Friday, March 05, 2004

What's It All About Alfie?

Well I suppose it's better to end the week on a bang rather than a whimper, so here I go with another of those posts. What really ended the week on a high note (or should I say a low one) was the US labour market. And since I am arguing that the euro-dollar parity is being driven at the moment by US labour market data, this news can only mean one thing: more upward pressure on the euro. Which makes me only want to re-iterate, and even more strongly, that an important opportunity was wasted yesterday to take some remedial action by lowering the interest rate. Remedial action which would also have supplied a much needed lifeline to Germany's beleagured economy. But this, like so many things, was not to be.

So what happens next? Well as I have been saying, how this ends is difficult to see. We are still trying to get to grips with the causes.

Of course two groups of people have it fairly easy. Firstly those who argue that this is all down to George Bush, and then, on the other hand, those who would want to say that the Indians are the culprits.

As always, both these arguments do contain a grain of truth. It's clear that GWB has not excelled in terms of his economic stewardship, and it's clear jobs are going to India. However I think pretty quickly both these simple solutions run out of steam given the depth of what is taking place. Some argue that Bushes stimulus could have been better directed: possibly, but there was still plenty of kick going into the US economy in the second half of 2003. And those famous tax cuts are still out there in the future, so while they may well be colouring the debate about the future of social security, they are hardly the key operative factor right now. Likewise high-end service jobs. In the future this is going to be important, but it is hard to see that this is having a major impact on the global economy in the here and now. So my argument is that something much bigger is happening, something which makes normal debates about economic management seem somehow totally inadequate.

My starting point is that, in terms of the global economy, we are seeing a profound transformation on three fronts: demography, technology, and development.

The OECD economies are ageing (and I'll leave this one here for today), we are living through a profound technological revolution, and thirdly the relative state of development of some of the worlds key economies is changing, and fast. On occasion I have called this globalisation phase 2.

What I really want to focus on in this post is one of the fundamental characteristics of this transformation: its deflationary implications. A year or so ago, it was much more fashionable to talk about deflation than it is now. Recently things have gone pretty quiet. Nonetheless the IMF (under Ken Rogoff as chief economist) did see fit to publish a background paper (warning PDF, and fairly technical, the Economist had a couple of easier articles here, and here). So let's go and take a reality check, why not: on deflation. Or rather disinflation, since this is the name the current global condition is popularly known by. In order to do that we could go on a quick inter-continental whistlestop tour.

And what better place to start than Chile:

Chile's annual inflation rate fell to zero for the first time since 1939 as companies such as General Electric Co. lowered prices following a 22 percent rally in the currency last year that made imports cheaper.

Consumer prices were unchanged in February from January -- after falling the four previous months -- and unchanged from February 2003, the National Statistics Institute said.

``We're passing on our lower costs,'' said Pablo Palavecino, manager of General Electric de Chile SA's appliance line in Santiago. ``Prices are a lot less.'' An imported refrigerator sells for 999,000 pesos ($1,655), down 17 percent from last year, he said.

Investors such as Andres Ergas at BanChile Administradora General de Fondos SA said the central bank will keep its benchmark lending rate at a record low of 1.75 percent at a policy meeting next week in a bid to prevent slowing inflation from turning into deflation. Central bankers have said they're concerned about deflation, which could slow the South American country's expansion by prompting consumers to delay spending on expectations that prices will keep declining.

Ergas said the lack of a pickup in inflation toward the central bank's target of an annual rate of between 2 percent and 4 percent would likely prompt policy makers to cut interest rates again.
Source: Bloomberg

This is striking, isn't it. A Latin American country with zero inflation and a 1.75% funds rate which is under review for reduction. Of course a big part of this picture is currency-appreciation-driven, and the currency appreciation in turn is driven by China's demand for copper. So Chile's miraculous disinflation is fairly lop sided, but still. It remains a striking situation. Where it an isolated case, then perhaps we could shrug our shoulders and say, well, that's life. So to make some comparison, now lets go a bit nearer home, to my country of birth, the United Kingdom:

Will CPI inflation ever rise back to 2% or above?

Since December, the Bank of England?s official remit is to target a 2% inflation rate as measured by the harmonised consumer price index (CPI). Conveniently, the Bank forecasts inflation to rise to around the 2% target by its two-year forecast horizon (assuming unchanged interest rates), from 1.4% currently.

Perhaps the strongest reason to expect CPI inflation to rise to 2% is that the Bank of England is now charged with making sure that this happens. After all, the Bank is a highly credible institution that almost exactly attained its former 2.5% objective for RPIX inflation (on average) over the 1997 to 2003 period. And, if everyone believes that the Bank will hit its new target too, cost and price setters should behave accordingly and the target should in fact be met, barring large unforeseen shocks.

However, things may not be that easy. After all, the last time CPI inflation stood at or above 2% was in May 1998; and it has averaged a mere 1.2% over the last five years. Thus, if past inflation performance is any guide to future inflation performance, and even factoring in that the Bank is now charged with aiming for 2% CPI inflation, there would seem to be a considerable risk that the 2% target will NOT be reached.
Source: Morgan Stanley Global Economic Forum

Again striking isn't it. The UK CPI hasn't been up to 2% since May 1998, and in fact the annual average is only 1.2%. And the current rate seems to be riding on the back of what I at least am prepared to recognise as a housing driven asset bubble. So if this is the case, the big question is what happens to the CPI the day the bubble bursts, it hasn't exactly got very far to fall. I am sure this fact is exercising Mervyn King's mind a lot these days.

OK, so now why don't we go to China?

Who Benefits from Productivity?

One can witness Chinese productivity first hand at the local Wal-Mart store. Yes, the Chinese economy is becoming more productive. I estimate that China?s total factor productivity (TFP) - how much more output with the same inputs - is 3-4% per annum ......... My guesstimate is that Chinese wages are rising at half the rate of labor productivity, which includes the impact of more capital per worker, and is about twice as much as TFP. Why can?t Chinese wages rise at the same pace as labor productivity, which would capture all the TFP to benefit Chinese workers?

The problem is that the competition for jobs in China is fiercer than the competition for goods in the world market. For the Chinese to gain jobs faster than average rates in the world economy, they need to sell their labor cheaply, i.e., passing on the TFP to western consumers in the form of lower prices so that they would buy more Chinese goods, i.e., more Chinese labor. The relative balance would change only when most Chinese are employed. When China reaches the tipping point, either its currency would appreciate, as in Korea and Taiwan in the 1980s, or its inflation would be higher than the global average, as in Hong Kong in 1980s and 1990s..............

Some believe that appreciating the Chinese currency would effectively deliver a raise to the country?s workers. Would this work? Would western consumers pay more for Chinese goods if China?s currency were to go up? I doubt it. China?s export price is determined by the relative balance between the number of Chinese workers and western consumers. How could manipulating the exchange rate change this reality? If western consumers refused to pay more in the event of a yuan appreciation, wouldn?t the result be to push down wages in China in order for its labor market to reach some sort of equilibrium?

Throughout the industrialization of the West, productivity also mostly benefited consumers; deflation prevailed due to productivity gains. What is occurring in China is not unusual. It is the vast pool of surplus labor that keeps down labor?s pricing power, and also makes consumers who are workers price-sensitive. Thus, productivity gains are competed away by businesses in endless price wars.............

The global economy is experiencing much higher productivity growth rates because information now spreads to developing countries much easier than before, which provides more people in the developing world with the skills to join the global economy. Thus, the global economy behaves like an emerging economy that gains productivity from moving labor from low-productivity rural sectors to high-productivity urban sectors............

Combating inflation is a central goal of modern central banking. But inflation is becoming less of a threat. The US economy has experienced disinflation for two decades. The same trend pushed Japan into deflation.
Source: Andy Xie, Morgan Stanley Global Economic Forum

Now here I have edited Andy Xie down to what I consider to be the bear essentials of the case. These essentials are:

That we have a global environment which is strongly disinflationary, and heading for deflationary. (He doesn't make this point but I will: interest rates are at near-historic minimum all over the place, and we are now - as Stephen Roach keeps reminding us - in the upswing phase, more price downsize is only to be expected later).

Technological change is driving down prices in some key sectors. Huge reserve armies, and massively increased connectivity are pushing them down in others: the whole global economy is behaving like a single emerging economy.

The situation in China is normal if you look at what happened in the European economies during a comparable period of technological change and industrialisation: the late 19th century.

I think I'll leave it there, but the picture should be plain enough. I don't buy the 'consensus' explanation. There is something more to all this than good housekeeping practices across the central banks. These US employment stats today are only a reminder. Now go have a nice weekend everyone.

Thursday, March 04, 2004

ECB: German Plea Falls On Deaf Ears

When this is all over, and we come to look back at the when and the where, maybe we will remember today's decision as just one more of those missed opportunities. Certainly not much notice seems to have been taken of Gerard Schroeders request for a helping hand on the interest rate front. Is there any significance in the fact that on the day the ECB decided to stand firm, German unemployment turned upward again to 10.3%, while it was also revealed that German factory orders fell unexpectedly by 2% in January: just for good measure I suppose.

Now before we go any further, I would like to make a retraction. I think it's only a small one, but still the point is worth making. Back after the last G7 meeting I mildly mocked the joint declaration for highlighting currency 'volatility' as the major problem. My point was that I didn't see much volatility in a movement in one direction only. In fact I was wrong. What we are seeing at this moment is 'volatility' as the dollar/euro value constantly readjusts back-and-forth. So even though I would stick my neck out, and go for a continuing upward pressure on the euro, the ups and downs are not without their consequences. This makes business forward planning much more complicated, and obviously is no help to those trying to export.

On the substantive question all eyes need to be on the US labour market. The minor dollar 'rally' this week was based on the expectation of a cut in euro interest rates, and a relatively stronger US labour market which would be pushing Greenspan in the direction of raising rates. Well we've seen that euro rates are staying put, so now we have to watch how the US data evolves over the next few weeks. My guess is that the $1.30 level will be being tested again before too long, but you never know, I may have got it wrong.

Meantime, and for a change, I'm linking to myself: I just got the latest copy of the Sprout, and here is my article for this month:

German Finances: Much Ado About Something

Germany's claim that it has its budget deficit under control and that its economy will quickly return to strong growth has recently been put into question by European Commission member Pedro Solbes. In his last assessment of Germany?s updated stability programme, Solbes welcomed Berlin?s pledge to lower its budget deficit, but stressed that differences remained over the "possible rates of growth?. The Commissioner even went so far as to suggest that the economic forecasts produced by Chancellor Gerhard Schr?der's government are unrealistic, and that in all likelihood Germany will breach the European Union's stability pact for a fourth successive year in 2005.
Behind all this lies a long-running sore of a problem which divides the Commission and the national governments, a problem where Solbes plays the part of ?villain in chief? for his role as defender of the growth and stability pact. Now that this problem has once more resurfaced it may be worth revisiting it roots.
At the heart of Solbes? most recent jab at Schroeder lies one stark and self-evident fact: Germany is growing old. Forty years ago, just 17 percent of Germans were aged 60 or older. Today, 23 percent are. Forty years from now, the share will be nearer to 40 percent. At least this will be the case if current estimates turn out to be anywhere near accurate. In fact the truth is that we don?t really know what the exact position will be, but there are grounds ? if we look at likely medical and other advances ? for thinking that life expectancy may well be significantly longer than we are currently calculating for.

Now much has and will be written about this topic, but here I would like to focus on three key components of what is going to be an extremely complex situation: demography, technology, globalisation.

As I have said Germany has an ageing population. This is bound to have an important labour market impact as the potential labour force declines, and its average age rises. So what can be done? Well broadly there are three remedies on the table. Firstly increase immigration to replace the lost workers, and in so doing attempt to redress some of the inevitable damage to the support ratio. This road seems highly unpopular, and is unlikely to be explored in any great depth if recent history is anything to go by. Indeed even culturally proximate groups, like the citizens of the new eastern accession countries seem less than fully welcome judging by recent decisions to have an ever receding transitional period for full freedom of movement.

Secondly you can lengthen the working life, from 65 to 70, and then from 70 to 75. The longer life expectancy scenario seems to make this attractive, but the response from those expected to extend their working lives does not appear to be too encouraging.

Thirdly you can increase participation rates: that is the percentage of those below retirement age who continue working. Yet here, once more there seem to be problems. Society at large may agree that this is an interesting objective, but two factors seem to stand in the way. On the one hand the interests of the individual corporate entity. A personal detail here, my wife works for a German multi-national. And do you know what, right now on her boss?s desk lies a proposal to ?recycle? all those employees with over 25 years service. Recycle here is a euphemism for finding a way for them to go through the door. And who can blame the firm. This is a competitive world, and they need to survive. In an era of accelerating technical change, and ever-shortening product and system cycles, rapid reaction on the fly has more value than accumulated wisdom. This means youth. Those valued work-teams of yesteryear, embodying as they did all that accumulated tacit knowledge don?t seem worth what they were. That, of course, is what the structural reforms are all about: asset devaluation. Changing the valuation placed on acquired capacities, in line with the way technical change ?creatively destroys? their value. Nowadays the boss doesn?t cut the quip in the elevator about his most valued asset not being the building but his workforce. No, today?s boss likes to tell his subordinates that his most valued assets are his high-speed broadband connections to cheap bright young minds in China and India. So make no mistake about it, youth brings comparative advantage, and the locus of that advantage is moving, eastwards: this is where the globalisation part comes in. In this sense the split identity we have between the private and the social seems a hard one to resolve.

There is, of course, another way to increase participation rates, and that is to bring more women into the labour market. This objective seems laudable, but is it realistic in an environment where public welfare provision is likely to be severely curtailed? Absent state-financed care, looking after the elderly inevitably tends to fall on the female member of the family. Is caring for an elderly parent with Alzheimer compatible with a high level of active participation in the labour market: I think not. Here we are trying to say that two plus two makes six, and it doesn?t convince.

Which brings us back to immigration, and to Pedro Solbes. One of the few viable strategies for facilitating increased female participation in an environment of dramatic ageing like the one which Germany has in front of it, is to increase the supply of cheap migrant labour, to globalise the internal labour market. On the other hand, as Solbes would I am sure point out, one of the explicit reasons for ?flexibilising? the stability pact was to promote growth, we have flexibilised, and the growth still isn?t coming. Of course we continue to hear that ?I promise it will, but next year?. I?m with Solbes on this, don?t give me pipe dreams, tell me what we are going to do in the here and now to get to grips with the problem. If we don?t do this we may well end up seeing one of those nasty financial crises which would be our worst nightmare. Isn?t it time we had a frank and open debate on all this? When you are living in denial maybe the first step forward is to recognise that you are.