refusal to spot the risks of deflation in the early 1990s. Had the Japanese lowered interest rates more aggressively back then, and had they simultaneously loosened fiscal policy, then, it is often alleged, Japan's "lost decade" would not have happened.
In other words, Japan's crisis didn't stem from its failure to use unconventional policies but, instead, from its unwillingness to use conventional policies at the right time. Western policymakers have gone out of their way to avoid repeating Japan's "errors" by launching a conventional stimulus on an unprecedented scale in recent years. Yet despite all the interest rate cuts and the increased budget deficits, Western economies, like Japan before, are still trying to fend off deflation. The argument is now shifting. Japan's mistake wasn't just its failure to use conventional policies to dig itself out of a hole. It also chose not to use unconventional policies. Western policymakers, in their infinite wisdom, know better.
There is, however, an alternative view. Japan's multi-year stagnation and the West's more recent problems simply show that policymakers should, at all times, be on the lookout for financial excess which, through leveraged balance sheets and so on, is devilishly difficult to deal with. Yet the aftermath of excess – debts, delinquencies and deflation – is even more of a challenge. Preventing bubbles should be a much bigger priority for central bankers for the simple reason that clearing up the mess after a bubble has burst is a lot more difficult than central bankers routinely believe. That was the lesson from Japan. Regrettably, it is a lesson that many Western policymakers have chosen not to heed.
Stephen King is managing director of economics at HSBC
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