Thursday, June 19, 2003

Crossing the Gate of Deflationland

Right, I believe putting your money up on the table time is getting near. What is happening now in Germany is clearly a turning point of a kind. The big ship has struck rock, water is coming in, and no-one really knows how to plug the leak. Of course, suggestions abound, mainly of the structural reform kind. Others commentators suggest more aggressive monetary policy, and yet others relaxation of the growth and stability pact. In some measure all of these are necessary, the problem is to what extent, when and how? Most discussion seems to me to suffer from the shortcoming that they assume that Germany has for some reason (normally this remains strangely unexplained, but occasionally it is put down to the impact of re-unification on Labour prices: this is cleary one case where it is asumed that Harrod-Samuelson-Balassa hasn't worked), anyway, as I was saying Germany has come unhinged from a nice clean constant equilibrium path, and therfore what is needed now is the right policy mix to get things nicely back into place. The problem with this line of thought is that it may well in fact be the case that the German economy might is following some kind of 'equilibrium' path, just not a nice one, and one to which it may well revert after the impact of any government induced endogenous shock has subsided.

What I am suggesting is that we may be looking at all this upside down, or through its reverse image. What we take as divergence from normality, may in fact be normality as we are likely to know it, and what we may be trying to do is shift the path to an 'abnormal' and unsustainable one. (Now I know I don't believe in 'paths' in the naieve sense, but I think my meaning is clear: if not please hit me with questions). If that is so we will surely fail to correct a problem we have misunderstood whatever the medicine we apply. The difficult question is where to begin to peel this particular onion. In my book, unfortunately, EMU is part of the problem, not a route to the cure. Whatever else may be said, Germany needs unshackling from the euro. This I take is the point about loosening the growth and stability pact. Without the euro Germany would be free to sink or swim on its own terms. Like Japan it could commence a skywards run-up in government debt. This alone would not resolve anything. But it would open up the option of 'unconventional' monetary policy and fiscal stimulus to try and get the magneto to turn (imagine trying to get the EU institutions to agree to inflation targeting for Germany). Whether this would make and difference or not would depend whether at its advanced age, German society is capable of coming to terms with its identity problem and opening itself and its labour markets to the world. All this may sound very drastic, but it would be a shot, maybe a long one, and maybe the only one available. For make no mistake about it, the deflation which is already arriving will not be benign, and it will be extremely difficult to shake off. It will need courage, imagination and determination. There is no 'easy' solution, but we are still a long way from taking full measure of the problems which lie in front of us. Are our politicians up to making the change, that is the question?

Now over to Steven Roach and the Morgan Stanley crew who have been applying themselves to exactly these topics in a timely and interesting debate.

Stephen Roach: In a recent Forum dispatch ("Euro-Wreck" dated 2 June), I raised what I believe are some serious concerns about the state of the European economy, fearing that an asymmetrical shock in Germany could tip this key region into outright deflation. I also raised the related point that the EMU-based recipe of fiscal and monetary policy, which focuses on average performance in the euro-zone, may be inappropriate to deal with severe country-specific shocks in the region's biggest economy.

Eric Chaney:

There is an asymmetric shock in Emuland, and it's a big one. Your conclusions Steve are fairly consistent with my own (see State of Emergency Calls for Emergency Remedy, May 16, 2003) proposals: giving Germany (and only Germany) its fiscal freedom temporarily (this is possible under the Stability Pact provisions) under the condition of a complete overhaul of the wage negotiation system. These ideas have circulated among policy makers circles and somebody I met at the G30 last Friday told me: "It's a good idea, Eric, which makes a lot of economic sense, but — this is a big but — it is impossible to sell it to politicians". I will try again.

............the risk I see is that we are not witnessing just another recession. Instead, we might well be crossing the gate of Deflationland, without knowing whether this will be benign and temporary (maybe necessary, as Joachim thinks) or the first symptom of the “quagmire” described by Paul Krugman, the last thing Europe needs. In addition, I am very far from advocating a fiscal stimulus in Germany. I am just saying that circumstances are indeed exceptional and that Germany should only recover the full use of its fiscal stabilisers, instead of trying pathetically to plug gaps in order to get a satisfecit from Brussels. At the end of the day, Germany will enter deeper in deflation and have an ever bigger public deficit. That is the cruel lesson of the Japanese debt deflation. The Pact (this brainchild of Theo Waigel, as you had wittily named it, if I remember well), mentions an outright recession, measured on an annual basis, as a case for not capping deficits. I am sure that you would agree with me on the fact that what matters is not the annual growth number, but the cumulated change in the output gap. German GDP growth was 0.6% in 2001, 0.2% in 2002 and, on our estimates will be around 0% this year. Even assuming that German potential growth is only 1%, then the increase in the output gap since the end of 2000, will be 2.2% at the end of this year. If all that had happened in one year, it would have been much more spectacular and even our dear Mr. Solbes would have conceded “extraordinary circumstances.” The most unrealistic part of my story is to free up Germany while keeping France and others under the Caudine Forks of the Pact. Impossible to sell it to politicians, I am told in Paris. The law is Nash, not co-operative equilibrium. Don't ask me why, maybe because there is another law saying it is forbidden to be intelligent. That is why I think we will go to deflation, and live a re-foundation crisis. Either the EMU will break up, or we will be wise enough to re-think the macro management of EMU. The theoretical solution to cases of externalities is to create a market where the causes of externalities can be traded. A refunded and innovative Stability Pact would allow governments to trade “rights to pollute,” sorry, I meant “rights to run excessive deficits.”

Stephen Roach: What a great debate. The intensity of the exchange is very gratifying. It shows how much we all agree on the importance of this problem and the stakes it holds for Europe and the broader global economy. In the great spirit of free and open intellectual engagement that we have long cherished at Morgan Stanley, you certainly won't find the pabulum of consensus thinking in this group. While I don't pretend to have the final word, I would like to offer just one point of clarification:

The German-specific policy efforts that I support reflect my deep concerns over the risk of a serious asymmetrical shock that could quickly spread to the rest of Europe. They do not represent a wholesale retreat from the long-term discipline of EMU. But one-size policies do little to deal with the extremes that are now evident if Germany is treated the same as Ireland. I would welcome runaway inflation in the latter if that is what it takes to pull Germany away from the abyss. The American analogy that is often used to assess the stresses and strains of Europe is not appropriate. The United States of Europe is very different from the United States of America. California, America's largest state, accounts for 10% to 11% of the US economy. Germany is fully one-third of Euroland and accounts for about 30% of the cross-border linkages that knit Euroland together. As Germany goes, so goes Europe. The risk of a destabilizing shock in Germany is growing larger, in my view. As insurance against that risk, the rules of EMU should be temporarily suspended while Germany gets some powerful medicine. My sympathies to the "Irelands" of Europe, but under the circumstances I'm afraid that such a concession may be well worth the price.
Source: Morgan Stanley Global Economic Forum

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