Am I Freaked Out?

No I'm not. But I'm not happy. Here's a partial list of why:

1. We haven't had sustained deflation yet, but the fact that Core CPI -- excluding food and energy -- dropped by 1% in October rings alarm bells. But that's not the only data point [pdf]: the PPI (Producer Price Index) for finished goods dropped by 2.8% in October following smaller declines in August and September. Yes, that is seasonally adjusted. That is not the core figure (which is still positive) but firms in the energy and commodity sectors still employ people. To some extent CPI usually lags PPI, so it doesn't seem unreasonable to expect future drops in CPI as well.

2. Dr. Oatley advocates thanking the Lord for creating Keynes. I'll do that right after I'm done asking for my unicorn, but I'm a bit more pessimistic regarding the potential gains. As I see it, a drop in aggregate demand isn't the cause of this crisis: the credit crunch is. I can tell a story in which we issue a massive fiscal stimulus package, but citizens don't respond by boosting consumption. Instead they hoard it, anticipating deflation, or mounting unemployment, or foreclosure, or whatever else. Since this is going to be deficit-spending at a time when the government is already massively imbalanced, people should also expect future tax increases, which would also incentivize them to save it. And since credit is still locked up, there's no mechanism for steering those savings towards the businesses who need it. If they don't get cash, those businesses don't expand, unemployment mounts, deflation deepens, and we're spiraling.

There's actually some evidence for my story: Shapiro and Slemrod found that only 20% of people said they would spend their stimulus checks (in 2001 and 2008); the other 80% said they'd use them to pay down debt or boost savings. It's true that people don't always act as they say they will, but in this case Johnson, Parker, and Souleles found that they did (in 2001): each dollar of stimulus spending by the government resulted in roughly 33 cents of increased spending by consumers. Souleles also noted that that number might decrease in the present because the overall balance sheets of American consumers is worse off now than in the past because of declining home values.

I'm not saying it's not worth trying. All I'm saying is that if we can't unfreeze credit markets, it's probably all for naught.

(Not Snarky) Response to Comments

Anonymous left some good comments on my deflation post. Let me reply to two points s/he makes.

"you make the same mistake many economists and all journalists make: deflation is not a decrease in prices. It is a decrease in the money supply (money+credit). The decrease in prices is the result, not the cause, of deflation."

Well, yes, except for when it isn't. To invoke quantity theory, PQ=MV. Thus, deflation can occur because M falls more rapidly than Q, or because Q rises more rapidly than M. Hence, deflation is what happens to P as consequence of the relationship between M and Q. In the current instance, concern about deflation is clearly a concern about M falling as a consequence of the credit crunch. In the late 19th century, deflation was a consequence of Q growing more rapidly than M.

In selecting a definition, we want one that incorporates all possibilities. Hence, deflation is a sustained decrease in the general price level caused by a reduction in M relative to Q.

The critic continues: And don't forget who put us in this mess: the Fed and the easy credit.

I know this is the popular take, but I fail to see how this makes sense in an open economy framework. Here's why I am puzzled.

Suppose Greenspan raises interest rates in 2001-02. What happens? It doesn't push us into recession. It merely sucks in foreign capital. Capital inflows appreciate the dollar; the dollar appreciation creates incentive to invest in the non-traded sector (housing). The result: a bubble fueled by foreign capital. Think here of the S&L crisis of the 1980s.

Suppose Greenspan keeps interest rates low, what happens? Less foreign capital gushes in; the dollar appreciates less; yet the inflows fuel a housing bubble.

Seems the choice the Fed faced, therefore, was between a bigger and a big bubble. You blame it for choosing the big one; I think that given its options, it made the right choice.

What we should focus on are those factors that created this choice: fiscal policy. Government dissavings driven by tax cuts and military expenditures and the associated current account deficit created the need to import foreign capital. These inflows strengthened the dollar and financed the bubble. So policy responsibility in my mind lies with Congress (to which the constitution assigns authority over revenue) and the current administration rather than with the Fed.

This is why I am truly puzzled about why everyone blames the Fed and more narrowly Alan Greenspan. Please explain why my read is mistaken.

US Dominance - Fading away?

The US National Intelligence Council just released its latest Global Trends report, and the analysis is far grimmer for the United States then its 2004 report.

According to the Intelligence Report, the world is moving towards multipolarity, with China, India, and Russia in line to challenge US dominance by 2025.  The dollar will continue to decline in prominence as power shifts eastward.

Interestingly, the report finds the worlds biggest security threats will stem from economic concerns - trade and investment disputes, competition for natural resources especially water and energy resources, and strategic technology development.

Now, there is considerable criticism about the track record of NIC report accuracy, especially regarding previous assessments of Japan and Russia.  However, the assessment is interesting in its pessimism.  Multipolarity upsetting the stabilizing effect of US hegemony, nuclear weapons deployed by rogue groups, the inadequacy of the US military in combating irregular warfare methods - seems like the current financial crisis is the least of our worries.

So, all you policy wonks, get to work crafting exit strategies - or at least start trying to find a way to get an EU passport . . . . .

Word of the Week: Deflation

Before Will gets us all freaked out about deflation, we should consider what is it, whether we are in it, and whether we should we care?

What is it: a sustained decrease in the general price level.
Are We in it:
Exhibit 1: The CPI fell by 1 percent in October relative to September. This is the largest decline since February 1947. Wow, that sounds scary.
Exhibit 2: Energy prices fell by 8%; transportation prices (cars) fell by 5.4%; clothes prices fell by 1%. Other prices rose slightly. This is neither general nor sustained.

On balance, no, we are not in deflation. We are seeing relative price changes; energy prices are down (that's good news) and the auto industry just had about its worst month ever.
Yet, we are at the risk of falling into deflation.

Should We Care? Yes
1. Debtors suffer as the real value of their debt rises. Hence, more difficulties to service loans (think about housing price collapses and mortgage foreclosures). Rising debt service problems can harm financial institutions (that's an ironic understatement).
2. Creditors benefit as the real value of their assets rises. Of course, this assumes that debtors continue to pay.
3. Consumers benefit, because things get cheaper every day.
4. Not so good at the aggregate level. If we expect everything to be cheaper next month, we won't buy it this month. If we all defer our purchases in expectation of lower prices in the future, we aggregate demand falls and we produce less--which means we employ fewer people. With less income from lower production, prices fall further, so we push our big purchases off to the future again. And so on and so on. Deflationary spiral, I believe it is called. This is pretty much what happened in 1929-1933.

So yes, we should care. Will's point, I think, is that monetary policy is increasingly of little utility because nominal interest rates are close to zero. I might point out to Will that the good Lord had the sense to create Sir JM Keynes in order to alert us to the utility of fiscal policy in precisely this circumstance.

Department of Ut-Oh (a continuing series)

Back in April, Peter Thiel said "there is no good scenario for the world in which China fails". He got a bit hysterical thinking about the possibility, concluding that a massive world war that effectively destroys human civilization is not outside the realm of possibility. I hope that scenario is too extreme, but the initial point stands: what is bad for China is bad for the rest of the world.

Presently we find that many things are bad for China:

Exports constitute nearly 40 percent of China's GDP--far too high a figure. (By comparison, in the U.S., exports account for about 10 percent of GDP most years.) And the global financial slowdown is already taking a terrible toll. Some 10,000 factories in southern China's Pearl River Delta area had closed by the summer of 2008. Gordon Chang, a leading China analyst, estimates that 20,000 more will shutter by the end of this year. In the third quarter of 2008, Beijing also reported its fifth consecutive quarterly drop in growth, and several private research firms expect a sharper slowdown next year. Additionally, unemployment is skyrocketing; in Wenzhou, one of the main exporting cities, about 20 percent of workers have lost their jobs, Reuters recently reported.

Don't forget the $586bn stimulus that China announced last week, which represents ~ 16% of 2007 GDP at the official exchange rate (less in PPP), and the fact that Chinese inflation and real growth rates are falling off. It now appears that if there is a global Great Depression, it may begin in China.

When You Wish Upon a Star...

Apropos of my last post, Greg Mankiw doesn't want a pony for Christmas; he wants a unicorn:

Here is one idea. Suppose the Fed cuts the federal funds rate once again to, say, 25 basis points. More important, at the same time, the Fed announces a target path for the price level as measured by the core CPI. The price path might be, say, an increase of 2 or 3 percent per year. The Fed promises not to raise the fed funds rate over the next 12 months and, after that, will keep the funds rate at that low level as long as the price level is significantly below its target path.

The credibility of the promise is paramount. To get long-term real interest rates down, the Fed needs to convince markets that it will vigorously combat deflation, and that if deflation happens in the short run, the Fed will reverse it by subsequently producing extra inflation.

In at least one way, Mankiw is wrong: the credibility of the promise to fight deflation isn't paramount. What is paramount is an assured belief that the Fed actually has the ability to effectively fight deflation. At this point, that proposition look tenuous at best, laughable at worst. And so Mankiw concludes:

That's where the prayer part comes in.

All together now: There's no place like home. There's no place like home.

Which Do You Want First?

The good news or the bad news?

Good: "Fed vows to fight against deflation"

Bad: There isn't really anything much the Fed can do. The effective Funds rate has been near-zero for a good while now. Oh, and core CPI slipped for the first time since 1982, so we're already experiencing deflation despite the Fed's best efforts. We can only hope it doesn't spiral.

Of course, the Fed can still work to recapitalize banks while the Congress/Treasury engage in massive fiscal stimulus in an attempt to resuscitate the real economy. But that task will be very difficult; the one sector of the economy which had kept us out of a recession was the export sector. Now that sector is slipping fast as well. As Brad Setser says: "Ut-oh".

The problem is that recapitalization of the banks doesn't address the demand-side concerns (unless it frees up cash for cheap debt used for consumption spending). And fiscal stimulus doesn't address the supply-side concerns. Meanwhile, the currency won't depreciate (which would boost exports) because the global demand for dollars has gone back up, while global demand for our exports has gone down. We're getting hit from all sides right now, and it is unclear which policy mix is capable of stemming the tide.

The Crisis from an Historian's Perspective

Niall Ferguson traces the history of the financial crisis here. It is self-recommending, as they say.

The Return of Capital Controls

In a classic essay following the Asian Financial Crisis, Paul Krugman laid out what he called the "Unholy Trinity" (which derives from the famous Mundell-Fleming model)*: it is not possible for a country to have a fixed exchange rate (and thus a stable currency), free capital movement, and an independent monetary policy. Countries may pick two of the three, but must sacrifice one. In recent months, we've seen the collapse of the independence of central banks all over the world. Some countries, especially export-biased countries, have also engaged in exchange-rate manipulation, but generally capital movement has remained free. But in the wake of the current crisis, many countries may decide that it is in their long run interest to accept some capital controls in order to re-establish the strength of their currencies and the independence of their central banks to fight recessions.

Krugman fell short of calling for capital controls in his most recent column, but others have been more vocal. Guillermo Calvo has called for the institution of capital controls in a VoxEU piece [pdf], and Bob Geldorf (!) has called for the institution of the Tobin Tax, a transaction tax on international capital movements. Whether or not we should be listening to Bob Geldorf (!) is certainly up for debate, but other academics (including Krugman and Dani Rodrik, among others) had been openly sympathetic to capital controls before this crisis occurred. Of course, there is still large resistance to capital controls in many of the neoliberal regimes, but if there is going to be institutional changes to the international financial system, some sort of capital controls would likely be the least painful option. No mention of this in the recent G20 statement, of course. But everyone knows that there isn't a free lunch; if you want less volatility, you'll have to accept less flexibility.

*Mundell-Fleming only applies to small, open economies, so it's application to larger OECD countries isn't perfect. But there is still some applicable intuition.

(ht: Dani Rodrik, for Calvo and Geldorf)

Viking Solidarity...

The IMF has approved a $2.1 billion credit for Iceland. This marks the first time since 1976 that a western European country has drawn from the Fund (last to do so was...the UK). The agreement unlocks Iceland's access to an additional $2.5 billion from Norway, Sweden, Denmark, and Finland . Additional money could come from Russia and Poland. None of the Scandinavians would support Iceland until the IMF signed off on the deal.

Iceland reached agreement in principle with the IMF in late October; Great Britain (and perhaps the Dutch as well) apparently refused to support the agreement at the IMF Executive Board until the Icelandic government agreed to guarantee the deposits that British residents had made in Icesave, an Icelandic internet bank that disappeared when the government nationalized its parent, Landsbanki.

The government finally agreed to guarantee these deposits on Sunday. "It was made clear to us that the IMF package and the $3.9 billion of loans from other countries would not be forthcoming unless we cleared the Icesave dispute," said Urdur Gunnarsdottir, a spokeswoman for Iceland's foreign ministry.

This would seem to be yet another instance in which governments use the IMF to protect the interests of private creditors at home (rather than the financial position of the borrowing country). This may be the first time, though, that the private creditors are individual depositors rather than large financial institutions.