Tick tock…here comes the Zero Lower Bound again

This week have brought even more confirmation that we are still basically in a deflationary world – particularly in Europe. Hence, inflation numbers for October in a number of European countries published this week confirm that that inflation is declining markedly and that we now very close to outright deflation in a number of countries. Just take the case of the Czech Republic where the so-called monetary policy relevant inflation dropped to 0.1% y/y in October or even worse Sweden where we now have outright deflation – Swedish consumer prices dropped by 0.1% in October compared to a year ago.

And the picture is the same everywhere – even a country like Hungary where inflation notoriously has been above the central bank’s 3% inflation target inflation is now inching dangerously close to zero.

Some might say that there is no reason to worry because the recent drop in inflation is largely driven by supply side factors. I would agree that we shouldn’t really worry about deflation or disinflation if it is driven by a positive supply shocks and central banks would not react to such shocks if they where targeting nominal GDP rather than headline consumer price inflation. In fact I think that we are presently seeing a rather large positive supply shock to the global economy and in that sense the recent drop in inflation is mostly positive. However, the fact is that the underlying trend in European prices is hugely deflationary even if we strip out supply side factors.

Just the fact that euro zone money supply growth have averaged 0-3% in the past five years tells us that there is a fundamental deflationary problem in the euro zone – and in other European countries. The fact is that inflation has been kept up by negative supply shocks in the past five years and in many countries higher indirect taxes have certainly also helped kept consumer price inflation higher than otherwise would have been the case.

So yes supply side factors help drag inflation down across Europe at the moment – however, some of this is due to the effect of earlier negative supply side shocks are “dropping out” of the numbers and because European governments are taking a break from the austerity measures and as a result is no longer increasing indirect taxes to the same extent as in earlier years in the crisis. Hence, what we are no seeing is to a large extent the real inflation picture in Europe and the fact is that Europe to a very large extent is caught in a quasi-deflatonary trap not unlike what we had in Japan for 15 years.

Here comes the Zero Lower Bound

Over the past five years it is not only the ECB that stubbornly has argued that monetary policy was easy, while it in fact was über tight. Other European central banks have failed in a similar manner. I could mention the Polish, the Czech central banks and the Swedish Riksbank. They have all to kept monetary policy too tight – and the result is that in all three countries inflation is now well-below the central bank’s inflation targets. Sweden already is in deflation and deflation might very soon also be the name of the game in the Czech Republic and Poland. It is monetary policy failure my friends!

In the case of Poland and Sweden the central banks have had plenty of room to cut interest rates, but both the Polish central bank and the Swedish Riksbank have been preoccupied with other issues. The Riksbank has been busy talking about macro prudential indicators and the risk of a property market bubble, while the economy has slowed and we now have deflation. In fact the Riksbank has consistently missed its 2% inflation target on the downside for years.

In Poland the central bank for mysteries reasons hiked interest rates in early 2012 and have ever since refused to acknowledged that the Polish economy has been slowing fairly dramatically and that inflation is likely to remain well-below its official 2.5% inflation target. In fact yesterday the Polish central bank published new forecasts for real GDP growth and inflation and the central bank forecasts inflation to stay well-below 2.5% in the next three years and real GDP is forecasted to growth much below potential growth.

If a central bank fails to hit its inflation target blame the central bank and if a central bank forecasts three years of failure to hit the target something is badly wrong. Polish monetary policy remains overly tight according to it own forecasts!

The stubbornly tight monetary stance of the Polish, the Czech and the Swedish central banks over the past couple of years have pushed these countries into a basically deflationary situation. That mean that these central banks now have to ease more than would have been the case had they not preoccupied themselves with property prices, the need for structural reforms and fiscal policy in recent years. However, as interest rates have been cut in all three countries – but too late and too little – we are now inching closer and closer to the Zero Lower Bound on interest rates.

In fact the Czech central bank has been there for some time and the Polish and the Swedish central bank might be there much earlier than policy makers presently realise. If we just get one “normal size” negative shock to the European economy and then the Polish and Swedish will have eventually to cut rates to zero. In fact with Sweden already in deflation one could argue that the Riksbank already should have cut rates to zero.

The Swedish and the Polish central banks are not unique in this sense. Most central banks in the developed world are very close to the ZLB or will get there if we get another negative shock to the global economy. However, most of them seem to be completely unprepared for this. Yes, the Federal Reserve now have a fairly well-defined framework for conducting monetary policy at the Zero Lower Bound, but it is still very imperfect. Bank of Japan is probably closer to having a operational framework at the ZLB. For the rest of the central banks you would have to say that they seem clueless about monetary policy at the Zero Lower Bound. In fact many central bankers seem to think that you cannot ease monetary policy more when you hit the ZLB. We of course know that is not the case, but few central bankers seem to be able to answer how to conduct monetary policy in a zero interest rate environment.

It is mysteries how central banks in apparently civilised and developed countries after five years of crisis have still not figured out how to combat deflation with interest rates at the Zero Lower Bound. It is a mental liquidity trap and it is telling of the serious institutional dysfunctionalities that dominate global central banking that central bankers are so badly prepared for dealing with the present situation.

But it is nonetheless a fact and it is hard not to think that we could be heading for decades of deflation in Europe if something revolutionary does not happen to the way monetary policy is conducted in Europe – not only by the ECB, but also by other central banks in Europe. In that sense the track record of the Swedish Riksbank or the Polish and Czech central banks is not much better than that of the ECB.

We can avoid deflation – it is easy!

Luckily there is a way out of deflation even when interest rates are stuck at zero. Anybody reading the Market Monetarists blogs know this and luckily some central bankers know it as well. BoJ chief Kuroda obviously knows what it takes to take Japan out of deflation and he is working on it. As do Czech central bank chief Miroslav Singer who last week – finally  – moved to use the exchange rate as policy instrument and devalued the Czech kurona by introducing a floor on EUR/CZK of 27. By doing this he copied the actions of the Swiss central bank. So there is hope.

Some central bankers do understand that there might be an Zero Lower Bound, but there is no liquidity trap. You can always avoid deflation. It is insanely easy, but mentally it seems to be a big challenge for central bankers in most countries in the world.

I am pretty optimistic that the Fed’s actions over the past year is taking the US economy out of the crisis. I am optimistic that the Bank of Japan will win the fight against deflation. I am totally convinced that the Swiss central bank is doing the right thing and I am hopeful that Miroslav Singer in the Czech Republic is winning the battle to take the Czech economy out of the deflationary trap. And I am even optimistic that the recent global positive supply shock will help lift global growth.

However, the ECB is still caught in its own calvinist logic and seems unable to realise what needs to be done to avoid a repeat of the past failures of the Bank of Japan. The Swedish central bank remains preoccupied with macro prudential stuff and imaginary fears of a property market bubble, while the Swedish economy now caught is in a deflationary state. The Polish central bank continues to forecast that it will fail to meet its own inflation target, while we are inching closer and closer to deflation. I could mention a number of other central banks in the world which seem trapped in the same kind of failed policies.

Ben Bernanke once argued that the Bank of Japan should show Rooseveltian resolve to bring Japan out of the deflationary trap. Unfortunately very few central bankers in the world today are willing to show any resolve at all despite the fact that we at least Europe is sinking deeper and deeper into a deflationary trap.


Update: Former Riksbank deputy governor Lars E. O. Svensson comments on the Swedish deflation. See here.


Abe should repeat Roosevelt’s successes, but not his mistakes

There is more good news from Japan today as new data shows that core inflation rose to 0.8% y/y in August and I think it is now pretty clear that the Bank of Japan is succeeding in defeating 15 years’ of deflation. Good job Mr. Kuroda!

BoJ chief Kuroda has done exactly done what Ben Bernanke called for back in 1999:

Franklin D. Roosevelt was elected President of the United States in 1932 with the mandate to get the country out of the Depression. In the end, the most effective actions he took were the same that Japan needs to take—- namely, rehabilitation of the banking system and devaluation of the currency to promote monetary easing. But Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment—-in short, to do whatever was necessary to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done. Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening?

To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.

So far so good and there is no doubt that governor Kuroda has exactly shown Rooseveltian resolve. However, while Roosevelt undoubtedly was right pushing for monetary easing to end deflation in 1932 he also made the crucial mistake of trying to increase wages.

One can say that Roosevelt succeed on the demand side of the economy, but failed miserably on the supply side of the economy. First, Roosevelt push through the catastrophic National Industrial Recovery Act (NIRA) with effectively was an attempt to create a cartel-like labour market structure in the US. After having done a lot of damage NIRA was ruled unconstitutional by the US supreme court in 1935. That helped the US recovery to get underway again, but the Roosevelt administration continued to push for increasing labour unions’ powers – for example with the Wagner Act from 1935.

While it is commonly accepted that US monetary policy was prematurely tightened in 1937 and that sent the US economy into the recession in the depression in 1937 it less well-recognized that the Roosevelt administration’s militant efforts to increase the unions’ powers led to a sharp increase in labour market conflicts in 1936-37. That in my view was nearly as important for the downturn i the US economy in 1937 as the premature monetary tightening.

Prime Minister Abe is repeating Roosevelt’s mistakes   

The “logic” behind Roosevelt’s push for higher was that if inflation was increased then that would reduce real wages, which would cut consumption growth. This is obviously the most naive form of krypto-keynesianism, but it was unfortunately a widespread view within the Roosevelt administration, which led Roosevelt to push for policies, which seriously prolonged the Great Depression in the US.

It unfortunately looks like Prime Minister Abe in Japan is now pushing for exactly the same failed wage policies as Roosevelt did during the Great Depression. That could seriously undermine the success of Abenomics.

This is from Bloomberg today:

“Abe last week began meetings with business and trade union leaders to press his case for wage increases, key to the success of his effort to spur growth under his economic policies dubbed Abenomics.”

This is exactly what Roosevelt tried to do – and unfortunately succeed doing. His policies was a massive negative supply shock to the US economy, which pushed wages up relatively what would have happened with out policies such as NIRA. The result was to prolong the depression and I am fearful that if Prime Minister Abe will be as successful in pushing for higher wage growth in Japan it will undermine the positive effective of Mr. Kuroda’s monetary easing – inflation will rise, but economic growth will stagnate.

What Prime Minister Abe is trying to do can be illustrated in a simple AS-AD framework.

Abe wage shock

Mr. Kuroda’s monetary easing is clearly increasing aggregate demand in the Japanese economy pushing the AD curve to the right (from A to B). The result is higher inflation and higher real GDP growth. This is what we are now clearly seeing.

However, Prime Minister Abe’s attempt of increasing wages can only be seen as negative supply shock, which if successful will push the AS curve to the left (from B to C). There is no doubt that the join efforts of Mr. Kuroda and Mr. Abe are pushing up inflation. However, the net result on real GDP growth and employment is uncertain.

I am hopeful that Mr. Abe is not really serious about pushing up wages – other than what is the natural and desirable consequence of higher demand growth – and I hope that he will instead push much harder to implement his “third arrow”, which of course is structural reforms.

Said, in another way Mr. Abe should try to push the AS curve to the right instead of to the left – then Abenomics will not repeat the failures of the New Deal.

Irving Fisher and the New Normal

A lot of the debate about how to escape the Great Recession is focused on the question of deleveraging and it is often said that we have entered a period of more or less permanent low growth – a “New Normal”. I fundamentally think the idea of the new normal theoretically and empirically flawed.

Irving Fisher – undoubtedly one of the greatest economists of the 20th century – formulated his debt-deflation theory, which is highly relevant for the debate about the “New Normal” and more importantly about how to escape the “New Normal”.

According to Fisher the economy and market goes through nine phases after the bubble bursts:

  1. Debt liquidation and distress selling.
  2. Contraction of the money supply as bank loans are paid off.
  3. A fall in the level of asset prices.
  4. A still greater fall in the net worth of businesses, precipitating bankruptcies.
  5. A fall in profits.
  6. A reduction in output, in trade and in employment.
  7. Pessimism and loss of confidence.
  8. Hoarding of money.
  9. A fall in nominal interest rates and a rise in deflation adjusted interest rates.

This is how a lot of people today think of the crisis. We had a bubble and it busted and now we have to go through these more or less “natural” phases and therefore we will just have to take the pain.

I would certainly not disagree that there is a serious risk that we indeed will live through a long period of low growth and a quasi-deflationary environment. Here is Fisher:

“Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.”

This is pretty much Fisher description of the New Normal. However, unlike the New Normal crowd Fisher did not think that we have to live through “a vicious spiral, for many years”:

“On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.”

So what is Fisher saying? Basically advocating a variation of the Market Monetarists solution to bring NGDP back to the pre-crisis trend level.

The skeptics, however, are saying that it is not possible to do that with monetary policy, but Fisher has an answer ready to the liquidity trap crowd:

That the price level is controllable is not only claimed by monetary theorists but has recently been evidenced by two great events: (1) Sweden has now for nearly two years maintained a stable price level, practically always within 2 per cent of the chosen par and usually within 1 per cent. (2) The fact that immediate reversal of deflation is easily achieved by the use, or even the prospect of use, of appropriate instrumentalities has just been demonstrated by President Roosevelt.

Fisher continues – about Roosevelt’s decision to give up the gold standard in 1933:

“Those who imagine that Roosevelt’s avowed reflation is not the cause of our recovery but that we had “reached the bottom anyway” are very much mistaken. At any rate, they have given no evidence, so far as I have seen, that we had reached the bottom. And if they are right, my analysis must be woefully wrong. According to all the evidence, under that analysis, debt and deflation, which had wrought havoc up to March 4, 1933, were then stronger than ever and, if let alone, would have wreaked greater wreckage than ever, after March 4. Had no “artificial respiration” been applied, we would soon have seen general bankruptcies of the mortgage guarantee companies, savings banks, life insurance companies, railways, municipalities, and states. By that time the Federal Government would probably have become unable to pay its bills without resort to the printing press, which would itself have been a very belated and unfortunate case of artificial respiration. If even then our rulers should still have insisted on “leaving recovery to nature” and should still have refused to inflate in any way, should vainly have tried to balance the budget and discharge more government employees, to raise taxes, to float, or try to float, more loans, they would soon have ceased to be our rulers. For we would have insolvency of our national government itself, and probably some form of political revolution without waiting for the next legal election. The mid-west farmers had already begun to defy the law…If all this is true, it would be as silly and immoral to “let nature take her course” as for a physician to neglect a case of pneumonia. It would also be a libel on economic science, which has its therapeutics as truly as medical science.”

So what is Fisher saying? Yes we are going through a debt-deflation cycle started by a monetary shock and it can go on for years, but the downward spiral can be stopped with monetary policy – for example by bringing NGDP back to the pre-crisis trend level – and there is no liquidity trap as long as policy makers use Rooseveltian Resolve or learn a lesson from the Swedish central bank Riksbanken.

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