What’s It All About Alfie?

Well I suppose it’s better to end the week on a bang rather than a whimper, so here I go with another of those posts. What really ended the week on a high note (or should I say a low one) was the US labour market. And since I am arguing that the euro-dollar parity is being driven at the moment by US labour market data, this news can only mean one thing: more upward pressure on the euro. Which makes me only want to re-iterate, and even more strongly, that an important opportunity was wasted yesterday to take some remedial action by lowering the interest rate. Remedial action which would also have supplied a much needed lifeline to Germany’s beleagured economy. But this, like so many things, was not to be.

So what happens next? Well as I have been saying, how this ends is difficult to see. We are still trying to get to grips with the causes.

Of course two groups of people have it fairly easy. Firstly those who argue that this is all down to George Bush, and then, on the other hand, those who would want to say that the Indians are the culprits.

As always, both these arguments do contain a grain of truth. It’s clear that GWB has not excelled in terms of his economic stewardship, and it’s clear jobs are going to India. However I think pretty quickly both these simple solutions run out of steam given the depth of what is taking place. Some argue that Bushes stimulus could have been better directed: possibly, but there was still plenty of kick going into the US economy in the second half of 2003. And those famous tax cuts are still out there in the future, so while they may well be colouring the debate about the future of social security, they are hardly the key operative factor right now. Likewise high-end service jobs. In the future this is going to be important, but it is hard to see that this is having a major impact on the global economy in the here and now. So my argument is that something much bigger is happening, something which makes normal debates about economic management seem somehow totally inadequate.

My starting point is that, in terms of the global economy, we are seeing a profound transformation on three fronts: demography, technology, and development.

The OECD economies are ageing (and I’ll leave this one here for today), we are living through a profound technological revolution, and thirdly the relative state of development of some of the worlds key economies is changing, and fast. On occasion I have called this globalisation phase 2.

What I really want to focus on in this post is one of the fundamental characteristics of this transformation: its deflationary implications. A year or so ago, it was much more fashionable to talk about deflation than it is now. Recently things have gone pretty quiet. Nonetheless the IMF (under Ken Rogoff as chief economist) did see fit to publish a background paper (warning PDF, and fairly technical, the Economist had a couple of easier articles here, and here). So let’s go and take a reality check, why not: on deflation. Or rather disinflation, since this is the name the current global condition is popularly known by. In order to do that we could go on a quick inter-continental whistlestop tour.

And what better place to start than Chile:

Chile’s annual inflation rate fell to zero for the first time since 1939 as companies such as General Electric Co. lowered prices following a 22 percent rally in the currency last year that made imports cheaper.

Consumer prices were unchanged in February from January — after falling the four previous months — and unchanged from February 2003, the National Statistics Institute said.

“We’re passing on our lower costs,” said Pablo Palavecino, manager of General Electric de Chile SA’s appliance line in Santiago. “Prices are a lot less.” An imported refrigerator sells for 999,000 pesos ($1,655), down 17 percent from last year, he said.

Investors such as Andres Ergas at BanChile Administradora General de Fondos SA said the central bank will keep its benchmark lending rate at a record low of 1.75 percent at a policy meeting next week in a bid to prevent slowing inflation from turning into deflation. Central bankers have said they’re concerned about deflation, which could slow the South American country’s expansion by prompting consumers to delay spending on expectations that prices will keep declining.

Ergas said the lack of a pickup in inflation toward the central bank’s target of an annual rate of between 2 percent and 4 percent would likely prompt policy makers to cut interest rates again.
Source: Bloomberg

This is striking, isn’t it. A Latin American country with zero inflation and a 1.75% funds rate which is under review for reduction. Of course a big part of this picture is currency-appreciation-driven, and the currency appreciation in turn is driven by China’s demand for copper. So Chile’s miraculous disinflation is fairly lop sided, but still. It remains a striking situation. Where it an isolated case, then perhaps we could shrug our shoulders and say, well, that’s life. So to make some comparison, now lets go a bit nearer home, to my country of birth, the United Kingdom:

Will CPI inflation ever rise back to 2% or above?

Since December, the Bank of England?s official remit is to target a 2% inflation rate as measured by the harmonised consumer price index (CPI). Conveniently, the Bank forecasts inflation to rise to around the 2% target by its two-year forecast horizon (assuming unchanged interest rates), from 1.4% currently.

Perhaps the strongest reason to expect CPI inflation to rise to 2% is that the Bank of England is now charged with making sure that this happens. After all, the Bank is a highly credible institution that almost exactly attained its former 2.5% objective for RPIX inflation (on average) over the 1997 to 2003 period. And, if everyone believes that the Bank will hit its new target too, cost and price setters should behave accordingly and the target should in fact be met, barring large unforeseen shocks.

However, things may not be that easy. After all, the last time CPI inflation stood at or above 2% was in May 1998; and it has averaged a mere 1.2% over the last five years. Thus, if past inflation performance is any guide to future inflation performance, and even factoring in that the Bank is now charged with aiming for 2% CPI inflation, there would seem to be a considerable risk that the 2% target will NOT be reached.
Source: Morgan Stanley Global Economic Forum

Again striking isn’t it. The UK CPI hasn’t been up to 2% since May 1998, and in fact the annual average is only 1.2%. And the current rate seems to be riding on the back of what I at least am prepared to recognise as a housing driven asset bubble. So if this is the case, the big question is what happens to the CPI the day the bubble bursts, it hasn’t exactly got very far to fall. I am sure this fact is exercising Mervyn King’s mind a lot these days.

OK, so now why don’t we go to China?

Who Benefits from Productivity?

One can witness Chinese productivity first hand at the local Wal-Mart store. Yes, the Chinese economy is becoming more productive. I estimate that China?s total factor productivity (TFP) – how much more output with the same inputs – is 3-4% per annum ……… My guesstimate is that Chinese wages are rising at half the rate of labor productivity, which includes the impact of more capital per worker, and is about twice as much as TFP. Why can?t Chinese wages rise at the same pace as labor productivity, which would capture all the TFP to benefit Chinese workers?

The problem is that the competition for jobs in China is fiercer than the competition for goods in the world market. For the Chinese to gain jobs faster than average rates in the world economy, they need to sell their labor cheaply, i.e., passing on the TFP to western consumers in the form of lower prices so that they would buy more Chinese goods, i.e., more Chinese labor. The relative balance would change only when most Chinese are employed. When China reaches the tipping point, either its currency would appreciate, as in Korea and Taiwan in the 1980s, or its inflation would be higher than the global average, as in Hong Kong in 1980s and 1990s…………..

Some believe that appreciating the Chinese currency would effectively deliver a raise to the country?s workers. Would this work? Would western consumers pay more for Chinese goods if China?s currency were to go up? I doubt it. China?s export price is determined by the relative balance between the number of Chinese workers and western consumers. How could manipulating the exchange rate change this reality? If western consumers refused to pay more in the event of a yuan appreciation, wouldn?t the result be to push down wages in China in order for its labor market to reach some sort of equilibrium?

Throughout the industrialization of the West, productivity also mostly benefited consumers; deflation prevailed due to productivity gains. What is occurring in China is not unusual. It is the vast pool of surplus labor that keeps down labor?s pricing power, and also makes consumers who are workers price-sensitive. Thus, productivity gains are competed away by businesses in endless price wars………….

The global economy is experiencing much higher productivity growth rates because information now spreads to developing countries much easier than before, which provides more people in the developing world with the skills to join the global economy. Thus, the global economy behaves like an emerging economy that gains productivity from moving labor from low-productivity rural sectors to high-productivity urban sectors…………

Combating inflation is a central goal of modern central banking. But inflation is becoming less of a threat. The US economy has experienced disinflation for two decades. The same trend pushed Japan into deflation.
Source: Andy Xie, Morgan Stanley Global Economic Forum

Now here I have edited Andy Xie down to what I consider to be the bear essentials of the case. These essentials are:

That we have a global environment which is strongly disinflationary, and heading for deflationary. (He doesn’t make this point but I will: interest rates are at near-historic minimum all over the place, and we are now – as Stephen Roach keeps reminding us – in the upswing phase, more price downsize is only to be expected later).

Technological change is driving down prices in some key sectors. Huge reserve armies, and massively increased connectivity are pushing them down in others: the whole global economy is behaving like a single emerging economy.

The situation in China is normal if you look at what happened in the European economies during a comparable period of technological change and industrialisation: the late 19th century.

I think I’ll leave it there, but the picture should be plain enough. I don’t buy the ‘consensus’ explanation. There is something more to all this than good housekeeping practices across the central banks. These US employment stats today are only a reminder. Now go have a nice weekend everyone.

7 thoughts on “What’s It All About Alfie?

  1. It won’t be long before that loon Patrick (G) comes back with some idiotic retort about the US unemployment figures you cite being all wrong… because of Bush.

  2. I can think of one very significant monetary movement tied to demographics that I have never heard anyone address. It is an open field for speculation. However, it is part of the solution, not part of the problem: Pension reform (privatization).

    I don’t have statistics for any of this, and am unsure what statistical impacts the trend would have.

    It pretty much started (for the US) in 1986 or so, with ERISA (Employee Retirement and Income Security Act). It was a very slow start, but that’s the date I choose to work from. About that same time, IRAs (Individual Retirement Accounts) became available, probably as part of ERISA.

    Now stop and think: where has pension reform (privatization) gone the furthest in the G7? In the UK, from what I read, followed by the US. Where are the big asset bubbles (mostly housing prices) currently building? In the UK and in the US (also in Australia and Ireland, neither of which are G7 countries). Which country has had the absolute highest sustained savings rate in the post-War (WWII) period? Japan. Where is deflation the largest problem? Japan, which is also the home of the first modern “super bubble” that affected every market (equity, debt, housing).

    On a microscale, traditionally the family home (if owned) has always represented the largest single asset, and the bulk of consumer wealth. I personally know a lot of homeowners whose retirement accounts (not trading accounts or other investments, but 401Ks, IRAs, etc.) are worth a great deal more than the equity they own in their homes. While anecdotal, that is a pretty serious demographic shift right there.

    Prior to ERISA (I can’t address the non-US situation), pensions were mostly unfunded future corporate obligations. They showed under GAAP accounting, but otherwise didn’t show in any monetary statistics at all. To achieve the same result in a completely privatized scheme, you’d need to issue the money to your employees, and have them allocate it to a fund to purchase newly issued shares in your stock, which shares would be retired as the pensions paid out. That is a huge set of financial transactions, which would skew all the statistics drastically.

    Now, remember, this is something like changing the temperature of a hot swimming pool by pouring in cold water with a garden hose. While some elements of ERISA affected all past liabilities (mostly accounting rules changes), the really serious impact (the privatization through IRAs and 401K accounts) was limited. Moreover, the initial participation in such schemes was very limited: the garden hose was turned on very slowly.

    During that initial phase, we had the end of the Cold War followed by the high-tech explosion. There was a lot of other things going on at the time.

    As I said in another comment, the reason interest rates stay too low in the face of hugely inflationary policies is because more people want to lend money than to borrow it. Where is the extra money coming from? From individuals trying to secure their retirement. But that seems stupid: the same funds were always there to pay for the retirement, the funds are just accounted for differently now.

    There’s two problems with that counter-argument: in the first place, the funds often weren’t there, and still aren’t there in a lot of cases today. The PBGC (Pension Benefit Guar. Corp., the US guarantor of pension liabilities) sees a huge shortfall emerging after the asset value crunch. The shortfall was aggravated by the equity crash, but the situation is improving every year as pension privatization continues to spread.

    The second problem is even more telling: the decisions on where to park the funds are being made more and more by the employees, not the employers. Small investors are going to have a very different pattern of decision making than a corporate financial officer.

    A corporation would typically take a huge chunk of capital like that, and make a strategic aquisition. They’d buy a substantial stake in a related company, and keep it. They typically would not invest it in retail securities. When someone like Warren Buffet buys into a company, the shares he gets are nothing like the shares you (as an individual investor) can buy from a broker: he gets board rights, oversight provisions, special reports, strategic alliances (e.g., exclusive supplier contracts), and a host of other benefits. (Note: Buffett himself generally eschews buying affiliates, so the strategic alliances apply less to his case.) Massive amounts of capital are effectively retired from circulation by such transactions.

    Now, the assets still exist, and the money is not converted into bank notes for incineration. So such transactions should affect the statistics the same way as the activities of lots of small investors managing their own accounts. But the large corporate investors are willing to tolerate much lower returns on affiliates (esp. wholly owned affiliates) as those affiliates contribute other benefits to a larger strategic plan. GM will happily contribute a long-term, interest-free convertible loan to a key parts supplier, and such a transaction has no impact whatsoever on the corporate bond market beyond removing the supplier from the market. That loan shows as a general asset on GM’s balance sheet, which offsets general liabilities, including its unfunded pension liabilities. Now try asking a GM employee to place his IRA in a similar scheme. It won’t happen.

    Retirement accounts have been blamed for the Tech Bubble (along with Rasputin). But all that excess liquidity is still out there, looking for a home. It’s driving down interest rates at the same time as it is once more driving up asset values.

  3. My apologies for the length of that last one.

    Let me state at the outset that I have no source of comprehensive data on privatization participation over the period 1985-2000. I’d love to see some.

    The topic may be old hat. If so, I missed it.

    There’s also a lot of other horses you can hook to that same carriage. Corporate takeovers declined drastically in the 1990s, largely attributed to the spread of bylaw defenses (poison pills, etc.). But perhaps the lack of access to pension funds constrained corporate buyers. Also, in the late 80’s, a lot of the takeovers were specifically to get access to the target’s pension funds to enable more takeovers.

  4. What perhaps is inhibiting the ECB governors from cutting interest rates is the effect on inflation in the seven Eurozone countries where the annual inflation rate was already running at 2 per cent or more in January: France (2.2%), Italy, (2.2%), Portugal (2.2%), Spain (2.3%), Ireland (2.3%), Luxembourg (2.3%) and Greece (3.1%).

    Source: http://europa.eu.int/comm/eurostat/Public/datashop/print-product/EN?catalogue=Eurostat&product=2-27022004-EN-AP-EN&mode=download

  5. Taylor, as is getting to be customary here, I really don’t have too much to add. Your reasoning seems fairly sound to me, and the point about the shift from coporate decision making to decisions by small investors equally interesting. I hadn’t thought about that one.

    Robert Schiller in Irrational Exuberance looks at the ‘baby boomers’ theory and is somewhat critical, although he clearly doesn’t discount there being some impact. In fact, due to its unique demographics of immigration the US may be the least affected by this impact, and you may need to look globally across the OECD to really see the picture. At least that is my conjecture.

    Also, again, demography is just one factor, and it is the way a variety of ’causes’ are interlocking which is producing the pretty unique situation we seem to have on our hands.

  6. Two illuminating reports in the news about the causes of, and the scapegoat for the Eurozone’s flagging economy:

    “The response to the ECB?s verdict was predictable. In a petulant swipe at the bank, Gerhard Schr?der, the German Chancellor, complained that he had no choice but to respect its decision, but said that his views on the action needed were unchanged. A few days earlier, both Herr Schr?der and France?s Prime Minister, Jean-Pierre Raffarin, had delivered their most vocal demands yet for the ECB to cut rates.” – from: http://business.timesonline.co.uk/article/0,,8210-1030057,00.html

    “EUOBSERVER / BRUSSELS – An influential report due to be unveiled later today (Monday 8 March) by Irish Taoiseach Bertie Ahern has delivered a very downbeat assessment of progress towards the EU’s economic goals. . . Overall, the report is highly critical of EU leaders for failing to implement the necessary economic reforms that would enable these goals to be met. The survey concludes, ‘even the most enthusiastic proponent of the Lisbon agenda can only describe the EU’s performance over the last 12 months as mediocre … After a second consecutive year of disappointing economic growth, it is already apparent that the EU will miss some of its key targets’.” – from: http://www.euobserver.com/index.phtml?aid=14708

  7. Sorry Edward,
    I couldn’t find anything in your post that would lead me to “retort about the US unemployment figures you cite being all wrong.”

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