Well, it seems I’m not the only one who thinks that the IMF have made a bad decision over Latvia, since this year’s economics Nobel Prize winner Paul Krugman seems to agree. From his New York Times blog:
Iâ€™ve been saying this for a couple of weeks, but Edward Hugh has the goods.
Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We canâ€™t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative â€” sharp wage cuts, and basically a major domestic deflation â€” will also make it hard to service those debts. In fact, Iâ€™d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)
This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy.
Actually I don’t know if HMV himself will get round to reading this, but I would like to take the opportunity provided by this post to say three things.
1/ A very Happy Christmas to all our readers – and especially those of you in Central and Eastern Europe who are having such a hard time of it at the moment.
2/ Devaluation is not a cure all, as we can see from the very serious situation which is developing in Ukraine even as I write. But it is a necessary first step in order to try to find a way through the mess which has been created. The big question is going to be who will soak up all the loan defaults that are now inevitable whichever road you go down, and looking at this from an EU point of view I have no doubt that the Union itself has to shoulder the primary reposibility, since it was the decision to impose eventual eurozone membership on the EU12 as a condition of EU membership (and not simply an option as in the case of the UK or Sweden) which made all that Eastern forex lending seem just as “safe as houses” to the funding banks over in Western Europe.
3/ There is no easy “ban-aid” solution to the problems now faced in the East of Europe, since unfortunately the extreme fragility we are seeing in their collective balance sheets is almost certainly associated – in some way, shape or form – with their almost unique demographic dynamics, and this is hardly going to be changed overnight. So, and this is the wonkish bit, in the first place, I would like to take this opportunity to thank Paul Krugman for writing – in 1998 – a paper on the Japan problem (see this whole post here) entitled It’s Baaack! Japan’s Slump And The Return Of The Liquidity Trap, since it was reading the extracts from this paper reproduced below which actually started me thinking about the debt deflation problem and about just how demography might influence the impact of deflation, especially given the problems Japan was experiencing, and indeed how, if this was the case, we might expect the kind of problems Japan was having to reappear in other countries with long term very low fertility.
But just what is the special problem which deflation presents? This is important, since the IMF, the EU, and the Latvian government have all just agreed, not only not to avoid price deflation in Latvia, but rather to actively provoke it. Ben Bernanke makes this point in a paper written around the same time as the Krugman one I mention.
To take an admittedly extreme case, suppose that …. (a borrower took out loan in 1992 which)…. was still outstanding in 1999 , and that at loan initiation he or she had expected a 2.5% annual rate of increase in the GDP deflator and a 5% annual rate of increase in land prices. Then by 1999 the real value of his principal obligation would be 22% higher, and the real value of his collateral some 42% lower, then he anticipated when he took out the loan. These adverse balance-sheet effects would certainly impede the borrowerâ€™s access to new credit and hence his ability to consume or make new investments. The lender, faced with a non-performing loan and the associated loss in financial capital, might also find her ability to make new loans to be adversely affected. This example illustrates why one might want to consider indicators other than the current real interest rateâ€”-for example, the cumulative gap between the actual and the expected price levelâ€”-in assessing the effects of monetary policy. It also illustrates why zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer term, than the economies of the nineteenth century. Further, unlike the earlier period, rising prices are the norm and are reflected in nominal-interest-rate setting to a much greater degree. Although deflation was often associated with weak business conditions in the nineteenth century, the evidence favors the view that deflation or even zero inflation is far more dangerous today than it was a hundred years ago.
Ben Bernanke – Japanese Monetary Policy: A Case of Self-Induced Paralysis?
So, deflation can be a real pain to handle, but what about deflation in the context of population decline (the Latvian case), well fot this I’ll hand you over to Krugman, and his arguments in the above mentioned paper – definitely only for wonks this one.
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.
In fact, even though economic demography does seem to be such an “non-mainstream” line of investigation, there are now at least four “major” economics Nobels who have been interested in the problems posed by demography at some stage or another in their work. Apart from Krugman, there was Franco Modigliani (Nobel 1985) who was primarily concerned with how our saving and borrowing behaviour changes over the life cycle, and whose last published paper was concerned with just why there is so much saving in China, Gunnar Myrdal (Nobel 1974) whose pioneering work in the 1930s laid the basis for our modern understanding of the impact of declining populations on economic performance (see his Godkin Lecture on the topic) and which resulted (via the work of his wife Alva) in the estabishment of the modern Swedish family support system as some sort of “preventive measure”, and finally there is the grand old master of population economics Simon Kuznets (Nobel 1971).
Well, I did warn you that this was going to be ultra wonkish. Now you have all the clues and bits and pieces, all you have to do is go assemble the jigsaw. Maybe on boxing day. Anyway, as I say, have a nice xmas everyone. Good luck, and good hunting.