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Saturday, September 20, 2014

The Japanisation Of Europe

By now it should be clear that the monetary experiment currently being carried out in Japan (known as “Abenomics”) is fundamentally different from the kind of quantitative easing which was implemented  in the United States and the United Kingdom during the global financial crisis. In the US and the UK QE was implemented in order to stabilize the financial system, while in Japan, and now the Euro Area (EA) the objective is to end deflationary pressures and reflate economies which are arguably caught in some form of liquidity trap.

In particular it is hard not to draw the conclusion that something structural and more long-term is taking place in Japan, and that that something is only tangentially related to the recent global financial crisis. One plausible explanation is that Japan’s long-lasting malaise is not simply a debt deflationary hangover from the bursting of a property bubble in 1992 but rather with the rapid population ageing the country has experienced. If this is the case then the ongoing economic stagnation in Europe may have a lot more to do with the Japan experience than it does with  the recent economic dynamics seen in the UK and the US. The reason for this is simple:  Europe’s population is the second oldest on the planet after Japan’s. Certainly at first sight the similarity is striking, especially when it comes to working age population dynamics.

So is the Euro Area the New "Japan"?

"Europe is becoming Japanese" is an expression that is being used more and more. People saying this normally point to the fact that German 10 year bund yields recently went under 1% (and hence have started to look like 10 year Japan Government Bonds).

But behind this argument lies some kind of "reverse causality". In Japan JGB yields have been driven to very low levels by central bank intervention, with the BoJ now buying a very large share of all new issue bonds. In Europe, on the other hand, the ECB isn't buying Euro Area sovereigns, the markets are in anticipation of QE. So to talk about the Japanisation of Euro Area yields is a little misleading. Bond purchasers and their models are provoking this downward lurch, not the central bank response to weak growth or creeping deflation. To really push Mario Draghi into Japan-style QE in the short term markets would need to move back into risk-off mode on periphery assets, yet there is little appetite to go for what might potentially become another "widowmaker" trade by taking on a powerful central bank. Yet as long as the bond markets remain relatively well behaved Draghi will try to do as little as possible.

Another argument used to justify the "Japanisation" of the Euro Area idea carries much more clout, and that is the one being used by Paul Krugman based on working age population dynamics. "If you’re worried that secular stagnation might be depressing the natural real rate of interest (the rate consistent with full employment)”, he told blog readers “and you think that demography is a big factor, Europe looks really terrible, indeed full-on Japanese."

Inflation dynamics in Europe also look strikingly similar to those seen in Japan (but with a 20 year lag, see chart below).

The basic idea is that working age population dynamics play a big part in determining movements in aggregate demand and hence inflation. This idea received support from a research paper published at the start of August by a group of IMF economists - "Is Japan’s Population Aging Deflationary?" The first part of the paper abstract runs as follows:
"Japan has the most rapidly aging population in the world. This affects growth and fiscal sustainability, but the potential impact on inflation has been studied less. We use the IMF’s Global Integrated Fiscal and Monetary Model (GIMF) and find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly makes matters worse as it leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need."
Strikingly Japan entered deflation not in 1992, but in 1997/8 at exactly the point the working age population peaked and in the EA it is happening in 2012/13 - just when EA working age population dynamics turned negative. The correlation may be just an odd coincidence, but it is striking.

Not according to the ECB

Naturally Mario Draghi will have none of this. "I think that the situation in the euro area is quite different from what it was in Japan in the 1990s and early 2000s", he told an ECB press conference in December 2013. He then went on to offer five reasons.

Reason No 1: "we have taken decisive monetary policy measures of great significance at a very early stage, even when, as a matter of fact, inflation was not at the levels at which it is today. It was way higher and way closer to 2% and this did not happen in Japan".

This is the case, but the vast majority of the ECB's non conventional policy measures were intended to avoid financial instability, not to  provoke inflation. The measures were largely liquidity oriented not outright "money printing" ones, so they were mainly addressing the monetary policy transmission mechanism - which was broken - not the fact that the refinancing rate was stuck up against the zero bound. There still hasn't been sufficient analysis of why outright deflation didn't hit the Euro Area sooner, but a big part of the story is probably associated with the presence of excessive rigidity in wages and prices and the constant consumption tax and administrative charge increases put in place as part of the deficit containment exercises.

It is noteworthy that in Greece, for example, wage costs came down sharply a long time before the CPI began to fall.

Reason No 2: "We are in the process of doing the asset quality review.......the situation in Japan lasted much longer than it should have because the balance sheets of the banking system and the private sector were burdened, and had to be deleveraged and the action to induce this deleveraging lacked for many years."

Well, maybe, just maybe, the ECB President has his timing a little bit out here. Japan's bubble burst in 1992, and the banks started getting seriously recapitalized in 1998. The global financial crisis hit the Euro Area in 2008, and the AQR - which is supposed to be the prerequisite for realistic recapitalization - is taking place in 2014. The time difference in fact seems to match. So we could also say the necessary action on the part of the ECB also "lacked for many years".  Of course, banks in some of the most troubled countries have already been recapitalized once, most notably in Ireland and then in Spain in 2012. But still problems remain, which is why the AQR is taking place. Earlier stress tests have just not been realistic or rigorous enough.

In a process not too dissimilar to the one taking place at the present time in the EA Japanese banks were recapitalized to the tune of 0.4% of GDP in March 2009, and by another 1.5% of GDP in March 1999. The order of magnitude of these recapitalization is not in any meaningful sense larger than that which is taking place in the Euro Area. Following an AQR type process conducted by the recently formed Japanese Financial Reconstruction Commission non performing loans were systematically identified and banks required to recapitalize accordingly. 14.8% of GDP's worth of NPLs were finally identified, a figure not notably different from the current Euro Area one, and well below the levels prevailing in the worst affected countries like Spain and Italy.

Reason No 3: "the situation of the private sector balance sheets is not at all comparable in the euro area. It is not at all comparable with what it was in Japan at that time."

I just think Draghi is wrong about this. The level of credit exposure of Japanese banks to the private sector was not *that* different from the EA one in 2008 (see chart below) and as we have seen the level of distressed lending was pretty comparable.

In effect this whole comparison with Japan in the late 1990s is a bit flawed, since as will be recalled Abenomics was only introduced in April 2013. The point being that Japan was still stuck in deflation up to that point (and may still be so when the effects of the devaluation and the tax hike wear off), and so it is a bit hard to pin all this on a couple of bad decisions in 1997 and 1998. Underlying structural factors are at work (liquidity trap, possibly driven by ultra low fertility) and these may be similar in both the European and the Japanese cases.

It is true that the bank of Japan underestimated the scale of the problem between 1992 and 1997, but the same sort of accusation can be brought to the door of the ECB. In both Japan and the EA measures were (and are being) implemented to help banks avoid liquidity crunches in the hope that this will encourage lending, but in neither case has (or is) this had/having any evident success. The poor initial demand for TLTROs being just one example of this problem.

 Reason No 4: "countries in the euro area have made significant progress in addressing their structural weaknesses....that’s the fourth difference between Japan in the 1990s and 2000s and us today."

Well, as Draghi himself admitted, the structural reform process in Europe is far from complete (France, Italy) and I think he also underestimates the kinds of reforms which were carried out in Japan at the time. The "lifelong employment" tradition, for example, was ended in the late 1990s.

Reason No 5:  "if you look at the inflation expectations in the euro area and the corresponding inflation rates you would see that in Japan the inflation expectations were dis-anchored quite significantly, and for a long period of time, which is not something we are seeing here."

This isn't exactly as straight forward as Draghi makes out either. He himself has accepted in his Jackson Hole speech that EA inflation expectations are not as well anchored as he thought they were, while on the other hand inflation expectations were better anchored in Japan than he seems willing to acknowledge (see chart below showing how 10yr inflation expectations evolved in Japan). That is to say in neither case did the central bank see the problem coming. (Click on image for better viewing)

Bottom line, despite all the denials from Mario Draghi that the Eurozone is not another Japan there are plenty of grounds for thinking that it is steadily becoming one.


The above arguments are developed in detail and at far greater length in my new book "Is The Euro Crisis Really 0ver? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Friday, September 19, 2014

Does Abenomics Work? - The Doubts Grow

Is something in the air? Do I detect a change in consensus on the way things are going in Japan? Certainly a slew of articles have been published in the financial press over the last month questioning where the Abenomics experiment is headed for. The general conclusion seems to be that wherever it is it is certainly not the originally designated endpoint. Thus the Economist.
"It is crisis mode in the Kantei, the office of Shinzo Abe, Japan’s prime minister. A succession of awful data has pummelled his economic programme, which consists of three “arrows”: a radical monetary easing, a big fiscal stimulus and a series of structural reforms. On September 8th revised figures showed that GDP shrank by 1.8% in the second quarter, or by 7.1% on an annualised basis, even worse than the initial estimate of 1.7%."

Or David Pilling in the Financial Times:

Something odd is going on with Japan’s labour market. Unemployment is at 3.7 per cent. Recently, it has been as low as 3.5 per cent, considered by some economists to be pretty much full employment....... You would have thought that wage inflation would be going crazy as a result. Unfortunately for Japan, you would be wrong. The government has badgered companies, which are making record profits, to share the love. Some have responded with modest wage increases, but not enough to keep pace with prices, which are rising thanks to monetary stimulus and a 3 percentage-point increase in sales tax......

Japanese wages do not seem to be responding to normal market pressures. Why not? The conundrum has its roots in the altered structure of the labour market. Contrary to common perception, Japan has an exceptionally flexible workforce. Outside the ranks of the protected “job-for-lifers” – a much rarer breed these days – nearly 40 per cent of workers are about as flexible as you get. They work in poorly paid jobs for hourly rates. Benefits are all but non-existent. For most of these workers, sometimes referred to as the “precariat”, unemployment is a mere “sayonara” away.......

For its reflationary experiment to work, wages must begin to rise in line with inflation. But the casualisation of the labour force is short-circuiting that process. Moreover, people in the precariat are less likely to marry and have children. If Japan is to solve its demographic problem, it will have to tackle the labour issue.
The WSJ's Takashi Nakamichi - in an article entitled Japan's Tax Increase Puts Abenomics at Risk- continues in a similar vein:
Mr. Abe took office in December 2012 and quickly engineered an upturn in growth that was dubbed Abenomics. Mr. Abe's policies were backed by the monetary "bazooka" of Bank of Japan Gov. Haruhiko Kuroda, who started flooding the economy with more cash in April 2013. Though economists warned that the recovery was still fragile, Mr. Abe decided to increase taxes, hoping to reduce Japan's massive debt load. On Friday, top government officials stuck by their view that Abenomics remains on track. Officials described the downturn in consumer spending as temporary, suggesting it had been exacerbated by rainy summer weather in parts of western Japan.
Or Stanley White at Reuters (Export recovery proves elusive for hollowed-out Japan) who focuses on the fact that, despite the sharp yen devaluation, exports have hardly improved.
Mazda Motor Corp  has returned to profit as the falling yen has rewarded the carmaker's export-heavy strategy. Mazda's response? Move some production to Mexico. Investing in plant abroad is hardly an endorsement for Prime Minister Shinzo Abe's strategy to revive the fortunes of the world's third largest economy, and one driven by exports. "Companies are not that interested in expanding capacity in Japan," said Kaori Yamato, senior economist at Mizuho Research Institute. "This is a problem for exports." With companies making less goods at home, it has become structurally difficult for exports to rise, even with the yen at multi-year lows as a result of Abe's policies, economists say.
In fact White's conclusions seem especially pessimistic. "Economists say the lost production may never come back," he tells us, and he could be right.

List As Long As Your Arm

The list of arguments about why Abenomics is not working is growing, but the core issues touched on above seem to be:

i) Unemployment is down, but an excessively flexible labour market means that wages keep falling.
ii) Inflation is rising (partial success) but living standards are falling.
iii) Beyond inflation Abenomics doesn't have clearly defined priorities and fiscal policy continually falls between the two stools of stimulating  the economy and reducing the debt: you can't eat your cake and have it.
iv) Times have changed in Japan, the workforce is ageing and to some extent the decline of the export industries may be becoming unstoppable.

Curiously despite the meager harvest the "put on a brave face" brigade are still out there, and even managed to not feel ridiculous putting up headlines like "Japan Wages Make Biggest Jump in 17 Years" which is true, but leaves out the inconvenient little detail that inflation is rising at a rate which takes us back even further in time. (See my Japan inflation at a 32 year high).

Indeed you have to work your way through to the end of the WSJ article todiscover that "the increase in earnings, however, was negative after accounting for inflation".

One of the problems external observers have in following Japan is that there are a variety of ways in which wages and salaries are measured and the headline number can vary according to which measure you take. One of the most popular ones  is worker household income (published monthly by the statistics office). According to this indicator household income even fell in nominal terms in July (-2.4% see below), and was of course way down in real terms (-6.2%).

The WSJ journalist chose to cite the preliminary monthly report from the Ministry of Health, Labor and Welfare, which showed average  total cash earnings (including bonuses and special payments) rose by 2.6%.in July over a year earlier. Average contractual cash earnings, on the other hand, were up just 0.9%. In both cases you have to subtract the 3.3% annual inflation to find the full impact on wages and earnings.

In fact the Health, Labor and Welfare ministry also publish a real wages index which is included as part of the same report. This initially showed basic real wages fell by 3% year on year in July. At the end of the day whichever indicator you choose the result has one common thread - it is always negative. (And indeed these preliminary numbers were revised down on Sept 18. Contractual cash earnings  went from a 0.9% to a 0.5% non inflation adjusted rise, and real basic wages went from -3% to -3.4%, so there you go).

Inflation May Not Be Sustainable

Then there is the question of whether Japanese inflation is not simply the result of the strong yen devaluation plus the tax increase (I have gone into this at some length here and here). Certainly real doubts exist about the sustainability of the current inflation given the lack of final demand to drive it. Economists Tsutomu Watanabe and Kota Watanabe at Tokyo University maintain a daily price index based on point of sale scanned price data. The index only covers 17 percent of the official Japan CPI in terms of consumption weight, but gives an indication of the trend in frequently purchased items - you can find a list of items covered by the index here. Certainly - if you look at the chart below its hard to see any clear inflationary push over the last six months, au contraire. (Click on image for better viewing).

Exports Going Nowhere

Perhaps the most evident flaw in the Abenomics story is to be found in the export department. The sharp yen devaluation was supposed to lead to a sharp boost in exports which would then drive the economy. And for a time it did.

But then, as Reuters Stanley White points out, the export drive simply ground into the dust, and Japanese exports have been moving sideways since the spring (see chart above). This should be pretty worrying for Abenomics theorists, since the stagnation in exports can't be put down to the tax hike.

Where we go from here is anyone's guess. The economy is surely going to have a brush with recession this quarter, and in any event it is hard to speak about a recovery in anything except inflation and the stock market.

Consensus economists are now expecting Bank of Japan governor Kuroda to go for another round of quantitative easing - to force the yen down yet one more time. But why should what didn't work once do any better the second time round? And anyway, Hurhiko Kuroda himself seems to be trying to talk down expectations in this regard. "Japan's economy has been on a path suggesting that the price stability target of 2 percent will be achieved as expected," he told business executives in Osaka last week, adding that "exchange-rate stability is extremely important". This suggests he is not contemplating any further sharp devaluation. Any yen weakening we will see is likely  be contained and not pronounced.

On the other hand the administration still has to decide whether to go ahead with next year's additional tax hike. The government is caught in a double bind, since if it doesn't raise the consumption tax as planned and cuts spending to compensate then the economy will still contract. And if it doesn't do either of these things  then the debt level will continue its march upwards. At the moment the government is mulling the idea of raising the tax and doing a 5 trillion yen ($47 billion) additional stimulus to compensate. Which sort of leaves me wondering why they want to raise the tax in the first place.

What makes people like me nervous is the thought that if the central bank can't deliver on its promise to deliver inflation and revive the economy, or if the Japanese voters decide they have had enough of the experiment, then a loss of confidence might ensue, and all those dubious risky asset positions might unwind suddenly, just like an earlier set did in 2008.

And there are plenty of people in Japan who have been pointing this out all along. Seki Obata, a Keio University business school professor for example, who in 2013 published a book "Reflation is Dangerous," argues exactly this, that "Abenomics" is exposing Japan to considerable risk without any clear sense of what it can accomplish. Obata also makes the extremely valid point that there is simply no way incomes can rise across the entire economy because the baby boomers are now retiring to be replaced by fewer young workers with post labour reform entry-level wages. Japan's overall consumer spending power will therefore fall, rather than rise as Abe hopes. "Individual companies may offer wage increases, but because of demographics it is simply impossible to increase the total amount that is paid out in wages," says Obata. "On the contrary, that amount will shrink." Simple logic you would have thought, but logic in the face of irrational exuberance scarcely stops people in their tracks.

As far as I can see, all of this  points to one simple and evident conclusion: that Japan needs deep seated cultural changes, especially ones directed to greater female empowerment and more open-ness towards immigration. Hardly matters for central bank initiatives, and indeed ones for which Shinzo Abe, who naturally has given his name to this new economic trend, is singularly ill equipped to carry through. Japan needs a series of structural reforms – like those under discussion around the third arrow – but these would be to soften the blow of workforce and population decline, not an attempt to run away from it. Monetary policy has its limits. As Martin Wolf so aptly put it, "you can't print babies".

The above analysis is based on arguments fleshed out in much more detail in my  "mini book" the A B E of Economics.

The book is available with Amazon as an e-book. It can be found here. You don't need to buy a Kindle to read this book. You can download a free app from Amazon.

Tuesday, September 16, 2014

Is The Euro Crisis Really Over?

The euro zone crisis is not back --, at least not yet it isn’t.

Despite the great progress which has been made over the last few years, the latest bout of market tensions over Greece serve to illustrate the degree of uncertainty which still hangs over the future of monetary union - will a so-called Grexit scenario will finally occur?

Certainly the most notable feature of the current Greece crisis is the way in which bond yields in the other Euro periphery countries have continued to head downwards, leading many to conclude that the “contagion” threat is now a thing of the past. But doubts remain: how much of this bond yield stability is due to the ECB QE programme? And what will happen if the ECB eventually terminates the bond purchases, or even tries to end them early under a Federal Reserve type “tapering” process? What will happen to bond spreads then? And what about the growing political instability in the region, as unemployment remains unacceptably high despite the apparent recovery.

Naturally the dramatic shift in market perceptions of Southern Europe which has taken place since the height of the crisis has surprised many. For some the level of investor appetite for shares and bonds in what was previously deemed an economic disaster zone is a sure sign another bubble is on the way, this time in government bonds. For others it is proof that the debt crisis is now well behind us, and indeed that the most seriously affected economies have now “turned the corner”.

For the time being the “Mario Draghi ultimately has my back” feeling continues to prevail, but with markets increasingly financing debt levels that many recognize as ultimately unsustainable nervousness will rise that the size of the pill – and German resistance to the process - may become just too big for the ECB to comfortably swallow, leaving the specter of private sector involvement (PSI) in debt restructuring to once more rear its ugly head.

Meanwhile, long term issues about the sustainability of Europe’s economies are emerging, largely for demographic reasons. Unable to adjust via a classic devaluation, and unwilling to bite the bullet of a sizeable adjustment in relative prices via an internal devaluation, economies in southern Europe are correcting via the long-wished-for route of transnational labour mobility. But as explained here, the associated migration process is not without problems in an era when working age populations are tilting downwards and elderly population ratios steadily on the rise.

One possible solution to many of these problems would be a complete federation of all Euro Area member states: the long talked about full political union. This wouldn’t be an instant cure all for the region’s problems but it would make the correction of country level imbalances much more manageable. Unfortunately there is little appetite for such a move on the part of those countries which would be large net contributors, and hence this outcome seems unlikely over the relevant time horizon. Instead we are witnessing a continuing battle between periphery and core Europe politicians over getting the ECB to continue with full blown QE to sustain debts, creating in the process a transfer union which has no visible transfers.

There is no doubt that both the participating countries and the Euro Area itself have made significant institutional advances during the crisis. But has enough been done, or have one can after another simply been kicked down the road? Certainly the unresolved issues are not hard to identify: low GDP growth, high unemployment, rising sovereign debt levels, creeping deflation, how to handle the problem of ageing and declining workforces. There plenty of potential sources for more crises, the issue is whether there is the will to address them before something happens, or whether the driver will, yet one more time, fall asleep at the wheel.


These arguments are developed at greater length in my new book "Is The Euro Crisis Really 0ver? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.

Thursday, September 11, 2014

The Catalan Vote: Why It's Time To Start Getting Worried About Complacency In Madrid

When Barack Obama told a CNBC interviewer last autumn that Wall Street ought to be "genuinely worried about what is going on in Washington" in reference to the US government shutdown he raised more than a few eyebrows. Normally political leaders try to calm and reassure markets, so this attempt to stir them up on the part of the US President was, in its way, something of a first.

Last May the Financial Times issued a similar warning in an editorial with a clear message: right now you should be more worried than you are about what is happening in Madrid. According to the newspaper, “secessionist demands have created a rolling crisis involving Catalonia and the national government in Madrid,” a crisis which it warns could end in a “head on collision” if the issues being raised are not addressed.

The issues have not been addressed, and  there is now  a  provisional date for that woeful collision to occur: the 9 November this year, the date chosen by the Catalan parliament for the holding a popular (non binding, not a referendum) consultation under a new law which will receive parliamentary approval on 19 September. The original intention of the Catalan parliament was to hold a referendum on the region’s future authorized by Madrid. With that intent parliamentary representatives took a proposal last spring to the Spanish parliament. The reply was a polite but near unanimous “no” since Spain’s parliamentarians took the view any such vote could be considered “unconstitutional”.

As Mariano Rajoy pointed out, given the way the Spanish Constitution is currently worded neither he, nor even the Spanish parliament, have the power to authorize such a vote. The Spanish prime minister’s view was also endorsed recently by the country’s constitutional court, who ruled that the proposed referendum would be unconstitutional under the terms of the constitution as it stands. The court however added an important rider to the judgment, a rider to do with the political problem of legitimacy. If in a discrete part of the national territory, the court suggested, a significant majority of the population are not satisfied with the current arrangements, and these arrangements are not changed,  then a constitutional crisis ensues.

Thus the issue moves from being a purely juridical one to a political one, and any eventual solution - even if this means accepting Catalan independence - needs in essence to be political. Effectively the court threw the ball back into the politicians’ court: if the constitution doesn’t permit a vote it can be changed, if there is the political will to do so. Amending the constitution didn’t seem to be such an insurmountable obstacle at the height of the sovereign debt crisis, when agreement was reach between the various parties in a matter of days to place constitutional limits on the level of government debt, a fact which does not escape the attention of those Catalans who feel themselves in urgent need of the right to a vote.

This is also what the FT had in mind when the editorial argued “it is disingenuous” for Mariano Rajoy “to hide behind the Spanish constitution”. Sooner or later democracy will out. This is why the newspaper argues the Spanish government needs to urgently formulate some sort of counter proposal, along the lines of the so called “third way”: an approach going beyond the current arrangements but falling short of full independence. The core of such a proposal, the paper argues, would be an improved fiscal arrangement, and more autonomy.

In the opinion of the present author these proposals look fine on paper, but arriving at any sort of agreement on them seems highly unlikely. In the first place, Spain’s ongoing economic issues make the financing of any new fiscal agreement extremely problematic. The economy may be showing signs of recovery, but it is a weak and fragile one, and the aftermath of the country’s property bust will cast a shadow of at least a decade over the country’s economic future. In addition there is no easy “win-win” solution available, since letting the Catalans keep more of their own money will undoubtedly mean someone else will receive less. Who will that someone else be? A glance at the political arithmetic shows that the major Spanish party closest to considering the third way is the socialist PSOE. But PSOE relies on votes from the country’s most populous region – Andalusia – and this would surely be one of the areas most negatively affected any substantial fiscal change.

More autonomy sounds nice, but what exactly would it look like? Would it allow the region, for example, to opt out of laws which are highly unpopular in Catalonia like the recent abortion one or the proposal to make bullfighting form part of the national heritage? And what about the identitarian issues which are really what lie at the heart of the current tension? From the Spanish point of view, the most contentious of the Catalan demands is their claim to have their identity as a nation included in any rewritten constitution. Any addressing of this long standing grievance would seem to open the door to solving another, that of having national sports teams to compete in international competitions. Are Spaniards – not simply Madrid politicians – ready for this?

Then there is the language. Far from the impression being given that Spaniards are getting more and more comfortable with linguistic coexistence the situation seems to be quite the opposite, with moves to restrict the use of the language in schools having taken place in the regions of Valencia, the Balearic Islands, and Aragon, in each of which there are significant Catalan speaking communities. Even in Catalonia proper the central government is currently trying to implement an education reform which restricts the autonomy of the Catalan education minister to decide matters of language policy. It is hard to see in any of this a reflection of a will to improve relations.

It seems to me that such feelings of national identity affect both Spaniards and Catalans. They are strong and deep seated, on both sides, and far more important than the economic ones. The difficulty is they cannot be changed either in committee or overnight. I repeat, is there any real sign of a desire among the Spanish population to make the sort of attitude changes which a successful implementation of a third way would imply? President Mas visited Prime Minister Rajoy in the Moncloa in July to discuss the situation. He presented a list of 23 issues about which they could talk. To date the Spanish Prime Minister has not replied. He seems content simply to chant the mantra "there will be no vote". But as the Constitutional Court pointed out you cannot generate political legitimacy by only explaining what won't happen.

Naturally this "no" to the possibility of voting has come to the forefront in recent days with the publication of an opinion poll showing that the "yes" vote might win in Scotland.

As for the Catalans, we have yet to discover what it is they really want. This is what the demand for a vote is all about, so that the wishes of Catalans can be registered in a fashion which goes beyond the innumerable opinion polls. Determining what people actually want is a basic prerequisite so that the democratic process can then go to work. In the meantime they will simply look on in envy on the 18 September as Scots exercise their basic right.

What then happens next? The Catalan parliament will on 19 September pass into law a formula which will allow opinion seeking, non-binding consultations to be held under Catalan rather than Spanish law.  It is not clear at this point whether the Madrid government will challenge this law. Possibly they won't, since it is probably not unconstitutional. Then the Catalan parliament will pass as second decree law convening a consultation with an already announced question for the 9 November.  Madrid have already made clear that they will not permit this question to be asked and will take the matter to the Constitutional Court.

Which brings us to 9 November itself: if it is not possible to have a vote then Catalonia’s President Mas has suggested he might call plebiscitary elections. The purpose of these elections would not be – as some suggest – to authorize the parliament to declare UDI, but to establish the size of the majority in favor of a vote. The newly constituted parliament will then have the responsibility for deciding what to do next.It would be a mistake to think that these elections - if held - would be the end of the matter. They will take the collision onto a new level and generate a very high degree of uncertainty about where things are going from that point on.

So although the world will not change on November 10, and even if there are elections instead of a vote on independence the outcome could well produce a definitive sea change about how Catalans view their relations with Spain. They may well mark a “point of no return”. So to go back to where we started. Right now global markets and most of the international press are being pretty sanguine about the situation, when – as President Obama suggested in the case of the US government crisis – perhaps they shouldn’t be. Perhaps they should be worried about the complacency in Madrid, and remember that one of the principal ways of letting something unexpected happen is to assume it won’t.

Thursday, September 4, 2014

Secular Stagnation Part III - The Expectations Fairy

"So what's going on here? Well, it might sound like a hokey religion, but central banking is really a Jedi mind trick. Just saying something can be enough to make it happen. That's because the power of the printing press gives their words a distinct power. Well, that and the fact that the economy is already one big self-fulfilling prophecy." - Matt O'brien,  "Abenomics has only worked because foreigners think it will"

"Lucas thought he could do better. His major innovation in his seminal 1972 article was to get rid of the assumption (implicit and often explicit in virtually every previous macro model) that government policymakers could persistently fool people." - The Concise Encyclopedia of Economics, "Robert Lucas".

Of course, if we knew - really knew - that one got much more reliable results by doing the things that ad-hoc macro does not, it would be a tool to be used only for the most preliminary examination of issues. But do we know that? - Paul Krugman, How Complicated Does the Model Have to Be?

"It is unfair for Keynesians to be making fun of the people who call for austerity by saying “confidence fairy” when they are making similar expectational-shift arguments themselves." -  Brad DeLong, Confusion: High Public Debt Levels and Other Sources of Risk in Today's Macroeconomic Environment

"You can fool some of the people all of the time, and all of the people some of the time, but you can not fool all of the people all of the .... Abraham Lincoln

Exiting a Liquidity Trap
The classic solution to the problem posed by a demand slump when monetary policy becomes ineffective due to the operation of a liquidity trap is a credible commitment to future inflation (see for example Paul Krugman's 1998 Japan's Trap). This commitment reduces the real interest rate despite the presence of a zero bound and thus stimulates spending, and it does so through the impact of the commitment on expectations about future inflation. In a later blog post Krugman himself puts it like this:
"Here’s the thing, however: the economy won’t always be in a liquidity trap, or at least it might not always be there. And while investors shouldn’t care about what the central bank does now, they should care about what it will do in the future. If investors believe that the central bank will keep the pedal to the metal even as the economy begins to recover, this will imply higher inflation than if it hikes rates at the first hint of good news – and higher expected inflation means a lower real interest rate, and therefore a stronger economy. So the central bank can still get traction if it can change expectations about future policy."
The tricky part is, as he goes on to note, this commitment won't convince if investors fear that at the first sign of good news the normally staid and serious central bankers revert to type and snatch away the punch bowl. An old Greek fable catches the feel of the situation remarkably well:
"A lion is trapped in a deep hole. A fox passes by and the lion asks it to pass down a tree branch. The lion makes many promises about the reward it will give the fox if it escapes from the trap. The fox understands that the lion is hungry and that once escapes the trap it will simply eat it. Once the lion is free from the trap it has no incentive to fulfill its promise but has every reason to make the fox its meal."
So the central bank has to commit to future inflation in a way which credibly convinces investors that they are not going to be turkey's participating in a Christmas promotion campaign. In an attempt to get over this his (at the time) PhD student Gauti Eggertsson came up with a set of proposals - in a paper entitled Committing to Being Irresponsible - where the core idea was that removing central bank independence would make the commitment more credible, presumably because politicians are known to have a lower anti-inflation bias than central bankers. Eggertsson puts it like this:
"In this paper the zero bound is binding because of large shocks that make the Central bank unable to lower the nominal interest rate enough to prevent deflation and a deleterious decline in output. We show that in the presence of these shocks there is instead a deflation bias of a discretionary independent Central Bank."

"In a liquidity trap the Central Bank would best achieve its goals if it could commit to moderate future inflation in order to maintain price stability and keep employment close to potential. If it is a discretionary maximizer it cannot, however, do this because its announcements are not credible. The result is a liquidity trap characterized by excessive deflation and undesirably low output."
Krugman uses exactly the same expression at the end of the post I cite above: "The hope now is that things have changed enough at the Bank of Japan that this time it can, as I put it all those years ago, 'credibly promise to be irresponsible'". So the question is, why isn't this short term irresponsibility - I presume the idea is that they don't go being irresponsible on forever (although see below) - some variant of what Matt O'brien calls the Jedi mind trick?

At the heart of the problem lies the issue of expectations, and what you can get people to credibly believe. Baron von Münchhausen was reputedly able to pull himself up by his own bootstraps , why don't you go try it?

The reasonable conclusion to draw is that expectations really are constantly at work in day to day economic processes, even if we don't fully understand the mechanisms through which they work, and it is a perfectly plausible approach - and not simply a Jedi mind trick - to adopt a policy aimed at changing people's expectations. Especially if the problem you are trying to deal with is deflation rather than inflation. As Mario Draghi says in his standard definition of deflation: “Deflation is a protracted fall in prices across different commodities, sectors and countries. In other words, it is a generalised protracted fall in prices, with self-fulfilling expectations." So obviously to break out of deflation you have to change expectations.

But the question arises: in the case of the deflation we are seeing in Europe and Japan is that possible?

Maybe it would be a good economic outcome for us all to practice levitation. But - despite what some may think - we won't be able to do so simply because some government agency or other works hard to try to convince us that we all can.  We need to think to some extent about the mechanics of flight.

Something similar is evidently the case with deflation. We need to think about the causes and whether or not the proposed solutions work before we can decide whether or not the attempt to generate (at the central bank or elsewhere) the appropriate expectation is achievable. If we think the current deflation is just an expectations issue – and not a phenomenon with deep roots in the real economy – we may well end up leading ourselves totally astray.


These arguments form part of a chapter in my new book "Is The Euro Crisis Really 0ver? - will doing whatever it takes be enough" - on sale in various formats - including Kindle - at Amazon.