Saturday, December 27, 2008

Friday, December 26, 2008

For Those of You Who Like Charts

Well, one good turn deserves another. So if, like Paul Krugman (and me, I think, though I hadn't gotton as far as thinking through all the implications of what was happening when I posted) you take the view the Ukraine industrial output chart I put up yesterday is the smoking gun (or starter's pistol, or line judge flag, or whichever metaphor works for you) that tells us that the second great depression has now begun, then here are some more of those tell tale charts to put in you pipe and smoke (or if , like Huck Finn that is your preference, to chew on),

Japan industrial output isn't exactly falling at the same dramatic pace as Ukraine, but a 16.2% year on year fall isn't to be sniffed at either.

And exports, which drive the Japanese economy, were down by 26.7% in the same month. Even more to the point, deflation is baaack, or almost back, since "core" core prices hit zero (or 0.1% below current overnight BoJ interest rates) in November, and outright deflation surely isn't far behind.

You can find more detail on all today's Japan data over at the Japan Economy Watch Blog, and for those of you who want some more deflation background on Japan, well, Krugman has the goods here (extermely wonkish)

Moving nearer to home we have Germany. Here is the latest (flash) December manufacturing PMI for Germany, which is just about as point of the spear as you can get in terms of just in time data.

The slope of that line looks pretty telling doesn't it, especially if you are in to depression economics. Then we have the November new orders chart, another shocker, and indicator of much worse to come, I think.

Now going back to this point:

“There is a burgeoning economic crisis in the European periphery,” Krugman said on the ABC network Dec. 14. “The money has dried up. That’s the new center, the center of this crisis has moved from the U.S. housing market to the European periphery.”

I think this is largely true, if we mean by the periphery the UK, Ireland, Eastern and Southern Europe, but the periphery in a very literal sense always ends up biting the hand that feeds it, since German industry depends on exports to that periphery perhaps more than to anywhere else, so it is not surprising that once the periphery folds, the shock wave moves on in towards the centre. I don't know if the blast that which is about to hit Germany next year will count as a depression, but if it doesn't, it is going to be a damn close call.

Moving now towards the periphery, we have Spain, where the money certainly has dried up, and with it demand for Spain's manufactured products. The November PMI was contacting at an all time series maximum for any country.

Central Europe

The whole of central European manufacturing is now contracting rapidly. First off, the Czech Republic

Then Poland

And Hungary

Then There Is Russia

Moving on now to Russia, industrial output was down by 8.9% year on year in November, so it hasn't yet reached Ukraine levels, but at the rate of contraction they are experiencing I wouldn't be too confident that that state of affairs will last too long.

And Finally China

Where the November PMI also showed quite a strong contraction:

So Where does that leave us?

Japan's Recession: Is the Liquidity Trap Back?

Japan's Recession: Is the Liquidity Trap Back?

by Michael Hutchison
Professor, UC Santa Cruz

Since the early 1990s, rising unemployment, price deflation, sluggish growth, and even recession have beleaguered Japan. The country's central bank, the Bank of Japan (BOJ), has responded by lowering interest rates to stimulate demand. Short-term rates, shown in Figure 1, were gradually lowered from 8.3% in early 1991 to virtually zero by early 1999 and have stood at that level for more than a year. By mid-1999, the two-year government bond rate was only 0.48% and the corporate bond rate was 0.80%.

With interest rates at historic lows, why is the Japanese economy still in a slump? One explanation, put forward by Paul Krugman (1998a, b), is that traditional monetary policy instruments are powerless to provide effective stimulus to the economy because Japan is in a "liquidity trap." This Economic Letter evaluates the liquidity trap argument against a leading alternative explanation: a credit crunch associated with Japan's banking problems.

Liquidity traps

Japan is the first major industrial economy to face serious deflation since the 1930s, and, not surprisingly, that also was the time that the liquidity trap explanation for the ineffectiveness of monetary policy was popularized. A liquidity trap is characterized by a situation--similar to Japan today--where interest rates are at or near zero. Monetary policy is seemingly impotent to stimulate demand and raise spending since interest rates are already at the lowest point possible--no one would normally be willing to hold bonds with negative yields over (zero interest-bearing) money.

Is Japan in a liquidity trap? Krugman (1998a) forcefully argues this case and suggests a specific and unorthodox policy recommendation--that the BOJ bring inflation and inflationary expectations up to 4% and keep them there for 15 years (see Spiegel 2000). The key element of Krugman's analysis is that the equilibrium real interest rate--that is, the real rate that would match saving and investment--is negative in a liquidity trap. How could the equilibrium real interest rate be negative? Because poor long-run growth prospects, which, in Japan's case, presumably are linked to unfavorable demographic trends, make investment demand so low that a negative short-term real interest rate would be needed to match saving with investment. Given a nominal interest rate floor of zero, Krugman argues that a positive expected rate of inflation is necessary to generate negative real interest rates, which will stimulate aggregate demand and restore full employment.

Krugman draws on two bits of empirical evidence to support the liquidity trap argument. First, he points to the fact that short-term interest rates have reached a minimum point, virtually zero. Moreover, the yield curve has been virtually flat, as the 10-year government bond yield declined to less than 1% for a brief period in late 1998. The low interest rates seen in Japan at the end of the 1990s are unprecedented for any major industrial country since the 1930s.

Second, Krugman points out that injections of liquidity by the central bank have not been very effective in raising the growth rate of the broader money aggregates. He shows that the monetary base grew 25% from 1994 to 1997, but that the broader monetary aggregate (M2 + CDs) grew only 11%, and bank credit grew not at all. And more recent statistics indicated that "money hoarding" continued to be evident in 1998-1999, as an expansion of the monetary base in the range of 8% to 10% resulted in only about a 3% growth in M2 + CDs. Bank lending has collapsed since early 1998, as shown in Figure 2. Moreover, low interest rates and expansion in the monetary base had not helped increase aggregate demand--the economy continued in recession.

Alternative explanation: the credit crunch

The main alternative explanation for the ineffectiveness of monetary policy to stimulate the economy is the "credit crunch" view. This explanation focuses on the contraction of the supply of bank credit (credit crunch) caused by massive nonperforming loans accumulating in the financial system.

This argument has two parts. The first focuses on the decline in bank capital due to the accumulation of bad loans held by Japanese banks. The capital asset ratio of the 20 largest financial institutions in Japan fell significantly between 1994 and the end of 1998. Less than candid reporting initially both by banks and by the Ministry of Finance about the magnitude of the nonperforming loan problem made it difficult for banks to raise capital in domestic and international financial markets. They therefore responded by reducing the amount of loans. Japanese financial institutions have attempted to raise capital-asset ratios, in part in response to recently tightened international capital standards, as well as in response to pressure from the markets and the government. But building capital-asset ratios by restraining lending takes a long time. And it induces a credit squeeze in the process--the origins of the credit crunch in Japan.

The second part of the credit crunch explanation focuses on the cautious lending attitude of Japanese banks following their recent experience with bankruptcies, nonperforming loans, and recession. Liabilities associated with bankruptcies hit an all-time high of 2.7 trillion yen in October 1997, and a trend line shows a sustained rise to the highest point in the postwar period towards the end of the decade. These circumstances make firms less desirable potential borrowers than they used to be, from the banks' point of view. And they also have the self-reinforcing effect of tightening credit conditions and worsening the recession.

Evidence of a credit crunch also is suggested by the BOJ survey known as Tankan. This survey asks firms their views of the "lending attitude of financial institutions." Despite the low interest rate environment, the survey indicates a sharp tightening of credit conditions in Japan since mid-1997 facing both large and small enterprises. The "lending attitudes" of financial institutions, at least from the borrower's perspective, have become much more stringent.

A credit crunch implies that injections of liquidity (base and narrow money expansion) do not increase credit and aggregate lending. This is exactly what has occurred in Japan. Base and narrow money have increased at a robust pace in 1997-1999, but the broader money aggregates most directly related to spending in the economy grew modestly. Most disturbing is that aggregate lending by banks has decreased sharply, the flip side of which is the tightening of credit conditions faced by enterprises in Japan.

Which is right?

Krugman (1998a) dismisses the credit crunch argument, arguing that banks with a large portfolio of nonperforming loans should take on excessive risk and stand ready to lend even to questionable borrowers. Excessive lending, rather than a credit contraction, would be predicted, as banks gamble on high-risk projects, hoping to restore solvency before they are forced into bankruptcy by the financial authorities.

This type of excessive lending occurred in Japan at the early stages of the banking crisis. Lending by real estate lending institutions, known as jusen, actually grew rapidly in 1991-1992, as they faced growing problems with nonperforming loans (Cargill, Hutchison, and Ito 1997). But at the current stage of the banking problem--with the creation of a new Financial Supervisory Authority, greater transparency, and more disclosure on loan positions--the supervisory authorities are not sitting by idly and allowing excessive risk-taking on the part of banks. Greater stringency in banking oversight is the new modus operandi in Japan since 1998 (Cargill, Hutchison, and Ito, forthcoming).

The balance of evidence seems to support the credit crunch explanation of why monetary policy--and zero interest rates--have not been effective up to this point in stimulating the Japanese economy. Low interest rates, slow broad money growth, and falling commercial loans are consistent with either a liquidity trap or the credit crunch explanation. But the Tankan survey results and some other facts tilt the balance of evidence towards the credit crunch view. In particular, the banking sector was hurt by the temporary emergence of the so-called "Japan premium" (extra expense Japanese banks must pay for raising funds in overseas markets) and by the downgrading of the investment ratings (by agencies such as Moody's) on debt issued by Japanese financial institutions. More generally, the overall negative publicity about the Japanese financial system and economy clearly contributed to a very pessimistic atmosphere in Japan in the late 1990s.

To address the banking and credit crunch problems, public funds totaling 60 trillion yen (12% of GDP) finally were set aside in 1998-1999 to recapitalize banks. A number of institutions have used these funds (via the issuance of special equity shares to the government) to increase capital-asset ratios significantly. In principle, this should ease the credit squeeze and induce banks--particularly with further injections of liquidity into the banking system--to increase lending. Long-delayed capital injections and restructuring of the banking system should finally help push Japan's economy into an expansion. The analysis here suggests that bank recapitalization should ease the credit crunch, and, if the BOJ keeps interest rates low, economic growth will soon follow.


Cargill, T., M. Hutchison, and T. Ito. 1997. The Political Economy of Japanese Monetary Policy. Cambridge, MA: MIT Press.

Cargill, T., M. Hutchison, and T. Ito. Forthcoming. Financial Policy and Central Banking in Japan. Cambridge, MA: MIT Press (November 2000).

Krugman, Paul. 1998a. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap." Brookings Papers on Economic Activity 2, pp. 137-205.

Krugman, Paul. 1998b. "Japan: Still Trapped?" (accessed June 6).

Spiegel, Mark. 2000. "Inflation Targeting for the Bank of Japan?" FRBSF Economic Letter 2000-11 (April 7).

Wednesday, December 24, 2008

From The Horses Mouth

by Paul Krugman

SYNOPSIS: Milton Friedman himself has conceded Krugman's point, in his debate with Ben Stein, that Friedman's monetarism was naive, by saying that ""The use of quantity of money as a target has not been a success . . ." Click here to read Krugman's reply to Ben Stein's screed.

Readers of the Unofficial Site may recall that Ben Stein launched a frantic attack on me after my quite innocuous column Missing James Tobin . Among the things that drove him wild was my statement that Milton Friedman's monetarism was a rather "naive" doctrine that has not stood the test of time.

But guess who now concedes the point?

By the way: Friedman did two great things: the permanent income theory of consumption, and the natural rate hypothesis. These do not make him a figure on a level with Keynes, who transformed the way we see the world, and may have saved the market economy. But they're pretty important.

Monetarism, on the other hand, was a misguided doctrine. Friedman was looking for a magic way to exclude judgement and discretion from economic policy; he didn't find it. And my own work on the liquidity trap has convinced me that his biggest case for monetarism - the attribution of the Great Depression to monetary contraction - was a huge misinterpretation. Yes, M2 contracted - but it's far from clear that the Fed was in control of M2.

Originally published on the Official Paul Krugman Site, 6.11.03

Wednesday, December 17, 2008

Did (or Didn't) Japan Just Re-introduce Quantitative Easing

With the US Federal Reserve now adopting some variant of quantitative easing (QE), while the Bank of Japan cuts interest rates amidst economic conditions which BoJ Governor Masaaki Shirakawa describes as "severe", perhaps it is worth looking a little bit at the experience of quantitative easing in Japan, and ask ourselves why it is that central banks may favour this particular approach this time round, rather than a simple knee-jerk return to/introduction of some form of Zero Interest Rate Policy (ZIRP).

To anticipate a little bit what will be argued in this rather lengthy post, there is a fundamental difference between the recent move towards QE taken by the Fed (especially after the end of September as explained by James Hamilton in this excellent post), and the policy pursued by the BoJ between 2001 and 2006, and that concerns the objectives of the policy. While both initiatives have in common that they are strategies to get that "something extra" out of monetary policy in a very low interest rate environment (near the so-called zero bound), they differ in that the Fed's current objective is to provoke a recovery in economic activity in the US, whereas the BoJ had the objective of provoking a sustained rate of inflation above zero. Obviously the two processes - provoking growth and provoking inflation - are similar, but there are also subtle differences in the way the respective banks attempt to achieve their objectives. The Fed is simply concerned about liquidity in an attempt to ease a credit crunch, and to do this by bringing yield spreads (and in particular the so called TED spread down), and no one doubts that once this objective is achieved the Fed will rapidly wind down its balance sheet just as rapidly as it wound it up at the end of September, while the BoJ was concerned to convince market participants that the excess balances would be maintained for a long time interval, beyond the point where the price index simply indicated it might move into positive territory. The BoJ had to convince market participants that they were serious about provoking inflation (that is what they were really targetting weren't bank reserve balances but inflation expectations) while the Fed (at this point at least, of course on a worst case scenario of outright deflation in the US, I am sure Bernanke has a Japan style "plan b" up his sleeve) currently has no inflation target beyond its general objective of price stability and is not trying to steer inflation expectations upwards. Not yet, anyway. And with that caveat......

The BoJ Cuts Rates, But Not To Zero

So if the Fed isn't exactly applying the BoJ 2001-2006 playbook at the present time, what about the BoJ, is it applying some kind of Bernanke style markII QE, and expanding its balance with the objective of easing the credit crunch? Well, this is a much more plausible interpretatio, and in some senses the earlier BoJ move (in October) in lowering interest rates from 0.5% to 0.3% could be thought of as some kind of initial step towards the reintroduction of some kind of QE in Japan, and last Friday's cut in the BOJ key policy rate to 0.10 percent when taken together with the commitment to expand the balance sheet, increase its purchase of JGBs and begin outright purchases of commercial paper in order to start pumping funds into the market to ease the ongoing corporate credit crunch really represents its de-facto initiation , although Governor Shirakawa was quick to stress that the bank's decision to cut interest rates and buy more assets did not mark a direct and immediate return to the earlier version of quantitative easing. This is because the BoJ - despite the evident danger signals - still does not anticipate a return to deflation, and thus is not willing to undertake any commitment to provoke inflation. Of course, they may well be criticised later for not being sufficiently proactive here, just as they were in 1998/1999.

What the BOJ did decide to do was raise the ceiling on the amount of Japanese government bonds it buys each month from 1.2 trillion yen to 1.4 trillion (a 17% increase), as well as committing itself to the purchase a of wider range of bonds, and expanding the range of eligible JGBs to include 30-year bonds, floating rate bonds and inflation-indexed bonds.

The Bank also decided to temporarily buy commercial paper outright, following in the footsteps of the U.S. Federal Reserve, despite the strong reservations which have been expressed by a number of BOJ officials in the past about accepting such assets with credit risk. In fact the Bank of Japan has long accepted commercial paper as collateral in its fund operations (and indeed such purchases were an important ingredient in the earlier QE experiment) but has up to now resisted calls to purchase them directly from issuers. The terms and conditions for such purchases still have to be decided, while Governor Shirakawa is still voicing his doubts, so in its press release the BoJ simply stated that all that it had done at this point was undertake to examine the range of corporate instruments and the degree of risk taking that are appropriate for the BoJ.

Thus the BoJ has obviously taken an important step, and is clearly open to the idea that such purchases could be a major instrument in monetary policy. We will obviously need to see more of the details, and some indication of the size of the CP-programme before we can be clearer about how aggressively the BoJ intends to proceed with the initiative at this point, although evidently, once the door is open the measures can obviously be expanded as the situation evolves.

What we can say with rather more conviction is that BoJ policy at this point seems to be oriented more towards the spread between three-month JGBs and the three-month interbank offered rate, Tibor, which rose to its highest level in a decade(0.922%) on December 16 before falling three straight days to hit 0.905% at the Friday fixing. The difference between what the government and Japan’s banks pay to borrow for three months, the so-called TED spread, was running at 46 basis points in mid-week, and this compares with an average of 16 basis points for 2007.

Fiscal And Monetary Tandem

To some extent fiscal and monetary policy is moving in tandem in Japan at the present time (as it is in the US) and the Japanese government also announced last week that it was going to purchase commercial paper, saying that it would buy as much as 20 trillion yen worth of shares held by banks in order to to boost their capital. The measure formed part of an emergency stimulus package worth 43 trillion yen ($489 billion). Thus nearly half of the package will be for purchasing commercial banks' equity holdings as part of efforts to improve the lenders' liquidity, according to the Nikkei business daily.

Evidently if such measures are approved by the Japanese parliament they will push spending to even higher levels. The Finance Ministry's draft budget suggested a spending increase of 6.6 percent to 88.5 trillion yen ($990.9 billion) for the next fiscal year — the biggest ever figure in an initial proposal. The budget proposal expects general spending to rise to 51.7 trillion yen ($578.9 billion) in the next fiscal year, even though tax revenue is projected to fall 13.9 percent to 46.1 trillion yen ($516.2 billion). As a result, Japan will see its primary budget deficit jump to more than 13 trillion yen ($145.6 billion) from 5 trillion yen ($56 billion) this year. This will mean bond issuances will need to rise to 33.9 trillion yen - up by 31.3 percent over fiscal 2008 - to cover the revenue shortfall. The expansion means saying an effective goodbye to Japan's governments goal of balancing the budget by 2011. But Prime Minister Taro Aso, whose popularity rating is falling more quickly than the Spanish construction industry, has made it clear he sees no role for fiscal discipline at a time like this.

In the current fiscal year (which ends next March) tax revenues are now expected to fall 7.13 trillion yen short of an initial estimate of 53.55 trillion yen due to slump in corporate tax revenues as the economy has slid into a recession. The bulk of the tax revenue shortfall will be covered by the government issuing deficit-covering bonds in the second supplementary budget that totals 4.8 trillion yen. To fund the economic steps through the extra budget, the government will also issue so-called construction bonds, which are used for specified purposes such as public works, worth 390 billion yen while dipping into reserves set aside in a special account for "zaito" fiscal investment and loan programmes (FILP). Thus spending in fiscal 2009 is expected to rise by 9.4% while revenue is expected to fall by 13.9% with evident consequences for the fiscal deficit and the size of the accumulated government debt.

On 12 December Prime Minister Aso introduced a 23 trillion yen "livelihood protection package". As part of that package there was a 2 trillion yen ($22 billion) CP purchasing allowance and the government instructed the Japan Finance Corporation (JFC) to engage in "crisis respone operations" and help struggling companies. The Development Bank of Japan is to serve as cashier to fund the CP purchases. Japan's 124 commercial lenders had 25.6 trillion yen in stockholdings at the end of March.

Around 1 trillion yen of low-interest financing for medium to large enterprises was also included and this expenditure will be counted as part of the Fiscal Investment and Loan Programme (FILP), and as a result the programme will expand for the first time in ten years. The ruling LDP has also established a new body the Team To Realise Financial and Real Estate Countermeasures, and this body seems to be pressing for the BoJ to commence open market purchases of JGBs and stocks and REITs, with the estabishment of an entity to purchase more than 10 trillion yen of stocks.

Why Not All The Way To Zero?

Certainly in the United States, it increasingly seems that Ben Bernanke has decided to adopt QE rather than a more straightfoward lowering of the federal funds rate directly to zero. Part of the thinking which lay behind this move was explained by Bernanke himself, in a paper he prepared with Vincent R. Reinhart (Director, Division of Monetary Affairs, Federal Reserve Board) back in 2004.

Bernanke and Reinhart give two reasons for not going all the way to zero. Firstly:

Observers have pointed out that rates on financial instruments typically priced
below the overnight rate, such as liquid deposits, shares in money market mutual
funds, and collateralized borrowings in the "repo" market, would be squeezed
toward zero as the policy rate fell, prompting investors to seek alternatives.
Short-term dislocations might result, for example, if funds flowed in large
amounts from money market mutual funds into bank deposits. In that case, some
commercial paper issuers who have traditionally relied on money market mutual
funds for financing would have to seek out new sources, while banks would need
to find productive uses for the deposit inflows and perhaps face changes in
regulatory capital requirements. In addition, liquidity in some markets might be
affected; for example, the incentive for reserve managers to trade federal funds
diminishes as the overnight rate falls, probably thinning brokering in that

and secondly:

"A quite different argument for engaging in alternative monetary policies before
lowering the overnight rate all the way to zero is that the public might
interpret a zero instrument rate as evidence that the central bank has "run out
of ammunition." That is, low rates risk fostering the misimpression that
monetary policy is ineffective. As we have stressed, that would indeed be a
misimpression, as the central bank has means of providing monetary stimulus
other than the conventional measure of lowering the overnight nominal interest

Thus, in the first place distortions occur in the normal functioning of the money markets, while in the second a mis-perception arises (on Bernanke's view) among the public that policy is ineffective and that the central bank can then do nothing. Both these lines of reasoning may help explain why the preferred line of attack at this point is to take rates to a very low level, just above zero, but not all the way to zero.

Quantitative Easing In Japan

Returning for a bit to the Japanese experience of QE in the early years of this century, we find that the Bank of Japan embarked (back in March 2001) on what was then an unprecedented monetary policy experiment. This experiment, which is commonly referred to as "quantitative easing," was an attempt to stimulate a Japanese economy which had become stagnant under the dead weight on continuing ongoing deflation expectations and a monetary policy which seemed to have gotten stuck at what had become known as the "zero bound". The BoJ had come under considerable criticism from a number of academic economists (most notably Ben Bernanke and Paul Krugman, see bibliography below) for failing to respond aggressively enough to the deflation problem in the 1990s.

QE was introduced as a response to what was seen as the failure of earlier monetary policy. As a response to the growing deflation problem following the onset of a sharp recession Japan lowered its overnight call rate from around 0.43% to 0.25% in September 1998. The rate was further lowered to near 0% in March 1999. In April 1999, the BOJ made an initial promise (subsequently seen as inadequate) to maintain a zero interest rate “until deflationary concerns are dispelled” - thus began the so-called zero interest rate policy (ZIRP). Following the application of this policy the Japanese economy appeared to be recovering, although not the price level, since it grew at a 3.3% year on year pace between Q3 1999 and Q3 2000. As a result the BoJ abandoned the ZIRP policy in August 2000, and it was this abandonment which has been the object of so much criticism - especially, and most notably, from Paul Krugman.

The economy, however, rapidly fell back into another serious recession following the global decline in the demand for high-tech goods subsequent to the internet bust. Actually my feeling here is that many of the critics are confusing two (logically, if not always practically) separate issues here, the export dependence of an elderly Japanese economy with insipid domestic demand growth, and the problem of the internal price level, or deflation. The two are obviously inter-related, but not so simply as to say that the Japanese economy fell back into recession due to the 2000 BoJ tightening of monetary policy. Undoubtedly the deflation problem worsened as a result of this policy, but the recession came because Japan was unfortunate enough to apply this policy just as the global economy went south bigtime, and again we can see the same sort of process at work in 2007, since the move of Japan's economy back towards recession is connected with export dependence (which could be to do with the high median age of its population) and not a by-product of the decision to end QE in 2006.

The BOJ announced the introduction of the quantitative easing policy in March 2001.

As I say above a key component of QE is the way the central bank handles expectations, and the BOJ initially committed to maintain the policy until the core consumer price index registered "stably" a 0% or a positive increase year on year. This commitment was further modified in October 2003 when the BOJ committed itself to continue providing ample liquidity "until both actual and expected inflation turned positive".

The core of QE was the maintainence of an ample liquidity supply by using the current account balances (CABs) at the BOJ as the operating policy target, with the commitment to maintain ample liquidity provision until the rate of change in the core CPI becomes positive on a sustained basis. Thus the focus of policy becomes not the interest rate itself, but the amount of liquidity as reflected in the current balances. In fact during the ZIRP period, the overnight call rate never actually reached zero, but declined to at most 0.01%, while during the period of QE, the rate further declined to 0.001%.

The BOJ also announced that it was ready to increase the amount of purchases of long-term government bonds in order to meet the target on the CABs. The target on the CABs was raised several times, reaching ¥ 30-35 trillion in January 2004, compared to the baseline required reserves which were running at approximately ¥ 6 trillion. In order to meet such targets the BOJ conducted various purchasing operations including the purchase of bills and commercial paper (CPs) in addition to treasury bills (TBs) and government bonds. After 2003, the BOJ also started buying asset-backed commercial paper (ABCPs) and asset-backed securities (ABSs).

Initially the CAB target was set at ¥ 5 trillion (in March 2001) at a time when the level of CABs was around ¥ 4 trillion, thus the initial diffeence was not that great. By May 2004 the CABs had grown eightfold, with an average annual growth rate of 92%. The principle vehicle of liquidity intervention was the purchase of JGBs and during the same period the BoJ purchased ¥ 37.8 trillion in Japan government bonds. The amount of monthly purchases of JGBs has been set and pre-announced by the BOJ. This amount was equivalent to 0.4 trillion yen per month in March 2001 and was gradually increased to 1.2 trillion yen by May 2004. As a result of these policies Japan's monetary base grew by 67% over the same period.

The three building blocks of Japanese QE were thus ensuring ample liquidity provision, commitment to continue such liquidity provision, and the use of various types of market operations, especially purchasing of long-term government bonds, and in many ways these correspond to the three balance sheet expansion mechanisms identified by Bernanke and Reinhart (2004) whereby a central bank can operate an expansionary monetary policy even at very low interest rates.

However, the two approaches are not identical. The BOJ policy of increasing the CAB target may have had the effect of making the liquidity-providing commitment more credible, and the BOJ’s long-term government bond purchasing operations certainly represented the major tool to meet the target on the CABs. The possibility remains, however, that changes in the composition of the BOJ’s balance sheet caused by its market operations have had some effects on the term structure of interest rates. While there exist differences between the policies these authors propose and those adopted by the BOJ, the basic ideas are the same. Even at a zero short-term interest rate, it is possible to pursue further monetary easing that affects expected future short-term interest rates and thus current long-term interest rates through a commitment to appropriate future monetary policy paths.

The policy was lifted five years later, in March 2006. At the launch of the program, many were skeptical that it would have any impact on the real economy, as overnight interest rates were already close to zero, and thus flooding Japanese commercial banks with excess reserves might only amount to swapoing two assets both of which had close to zero yields. Others had been highly critical of the Bank of Japan in the years prior to the introduction of QE (among others Ben Bernanke himself, see here), in particular for their strong reluctance to engage in open ended "unsterilised" interventions. With the introduction of quantitative easing all of that changed to some considerable extent.

Whether the ZIRP and/or RZIRP have affected expected future short-term interest rates, however, is a more subtle question than it initially appears to be. Even without any commitment by the central bank, the market normally forms expectations about future monetary policy stances, ie the path of short-term interest rates.

The Recent Fed Initiative

The Federal Reserve Open-Market Committee decided this week that it was going to use “all available tools” in an attempt to generate a resumption of GDP growth in the United States. This, and the maintenance of price stability, would seem to be the Fed's principal objectives at the present time, and the effective demotion of the benchmark interest rate as a focus of policy attention (the target for overnight loans between banks will henceforth and until conditions improve be maintained in a range between zero to 0.25 percent) is merely a commitment to maintaining a low interest rate environment while the other tools, the balance sheet enhancing ones, do the actual heavy lifting. Since this rate objective is now not going to change in the foreseeable future (the Fed's commitment is for "as long as it takes"), the focus of attention will turn to the liquidity providing measures which the Fed will adopt and to the TED spread as an indicator of the degree of severity of the credit crunch.

As a consequence the Federal Reserve is now exploring a wide range of possibilities, including open market purchases of lower-rated securities, with backing from the Treasury. The Fed thus looks set to expand its current $600 billion initiative to buy debt issued or backed by the government-chartered mortgage-finance companies - it is alreadt trying to lower mortgage rates via the purchase of up to $100 billion of Fannie Mae and Freddie Mac debt as well as $500 billion of mortgage-backed securities they have guaranteed. It is also “evaluating” purchases of longer-term Treasury securities. It may well also enhance other existing programs which include the purchase of commercial paper from companies and financial firms and a offering a backstop for money-market mutual funds.

Thus composition and size of its balance sheet will now be the Fed’s principal policy focus, and, in a key difference with Japan’s earlier quantitative easing experience, the Fed is targeting specific assets for purchase to lower credit spreads rather than expanding the amount of cash in the banking system per se. In fact the Fed will still work to maintain large quantities of liquidity in the bank reserve balances, but whereas the BoJ principally increased the balances through the purchase of JGBs the Fed is placing much more emphasis on the direct purchase of agency securities, on the acquisition of mortgage-backed securities and on lending money directly to the private sector.

“The focus of the committee’s policy going forward will be to support the
functioning of financial markets and stimulate the economy through open market
operations and other measures that sustain the size of the Federal Reserve’s
balance sheet at a high level,” the FOMC said.

The Fed “will employ all available tools to promote the resumption of
sustainable economic growth and to preserve price stability,” the Federal Open
Market Committee said today in a statement in Washington. “Weak economic
conditions are likely to warrant exceptionally low levels of the federal funds
rate for some time.”

These moves have already increased the Fed’s balance sheet substantially, and it has risen to a current $2.26 trillion from $868 billion in July 2007. And in addition there is the $700 billion Troubled Asset Relief Program, which the U.S. Treasury has been using since October to channel about $335 billion of capital injections into banks and other financial institutions.

The federal funds target rate has been steadily weakening as a monetary policy tool simply because the flood of funds the Fed has been sending to the markets since late September has meant that the average daily rate (or effective rate) has trade below the actual policy goal rate on every day since Oct. 10. The gap between the target and the effective rate, or average daily market rate, has averaged about a half point since September 12. The gap averaged just above zero from the start of this year up to September 12. This state of affairs is thus not that dis-similar from the Japanese situation in 1998/99, since at that point the actual Japanese overnight market rate was systematically trading below its overnight target and a reluctant BoJ was eventually forced to cut its target rate in two small steps.

So is this quantitative easing? Well the Fed statement said simply that it would be using its balance sheet to support credit markets and the economy, however a senior Fed explained to the somewhat bemused journalists that the bank's approach is seen as being distinct from quantitative easing as practised by the Japanese. The official pointed out that Fed's balance sheet has two sides: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan's quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed's focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. This securities-lending approach is intended to directly affects credit spreads, which is where the Fed perceives the problem to be today.

The Fed official stressed in his explanation that the Fed does not expect deflation, but expects inflation to fall.

Quantitative Easing Or Not Quantitative Easing?

So do we or don't we have quantitative easing in Japan? Well my opinion is that the BoJ has effectively turned to some kind of quantitative easing regime, despite protests to the contrary from Governor Shirakawa at the BoJ post meeting press briefing. But this version of QE is different from the previous one, since the BoJ is not targeting inflation expectations at this point. Governor Shirakawa has argued strongly for keeping short-term money market interest rates slightly positive to improve the functioning of the money market, so it is unlikely the BoJ will move to further reduce the overnight target rate. What I do think we will see, however, is more moves to expand the BoJ's balance sheet, focussing initially the asset side and on the three-month Tibor rate spread with three-month JGBs - purchasing ever increasing quantities of government debt, followed by a subtle shift over to emphasising the liabilities side of the balance sheet, and the size of current balances as deflation locks in and the bank once more attempts to "steer" expectations about the price level.

To try to help us understand where we are, and where we aren't here, below I am reproducing a selection of Sirakawa's comments in the press conference which followed the rate setting meeting.

Shirakawa's Comments After The Announcement

"In broad terms, Japanese interest rates are already close to zero. The last time the BOJ adopted quantitative easing, it aggressively supplied cash to markets to push down rates to zero. In that sense, we haven't adopted quantitative easing or a zero rate policy ...

"It was a decision reached after a comprehensive assessment on how to stimulate the economy and also pay heed to market functions."

"Of course, we can't say we will never opt for a certain monetary policy step in the future. This time we cut the call rate target but left the interest we pay to excess reserves parked at the BOJ at 0.1 percent, after much debate about how to maintain money market functions ...

"We cut rates to 0.1 percent and decided to buy various assets, but these measures are not aimed at expanding the BOJ's balance sheet. We will of course aim to stabilise financial markets and support corporate financing. We are taking measures for these purposes, not to expand our balance sheet."

(Asked about the effect of the BOJ's past experience of pledging to keep monetary conditions easy until consumer inflation emerged, or so-called 'policy duration effect')

"Pledging to maintain low interest rates even when the economy was recovering had a certain effect in pushing down long-term interest rates ... When the economy is in bad shape, no one believes the central bank will raise rates so the impact of the commitment is not big."

"We've raised JGB buying by 200 billion yen in the past. So I think it was a natural increment........We'll start buying long bonds and we'll start buying based on maturity ... Long bonds will remain on our balance sheet for a long time. But we judged that our holding of JGBs will remain below the amount of notes in circulation even after the increase.......I'm not planning to increase the amount of JGB buying further for the time being......Regarding the question of whether we are aiming at bringing down long-term interest rates, the increase in the purchase of long-term bonds is not aimed at that.

"This is about money market operations, not about lowering long-term interest rates......It is aimed at avoiding a distortion of money markets that could occur by relying too much on short-term market operations in providing long-term funds......The increase could affect the demand-supply balance of a certain sector of JGBs as a result. But we are not aiming to reducing risk premium (on long-term bonds)."

"The last time Japan adopted quantitative easing, it was a policy aimed at stimulating the economy through massive liquidity supply by targeting the amount of current account reserves at the BOJ. In this sense, both the United States and Japan have not adopted quantitative easing.

"Of course, we continue to provide liquidity actively to maintain financial market stability and smooth corporate financing. The current account balance could increase as a result of measures to stabilise the financial market and banking system, but that has a somewhat different meaning than last time ...

"Given our experience in the past, we can say that increasing the amount of money was effective in stabilising the financial system. As for its impact on the economy and prices, I'm not saying it didn't have an effect at all. But it was hard to find a clear effect.......It's hard to say anything about the future because members of the policy board could change by then ... Still, no one on the BOJ board seems to think that boosting base money would stimulate the economy."

"Every board member agreed that economic conditions are very severe. We want to stimulate the economy through interest rates but given that rates were already at 0.30 percent so there was limited room for cuts. ......And we wanted to keep the functioning of money markets. We didn't want it to weaken because of our policy.....By cutting interest rates to 0.10 percent, some of the function of money markets may be hampered. But by maintaining positive interest rates, there will remain incentives for trade and the bedrock for financial activity."

Well, there certainly do seem to be a lot of subtleties and nuanceshere, and a lot market observers may well have real difficulties in understanding what he is trying to say, although I do hope that after reading this post, many of my readers may not now be labouring under that difficulty (it certainly took me some time to get through to what was actually going on). In this sense Shirakawa might do well to reflect on this key point in Bernanke and Reinhardt:

"Note that the expectational and fiscal channels of quantitative easing, though
not the portfolio substitution channel, require the central bank to make a
credible commitment to not reverse its open-market operations, at least until
certain conditions are met. Thus, this approach also poses communication
challenges for monetary policy makers."

The Fed does seem in this sense to have been somewhat clearer:

"The Federal Reserve will employ all available tools to promote the resumption
of sustainable economic growth and to preserve price stability. In particular,
the Committee anticipates that weak economic conditions are likely to warrant
exceptionally low levels of the federal funds rate for some time. "

Did Quantitative Easing As Tool For Monetary Policy Caught In A Liquidity Trap Actually Work In Japan?

Well, this is the three trillion yen question isn't it. Certainly there is no consensus that this policy, rather than the sudden sharp rise in global commodity prices, was what dragged Japanese headline CPI numbers kicking and screaming out of years of deflation, nor is it clear that the termination of this policy, rather than the global trade slump which has followed the credit crunch, is what is sucking the Japanese CPI back below zero. There is little strong evidence on either side about the precise impact of QE on the price level, and certainly any effect there may be is small. Perhaps the best that can be said is that this policy helped avoid a worse outcome, with Japanese prices sinking ever deeper into deflation.

But it does now seem that back we jolly well go, since Japanese core annual inflation slowed in October for a second straight month, raising concerns that the sharp negative energy price shock heightens the risk of a return to deflation as we enter 2009. The core consumer index - which excludes volatile prices of fresh fruit, vegetables and seafood but includes the cost of oil products that are falling rapidly in price - rose 1.9 percent in October from a year earlier, slipping back from the 2.3 percent increase in September. Annual inflation excluding oil products dipped to 1.2 percent while Tokyo figures for November point to further falls in inflation.

If we look at what is known as the "core-core" index (which strips out both energy and fresh food) then we can see that it is far from clear that Japan ever really escaped from the deflation trap, since this reading has been completely flatlining around (and normally slighly below) zero over the last twelve months, and with a very large capacity overhang now developing, this index will almost certainly get back into negative territory very, very soon.

Appendix: Why Japan And The United States Are Different

Finally, should we anticipate a Japanese "outcome" in the United States. I think not. The US economy may well have a brush with deflation in 2009, and monetary policy may not be as effective as Bernanke hopes in avoiding this, but equally the US economy is unlikely to get stuck in deflation in the same way that Japan has (which isn't the same thing as saying we may not see a protracted slowdown in headline US GDP growth) since Japan's ongoing deflation issue is structural, and associated with the country's underlying demographic dynamics. As an illustration of this, I am reproducing here in the form of an appendix some excerpts from one of Paul Krugman's more widely read analytical papers on the Japan problem - It's Baaack! Japan's Slump And The Return Of The Liquidity Trap. Obviously this extract doesn't "establish" anything, but it does provide an illustration of one possible way of looking at the Japan question, and does suggest (since US demographics are very, very different) one good reason for not anticipating a Japan outcome in the US.

One way of stating the liquidity trap problem is to say that it occurs when the equilibrium real interest rate, the rate at which savings and investment would be equal at potential output, is negative. An immediate question is therefore how this can happen in an economy which is not the simple endowment economy described above, but one in which productive investment can take place - and in which the marginal product of capital, while it can be low, can hardly be negative. An answer that may be extremely important in practice is the existence of an equity premium. If the equity premium is as high as the historic U.S. average, the economy could find itself in a liquidity trap even if the rate of return on physical capital is as high as 5 or 6 percent. A further answer is that the rate of return on investment depends not only on the ratio of capital's marginal product to its price, but also on the expected rate of change of that price. An economy in which Tobin's q is expected to decline could offer investors a negative real rate of return despite having a positive marginal product of capital. This point is actually easiest to make if we consider an economy, not with capital, but with land (which can serve as a sort of metaphor for durable capital) - and also if we temporarily depart from the basic setup to consider an overlapping-generations setup, in which each generation works only in its first period of life but consumes only in its second. Let A be the stock of land, and Lt be the labor force in period t - that is, the number of individuals born in that period. Given the special assumption that the young do not consume during their working years, but use all their income to buy land from the old, we have a very simple determination of qt, the price of land in terms of output: it must simply be true that

qt.At = wt.Lt

where wt is the marginal product of labor. So in this special setup q itself is not a forward-looking variable; it depends only on the size of the current labor force. However, the expected rate of return on purchases of land is forward-looking. Let Rt be the marginal product of land, and rt the rate of return for the current younger generation. Then we have that:

1 + rt = Rt+1 + qt+1 /qt

Now suppose that demographers project that the next generation will be smaller than the current one, so that the labor force and hence (given elastic demand for labor) the real price of land will decline. Then even though land has a positive marginal product, the expected return from investing in it can in principle be negative. This is a highly stylized example, which begs many questions. However, it at least establishes the principle that a liquidity trap can occur despite the existence of productive investment projects.

In fact, this exercise suggests that the real puzzle is not why Japan is now in a liquidity trap, but why this trap did not materialize sooner. How was Japan able to invest so much, at relatively high real interest rates, before the 1990s? The most obvious answer is some version of the accelerator: investment demand was high because of Japan's sustained high growth rate, and therefore ultimately because of that high rate of potential output growth. In that case the slump in investment demand in the 1990s may be explained in part by a slowdown in the underlying sources of Japanese potential growth, and especially in prospective potential growth.

As noted above, there is considerable uncertainty about the actual rate of Japanese potential growth in the 1990s. Nonetheless, it is likely that there has been a slowdown in the rate of increase in total factor productivity, even cyclically adjusted. What is certain, however, is that Japan's long-run growth, even at full employment, must slow because of demographics. Through the 1980s Japanese employment expanded at x.x percent annually. However, the working-age population has now peaked: it will decline at x.x percent annually over the next xx years (OECD 1997), and - if demographers' projections about fertility are correct - at a remarkable x.x percent for the xx years thereafter. As suggested by the discussion of investment and q in the first half of this paper, such prospective demographic decline should, other things equal, depress expectations of future q and hence also depress current investment.

Of course, the looming shortage of working-age Japanese has been visible for a long time; indeed, the budgetary consequences of an aging population have been a preoccupation of the Ministry of Finance, and an important factor inhibiting expansionary fiscal policy. Why, then, didn't this prospect start to affect long-term investment projects in the 1980s? One answer is that businesses may have believed that total factor productivity would grow rapidly enough to make up for a declining work force. However, the "bubble economy" of the late 1980s may also have masked the underlying decline in investment opportunities, and hence delayed the day of reckoning.

Excerpted from Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap


Ben S. Bernanke and Vincent R. Reinhart, Director, Division of Monetary Affairs, Federal Reserve. Conducting Monetary Policy at Very Low Short-Term Interest Rates. Paper Presented in the form of a Lecture at the International Center for Monetary and Banking Studies , Geneva, Switzerland, 2002.

Ben S. Bernanke, Japanese Monetary Policy: A Case of Self-Induced Paralysis?, University of Princeton, Working Paper, 1999

Athanasios Orphanides, Board of Governors of the Federal Reserve System, Monetary Policy in Deflation: The Liquidity Trap in History and Practice, December 2003.

Kobayashi, Takeshi, Mark M. Spiegel, and Nobuyoshi Yamori. "Quantitative Easing and Japanese Bank Equity Values.", Journal of the Japanese and International Economies, 2006

Oda, Nobuyuki, and Kazuo Ueda. 2005. "The Effects of the Bank of Japan's Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach." Bank of Japan Working Paper Series, No. 05-E-6.

Baba, Naohiko, Motoharu Nakashima, Yosuke Shigemi, Kazuo Ueda, and Hiroshi Ugai. 2005. "Japan's Deflation, Problems in the Financial System, and Monetary Policy." Monetary and Economic Studies 23(1), pp. 47-111.

Gauti Eggertsson and Jonathan D. Ostry, Does Excess Liquidity Pose a Threat in Japan?, IMF Working Paper, April 2005.

Gauti B. Eggertsson, How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible, IMF Working Paper, March 2003

Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap

Lars E.O. Svensson, "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap,", Monetary and Economic Studies 19(S-1), February 2001.

'Helicopter Ben' confronts the challenge of a lifetime

By Martin Wolf, Financial Times, 16 Dec 2008

Central banks may soon resort to their most powerful weapons against deflation: the printing press and the "helicopter drop" of money. It is a time for which Ben Bernanke, chairman of the Federal Reserve, has long prepared. Will this weaponry work? Unquestionably, yes: used ruthlessly, it will eliminate deflation. But returning to normality thereafter will prove far more elusive.

Mr Bernanke delivered a celebrated speech on the topic in November 2002, when still a governor.* He spoke quite soon after the US stock market bubble burst in 2000. Policymakers then feared the US might soon follow Japan into deflation – sustained declines in the general price level.

Yet Mr Bernanke then insisted "that the chance of significant deflation in the US in the foreseeable future is extremely small". He pointed to "the strength of our financial system: despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape". The words "pride" and "fall" come to mind. Six years and a housing-cum-credit bubble later, chairman Bernanke must be sadder and wiser.

Mr Bernanke's view was also that "the best way to get out of trouble is not to get into it in the first place". The fear that reversing deflationary expectations would prove hard explains why the Fed has cut its official interest rate so quickly since the crisis broke in August 2007.

Is deflation a realistic likelihood? Core measures of inflation strongly suggest not. But one measure of expected inflation – the gap between yields on conventional and index-linked?Treasuries – has collapsed to 14 basis points. Moreover, yields on 10-year US Treasury bonds are already where Japan's were in 1996, six years after the latter's crisis began. (See the charts, which start one year before respective asset price peaks.)

Why then should central banks fear deflation? First, deflation makes it impossible for conventional monetary policy to deliver negative real interest rates. The faster the deflation, the higher real interest rates will be. Second, as explained by the great American economist Irving Fisher in the 1930s, "debt deflation" – the rising real value of debt as prices fall – then becomes a lethal threat. In the US, whose private sector gross debt soared from 118 per cent of gross domestic product in 1978 to 290 per cent in 2008, debt deflation could trigger a downward spiral of mass insolvency, falling demand and further deflation.

Already, the Fed has adopted a host of unconventional actions to keep the economy afloat. By December 10 the Federal Reserve's balance sheet had reached $2,245bn (€1,663bn, £1,490bn), a jump of $124bn over a week and $1,378bn over a year. It held a wide range of government and private paper, including $476bn in Treasury securities, $448bn in "term auction credit", $312bn in commercial paper and $233bn in "other loans", which includes $57bn of credit to AIG alone. If it keeps going, the Fed may become the largest bank in the world.

Does it face any constraint? Not really. As Robert Mugabe has shown, anybody can run a printing press successfully. Once the interest rate hits zero, the Fed can perform much further easing. Indeed, it can create money without limit. Imagine what would happen if an alchemist could transform lead into gold, at no cost. Gold would not be worth much. Central banks can create infinite quantities of money, at no cost. So they can reduce its value to nothing without difficulty. Curing deflation is child's play in a "fiat money" – a man-made money – system.

So what might central banks do? They might lower longer-term interest rates by buying as many long-term government bonds as they wish or by promising to keep short rates low for a lengthy period. They might lend directly to the private sector. Indeed, they might buy any private asset, at any price and in any quantity they choose. They might also buy foreign currency assets. And they might finance the government on any scale they think necessary.

Alternatively, the fiscal authorities can run a deficit of any size they wish and then finance it by issuing short-term paper that the central bank would have to buy, to keep interest rates down. At the zero-rate boundary, fiscal and monetary policies become one. The central bank's sole right to make monetary policy is gone. But the reverse is also true: the central bank can send money to every citizen. This is the helicopter drop proposed by the late Milton Friedman and recently discussed by Eric Lonergan on the FT's economists' forum.

At this point, one might wonder why Japan has struggled with deflation for so long. I have little idea. But the explanation seems to be that the Bank of Japan did not wish to take such drastic measures and the Ministry of Finance did not dare to force the point. Such self-restraint will not deter the US authorities.

So will the Federal Reserve drown the world in dollars, whereupon we will be able to wake from the nightmare? As Willem Buiter shows in a recent blog, "Confessions of a Crass Keynesian", the answer is No.

Once inflation returns, the central bank will need to sell assets into the market, to mop up the excess money it has created in fighting deflation. Similarly, the government must reduce its deficit to a size it can finance in the market. Otherwise, deflationary expectations may swiftly turn into expectations of above-target inflation. This may also happen if the debt sold in efforts to sterilise the monetary overhang is deemed beyond the government's ability to service.

Countries without a credible currency may reach this point early. As soon as a central bank hints at "quantitative easing", flight from the currency may ensue. This is particularly likely when countries remain burdened under a huge overhang of domestic and foreign debt. Creditors know that a burst of inflation would solve many problems in the US and the UK. The US may manage the danger of resurgent inflationary expectations. The UK is likely to find it more difficult. Avoiding deflation is easy; achieving stability thereafter will be far harder.

Ironically, we are where we are partly because the Fed was so terrified of deflation six years ago. Now, a credit bubble later, Mr Bernanke has to cope with what he then feared, largely because of the Fed's heroic attempts at prevention. Similar dangers now arise with the drastic measures that look ever more likely. This time, I suspect, the result will ultimately not be deflation but unexpectedly high inflation, though probably many years hence.

Sunday, December 14, 2008

The Deepening Global Financial Crisis

The turmoil in financial markets intensified in September 2008 following the bankruptcy of Lehman Brothers and other institutions and the extension of emergency credit lines to American International Group (AIG), as market participants lost confidence that the case-by-case approach to defaults adopted so far would prove effective in the face of mounting systemic risks. Money markets, interbank markets, and markets for short-term commercial paper in the United States and Europe largely froze, as reflected, inter alia, in bank credit default swap (CDS) and corporate bond spreads, which rose to unprecedented levels.

Monday, December 8, 2008

Emerging Markets: Rise And Decline Of A Fairy Tale?

In some ways a quick look at look at the Reuters/Jeffries CRB commodities index (see below) says it all. The accompanying chart - which shows the evolution of this index from the mid 1990s to date - immediately makes a number of important details about what just happened incredibly clear. In the first place we can see how, after long languising idly around a mean, a secular rise in commodity prices starts up around 2002 and last for around four years, eventually flattening out from between 2006 to mid 2007, and then we can see a further strong surge forward in and a sharp spike upwards. Of course, after the rise always comes the fall, and this sudden and dizzying spike was in its turn followed by a pronounced downward crash, under the weightof which we are still labouring at the time of writing. In fact the index hit an all-time series high of 473.518 on 2 July 2008, and was stuck down in the low 200s as 2008 drew to a close.

Now, depending on how you see things, you will put one interpretation or another on all this. What follows is simply my own intepretation, and doubtless others will have theirs to offer. But what I personally find most interesting, indeed intriguing I would say, is just how that initial flattening-out of the trend coincides (more or less) with the arrival of the housing slowdown in the US (and thus arguably with the begining of the end for this most recent business cycle), while the subsequent 2007 spike would seem to be a clear a knock-on consequence of the start of the August sub-prime "troubles" in the summer of 2007, reflecting the sharp capital outflows into the growth thirsty emerging markets that this first world financial shock precipitated. Well, all of this should give us plenty of food for thought, as should the rout in commodity prices which followed the arrival of the July 2008 peak, a peak which anticipated by almost two months the dénouement of the financial crisis with Lehmann Brothers bankruptcy in September.

More Than Just A Commodities Boom

So, amidst all that coupling, recoupling, decoupling, uncoupling rhetoric, might it not be interesting at this point to ask ourselves just what has been happening here? For my part, the first point I would like to make is that the chart does seem to offer us some evidence to support the idea that there was some form of long term structural break in the growth path of some key emerging economies following the aftermath of theAsian crisis of 1998. As can be seen from the long term trend in commodity prices, something was finally starting to move in the world of emerging economies, and the big question is why this was.

And then we have the end point, in 2008 when, as the IMF World Economic Outlook put it “the world economy entered new and precarious territory”. Perhaps the most remarkable feature of the whole recent situation have been the marked contrasts between booming commodity prices on the one hand and developed economy credit-market collapses on the other, between the buoyant growth being clocked up in many emerging economies and the incipient recessions which were emerging in the US, Europe and Japan.

The point to note here is not just that a significant group of investors and their fund managers were busily adapting their behaviour to changed conditions in the US and Europe, but rather that a very novel problem set began to emerge, as the credit crunch wended its way forward and property markets drifted off (at best) into stagnation in one OECD economy after another. Almost overnight it suddenly started "raining money" in one emerging economy after another as foreign exchange came flooding in (as can be seen in the Indian case in the chart below) and the question became not how to attract funding, but rather how to avoid an excess of it, with Thailand even attaining a certain notoriety by imposing capital controls with the rather novel objective of trying to stop funds entering the country.

But then suddenly things moved on, and night became day as the fund flow started reversed just as quickly as it had arrived, after one emerging market economy after another began to wilt under the growing strain of sharply rising inflation. The EM "mini-bubble" burst and at the time of writing the immediate future does not look exactly bright with growth rates being locked into an ongoing cycle of repeated downward revisions. By November the IMF had cut its global growth estimate for 2009 to 2.2 percent from 3.7 percent for 2008. The World Bank went even further, and in an early december forecast projected that world trade would fall in 2009 for the first time since 1982, with capital flows to developing countries being expected to plunge by 50 percent. The Bank even forecasts that the global economy will only grow by 0.9 percent in 2009. If these dire forecasts are realised we will have the slowest pace of global growth since 1982, when global economy only grew by 0.3 percent. According to the Bank forecast developing countries will only grow by an average of 4.5 percent next year (a pace that many economists consider equivalent to a recession, given that many developing countries need to grow rapidly in order to generate enough jobs to assimilate the large numbers of young people arriving on the labour market) and even this may turn out to be excessively optimistic, depdending on how rapidly the turn around comes.

The volume of world trade, which was up by 9.8 percent in 2006 and by an estimated 6.2 percent in 2007, is forecast to contract by 2.1 percent in 2009. Such a drop would be deeper than the last major contraction in trade, when it dropped by 1.9 percent all the way back in 1975. Net private flows of capital to developing countries are also projected to decline, to $530 billion in 2009 from $1 trillion in 2007. The loss of such capital will obviously sharply constrict investment in emerging-market economies, and annual investment growth is projected to slow to 3.5 percent in 2009 from 13.2 percent in 2007.

Having said this, and while fully recognising that the future is never an exact rerun of the past, and especially not of the most recent past, given that emerging economies have been the key engines of global growth over the last five years, is there any really compelling reason for believing they won't continue to be over the next five? Could we not draw the conclusion that what was "unsustainable" was not the solid trend growth which we were observing between 2002 and 2007, but rather the excess pressure and overheating to which the key EM economies were subjected after the summer of 2007?

According to IMF data, the so called BRIC countries actually accounted for nearly half of global growth in 2008 - China alone accounted for a quarter, and Brazil, India and Russia were responsible for another quarter. All-in-all, the emerging and developing countries combined accounted for about two-thirds of global growth (as measured using PPP adjusted exchange rates) . Furthermore, and most significantly, the IMF notes that these economies “account for more than 90 per cent of the rise in consumption of oil products and metals and 80 per cent of the rise in consumption of grains since 2002”.

But behind the recent EM phenomenon what we have is not only a newly emerging growth rate differential, there is also a large scale and ongoing currency re-alignment taking place, a realignment which is being driven by those very same growth rate differentials. The consequential rapid and dramatic rise in dollar GDP values (produced by the combination of strong growth and a declining dollar) has meant that a convergence in global living standards - at least in the cases of those economies who are experiencing the strongest acceleration - has been taking place much more rapidly than anyone could possibly have dreamed back in the 1990s, even if the long term importance of this is currently being masked by the recent collapse in commodity values and the downward slide in emerging currencies associated with this and the wekening in risk appetite. But the impact is there and is very well illustrated by the case of Turkey, as can be seen in the chart below.

Of course there is upside and downside here, and alongside the steadily rising importance of the BRIC and other developing economies we have witnessed a significantly weaker role for "home grown" US growth. In 1999 the US economy represented 30.91% of world GDP, and in 2007 this percentage will be down to 22.4% (on my calculations based on the forceast made by the IMF in October 2007). In 200 the US economy accounted for a staggering 40.71% of global growth, and by 2007 this share is expected to be down to 6.43%.

Slow Growth In The Credit Boom Driven Economies

So what does the future have in store for us? Well the recent pronounced fall in global economic activity, coupled with the collapse of commodity prices and inflation rates, has evidently reawakened deflation fears, and monetary policy, at least in the United States and Japan, looks set to be very very loose indeed, which bring only one word to my mind in an emerging markets context "carry".

While the economic and financial world as we know it is far from at an end the present global recession surely looks set to be both long and severe, certainly by recent historical standards in the OECD world. 2009 promises to be hard all round and if we are to see a new self-sustaining global expansion getting underway then it is hard to see where the momentum for this will come from if it is not from the emerging economies.

This is doubly true, since following the credit and current account excesses of recent years a number of the richer economies will undoubtedly suffer from a sustained period of low growth as private consumers and corporates steadily deleverage from the very high levels of debt they have accumulated, while their national governments will find themselves forced to adopt a more restrictive fiscal posture as they pay down the extra debt acquired in the course of the bank and financial system bailouts. And those larger economies who did not accumulate such excesses, like Germany and Japan, will undoubtedly notice the lack of customers for all those exports on which growth in their economies depends.

This recession then marks the end of the era where a few of the richer OECD economies assumed the role of the global consumers of the last resort, with the "counterparty" countries playing the role of net producers and bankers of the last resort, in terms of their willingness to fund the associated ongoing current account deficits.

Export Driven Ageing Economies No Global Drivers

So the really key question we all now face, as one heavily indebted economy after another tries to turn itself into an export driven growth miracle, is who is going to play the part of consumer in this new world, and who is going to assume the inevitable current account deficits which will be generated in the process? Clearly the golbal net current account balance is a zero sum game, since we can't all run surpluses at one and the same time. All the recent efforts to translate high national savings rates in Japan and Germany into stronger consumption have been futile will become even more futile now given that these countries have rapidly aging and declining populations, and you simply can't go round with a shotgun and try to force people to consume when what they are really worried about is the sustainability of their pension. So the main industrial economies are at this point either too stretched financially or too old and sclerotic to offer the energy and consumer dynamic needed to lead the next long-term expansion. What they can, evidently do, is provide the credit and all the machinery and equipment which can be bought with it to allow others to start producing and hopefully then consuming.

BRICS Split In Two

So rather than looking towards ageing economies like Germany and Japan, a rather more plausible source of global demand is likely to be found in the still largely untapped consumption potential of the growing middle classes in the big emerging-market countries. The needs and tastes of Chinese, Indian and Brazilian middle-class families seem to be well positioned to replace consumers in the U.S. , the UK, Spain and elsewhere, who at least in the near term will be restrictively focused on trying to straighten-out their severely strained balance sheets. However the earlier categorisation of the four leading emerging economies into one single group simply on the basis of the size of their populations can now be seen to have been overly simplistic. While all four BRIC countires look set to slow considerably in 2009, , Russia and China seem to single themselves out from the group as having rather more serious corrections in front of them.

At the time of writing the IMF still projects China’s growth in 2009 as running at around 8.5 percent, although as they suggest, with exports likely to fall sharply and the property sector weakening, risks here are firmly tilted to the downside. My own feeling is that as we move forward there will be significant downward revisions to the outlook, and that we may well even see negative growth in Russia's economy in 2009, and China growth in the very low single digits. Numerous issues now raise their heads in the case of both these two countries - stretching from their very special demographic profile, to the quality of their democratic institutions, to their ability to respond flexibly to what are inevitably very complex economic policy needs, to the whole foundation of their export (China) and commodity (Russia) driven growth models. In this sense I feel the next growth wave will see a fissure in the BRIC camp, with India and Brazil increasingly singling themselves out as poles of stability in what would otherwise be a fairly unstable world of emerging economies.

It's The Demography Silly

Basically the what I have argued above only depends on one simple premiss, that in the world of economics demography matters, and it matters a good deal more than many imagine. If we want to understand why it is that so many EMs have been finally emerging over the last decade, then, apart from the greatly improved institutional quality we are seeing, the fact that many of these countries have been passing through the most favourable stage in their demographic transition is surely not incidental. Equally, given that this transition is having a differential impact on countries at one stage or another I would suggest that the export dependence of a new group of elderly economies - lead by Germany and Japan - can equally not be understood without some reference to their demographic profile.

And if this sort of argumentation has any validity at all, it is bound to have implications for one of the key problems which we will face in the context of the next global upturn: what to do with the financial architecture which we have inherited from the original Bretton Woods agreement (or Bretton Woods II as some like to call it). The limitations of the current structure have become only too painfully apparent during the present recession, since with both the Eurozone and the US economies contracting at the same time, the currency see-saw between the dollar and the euro has failed to provide any adequate form of automatic stabiliser. And Japan is in an even more parlous state, deep in recession, and desparate for exports, it is having to live with a yen-dollar parity which is at levels not seen since the mid 1990s. The issue is in many ways similar to the one relating to who it is who will run the current account deficits and do the necessary consuming during the next upturn. Evidently the main problem we have seen in the last business cycle has been the size of the imbalances which have been run up, and policy decisions are urgently needed to impose measures and structures which help avoid a repeat of the same in the near future. But there is also the question of the basket of reserve currencies to be held by central banks, and this basket now badly needs widening, at the very least to take account of the new global role to be played by Brazil and India by opening these baskets to the two leading emerging economy global currencies.