Dear guys,
Article that is certainly worthwhile reading in the inflation/deflation debate.
Cheers,
Sunstone.
Greenspan's greatest fear
Jun 28
Peter Hartcher
This is one of those moments where you realise we have stepped Through the Looking Glass, one of those times when you grasp that the established order of human affairs has turned topsy turvy.
It has happened so gradually that the change has been almost imperceptible, but this week drove home that we are now on the other side of the mirror.
A top Japanese official in Washington asked the other day what Australia's inflation rate was. Hearing that it was a little over 3per cent, he looked impressed and offered a heartfelt: "That's wonderful! You are to be congratulated."
Not that it is so low, but that it is so high.
Japan is stuck in chronic deflation, with prices falling by 1per cent a year. It wants inflation back again.
It seems absurd that the great evil of the latter half of the 20thcentury, inflation, is now highly prized.
The nations of the world subjected themselves to enormous hardship for 30 years to purge inflation.
And if they couldn't bear to throw themselves into the fires of recessionary expurgation to expel the demon of rising prices, officials from the International Monetary Fund, like fanatical exorcists, would fly in blazing-eyed from Washington to do it for them.
"In this world, there are only two tragedies," Oscar Wilde remarked. "One is not getting what one wants, and the other is getting it."
We got what we wanted. Inflation is dead. The world average inflation rate collapsed from 19 per cent a decade ago to 4per cent last year, and falling.
The average in rich countries has halved from 2.8 to 1.4 per cent - and is still falling, according to the exorcists themselves, the IMF.
And as these numbers slide towards zero or below, it is the opposite, deflation, the word that for most recalls the searing experience of the Great Depression, that is the most feared phenomenon.
This week has proved to be a threshold moment in the dawning of the new age in each of the world's two biggest economies.
In Japan, deflation treated us to another Alice in Wonderland moment. On Thursday, the interest rate on overnight loans between banks fell so far that it turned negative for the first time.
It's difficult to conceive. But banks were lending to each other at a rate as low as negative 0.1 per cent, according to the Bank of Japan.
Try to grasp this: one bank would pay another to take money off its hands. Banks are paying to be rid of their cash.
This is truly the world on the other side of the looking glass. And until this year the other rich countries of the world were confident that that was where the deflation problem would remain.
Japan was obviously some sort of aberration; OK, it was happening in China, too. And Taiwan. And Singapore.
The looking-glass world seemed to be growing; the sane world appeared to be shrinking. But deflation could never happen in the US or Europe, surely.
Then, in April, the IMF published two remarkable research papers. One declared, for the first time in the half-century of the institution's existence, that inflation was no longer the dominant problem of the world economy, but deflation was.
The other warned that Germany was at high risk of slipping into deflation. The next month, German consumer prices fell by 0.2 per cent.
It was now happening in the world's second-biggest economy, Japan, and its third-biggest, Germany, as well as in the world's biggest developing economy, China.
For the authorities, it was time to move from denial into damage control.
In Germany, the chief of the central bank, Ernst Welteke, conceded that "mild deflation is fairly likely to take hold in Germany", but said "it is highly unlikely that Germany will experience pernicious deflation".
Simultaneously, the chairman of the US Federal Reserve, Alan Greenspan, made the same tactical shift. Seven months earlier Greenspan had reassured anxious members of the US Congress that "we are not close to the deflationary cliff". But last month he and his colleagues on the US Federal Reserve's key policy committee changed their minds. They evidently decided that the US economy was in real danger of teetering over the edge into deflation, and they said so.
It was the first time that the Federal Open Market Committee had branded deflation Public Enemy Number One. And it said it would set US official interest rates accordingly. This is the opposite of Fed policy for a third of a century.
In the age of inflation, the Fed kept rates high enough to keep prices in check. Now it says it will keep interest rates low enough to keep inflation up.
And this week the Fed passed through the looking glass and for the first time acted specifically with the defeat of deflation as its stated purpose: it cut official US interest rates from 1.25 per cent to 1 per cent.
"Greenspan was part of the crowd in the Ford administration in the 1970s that put out buttons saying 'whip inflation now'," recalls Brian Wesbury of Chicago investment bank Griffin, Kubik, Stephens & Thompson. "He's come full circle - maybe we need buttons now that say 'whip deflation now'." Greenspan didn't appear before the television cameras sporting such a badge, but he did the next best thing. His policy committee issued a statement on Thursday that the fear of deflation was the "concern [that] is likely to predominate for the foreseeable future".
What's going on? What's the cause of deflation? And is it a real risk to the lives and livelihoods of the world population, or is it just some mumbo jumbo to keep economists busy?
The cause is in hot dispute, but one person took a step back - several steps, actually - to look at the big picture. In 1996, the economic historian David Fischer published The Great Wave, an investigation of inflation over the past 800 years.
He identified four great waves of inflation - he calls them price revolutions - in the past eight centuries, each running for about a century.
And he drew the tentative conclusion that the fourth of these, the one that dominated the 20th century, was already crashing to a conclusion.
Since his book was published, the evidence continues to mount that he was right.
So how real is the risk?
Greenspan's short answer is that the reason this is such a dangerous new era is because no one knows.
The great guru of the global economy would never admit publicly that he hasn't a clue, but he did concede as much in private to an old friend a couple of weeks ago.
The Fed chairman invited the eminent US economist (and a friend of Greenspan's for 30years) Allan Meltzer to his office to discuss the issue.
After their conversation, Meltzer, a professor at Carnegie Mellon University and a former adviser to the US Treasury and the Fed, told Weekend AFR: "There are many people, including people at the Fed, who don't believe the deflation story, but they don't include the chairman. He feels strongly about it. You can't win an argument with him. You can try to influence his thinking - I made him think about his reasons."
At the core of Greenspan's argument is uncertainty - that no one knows enough about the working of the modern global economy, not even Greenspan himself, to be sure that a dangerous deflation can be averted.
His thinking seems to have been influenced by an important research paper by 13 Fed staff economists, entitled Preventing Deflation: Lessons from Japan's Experience in the 1990s. It contains a cautionary tale about complacency and intellectual arrogance.
It says: "Japan's deflationary slump was not anticipated. This was true not only of the Japanese policymakers themselves, but also of private-sector and foreign observers, including Federal Reserve staff economists.
"Moreover, financial markets had no better handle on the economy's prospects ... The failure of economists and financial markets to forecast Japan's deflationary slump in the early 1990s poses a cautionary note for other policymakers in similar circumstances: deflation can be very difficult to predict in advance.
"In consequence, as interest rates and inflation rates move closer to zero, monetary policy perhaps should respond ... to the special downside risks - in particular, the possibility of deflation."
In short, the US economy may be in the process of stepping Through the Looking Glass, but you can't be sure about it until you wake up one day and find yourself there, in a strange new world where prices don't go up but down, and banks pay you to take their money.
Sounds wonderful; why is everyone so worried about it? And it's true that deflation is not necessarily a bad thing. The world economy has enjoyed booms while prices were falling - during the 1920s, for example.
But deflation is especially dangerous now because the US has unprecedented proportions of debt. Why does this matter?
In an inflation, money loses value, so the inflation-adjusted value of debt shrinks as the years go by. So inflation is kind to borrowers.
But in a deflation, the opposite holds. Because prices are falling, the real value of money goes up in a deflation. So the value of debt actually rises, and borrowers are punished.
This can create a debt trap, forcing firms and families into a spiral of cutbacks to service a growing burden of debt - even though they're not borrowing a cent more. This pattern of retrenchment and bankruptcy can create recession and depression.
Greenspan is determined to keep the US from passing through into Wonderland, no doubt preferring a place in history as the Cheshire Cat rather than the Mad Hatter.
Article that is certainly worthwhile reading in the inflation/deflation debate.
Cheers,
Sunstone.
Greenspan's greatest fear
Jun 28
Peter Hartcher
This is one of those moments where you realise we have stepped Through the Looking Glass, one of those times when you grasp that the established order of human affairs has turned topsy turvy.
It has happened so gradually that the change has been almost imperceptible, but this week drove home that we are now on the other side of the mirror.
A top Japanese official in Washington asked the other day what Australia's inflation rate was. Hearing that it was a little over 3per cent, he looked impressed and offered a heartfelt: "That's wonderful! You are to be congratulated."
Not that it is so low, but that it is so high.
Japan is stuck in chronic deflation, with prices falling by 1per cent a year. It wants inflation back again.
It seems absurd that the great evil of the latter half of the 20thcentury, inflation, is now highly prized.
The nations of the world subjected themselves to enormous hardship for 30 years to purge inflation.
And if they couldn't bear to throw themselves into the fires of recessionary expurgation to expel the demon of rising prices, officials from the International Monetary Fund, like fanatical exorcists, would fly in blazing-eyed from Washington to do it for them.
"In this world, there are only two tragedies," Oscar Wilde remarked. "One is not getting what one wants, and the other is getting it."
We got what we wanted. Inflation is dead. The world average inflation rate collapsed from 19 per cent a decade ago to 4per cent last year, and falling.
The average in rich countries has halved from 2.8 to 1.4 per cent - and is still falling, according to the exorcists themselves, the IMF.
And as these numbers slide towards zero or below, it is the opposite, deflation, the word that for most recalls the searing experience of the Great Depression, that is the most feared phenomenon.
This week has proved to be a threshold moment in the dawning of the new age in each of the world's two biggest economies.
In Japan, deflation treated us to another Alice in Wonderland moment. On Thursday, the interest rate on overnight loans between banks fell so far that it turned negative for the first time.
It's difficult to conceive. But banks were lending to each other at a rate as low as negative 0.1 per cent, according to the Bank of Japan.
Try to grasp this: one bank would pay another to take money off its hands. Banks are paying to be rid of their cash.
This is truly the world on the other side of the looking glass. And until this year the other rich countries of the world were confident that that was where the deflation problem would remain.
Japan was obviously some sort of aberration; OK, it was happening in China, too. And Taiwan. And Singapore.
The looking-glass world seemed to be growing; the sane world appeared to be shrinking. But deflation could never happen in the US or Europe, surely.
Then, in April, the IMF published two remarkable research papers. One declared, for the first time in the half-century of the institution's existence, that inflation was no longer the dominant problem of the world economy, but deflation was.
The other warned that Germany was at high risk of slipping into deflation. The next month, German consumer prices fell by 0.2 per cent.
It was now happening in the world's second-biggest economy, Japan, and its third-biggest, Germany, as well as in the world's biggest developing economy, China.
For the authorities, it was time to move from denial into damage control.
In Germany, the chief of the central bank, Ernst Welteke, conceded that "mild deflation is fairly likely to take hold in Germany", but said "it is highly unlikely that Germany will experience pernicious deflation".
Simultaneously, the chairman of the US Federal Reserve, Alan Greenspan, made the same tactical shift. Seven months earlier Greenspan had reassured anxious members of the US Congress that "we are not close to the deflationary cliff". But last month he and his colleagues on the US Federal Reserve's key policy committee changed their minds. They evidently decided that the US economy was in real danger of teetering over the edge into deflation, and they said so.
It was the first time that the Federal Open Market Committee had branded deflation Public Enemy Number One. And it said it would set US official interest rates accordingly. This is the opposite of Fed policy for a third of a century.
In the age of inflation, the Fed kept rates high enough to keep prices in check. Now it says it will keep interest rates low enough to keep inflation up.
And this week the Fed passed through the looking glass and for the first time acted specifically with the defeat of deflation as its stated purpose: it cut official US interest rates from 1.25 per cent to 1 per cent.
"Greenspan was part of the crowd in the Ford administration in the 1970s that put out buttons saying 'whip inflation now'," recalls Brian Wesbury of Chicago investment bank Griffin, Kubik, Stephens & Thompson. "He's come full circle - maybe we need buttons now that say 'whip deflation now'." Greenspan didn't appear before the television cameras sporting such a badge, but he did the next best thing. His policy committee issued a statement on Thursday that the fear of deflation was the "concern [that] is likely to predominate for the foreseeable future".
What's going on? What's the cause of deflation? And is it a real risk to the lives and livelihoods of the world population, or is it just some mumbo jumbo to keep economists busy?
The cause is in hot dispute, but one person took a step back - several steps, actually - to look at the big picture. In 1996, the economic historian David Fischer published The Great Wave, an investigation of inflation over the past 800 years.
He identified four great waves of inflation - he calls them price revolutions - in the past eight centuries, each running for about a century.
And he drew the tentative conclusion that the fourth of these, the one that dominated the 20th century, was already crashing to a conclusion.
Since his book was published, the evidence continues to mount that he was right.
So how real is the risk?
Greenspan's short answer is that the reason this is such a dangerous new era is because no one knows.
The great guru of the global economy would never admit publicly that he hasn't a clue, but he did concede as much in private to an old friend a couple of weeks ago.
The Fed chairman invited the eminent US economist (and a friend of Greenspan's for 30years) Allan Meltzer to his office to discuss the issue.
After their conversation, Meltzer, a professor at Carnegie Mellon University and a former adviser to the US Treasury and the Fed, told Weekend AFR: "There are many people, including people at the Fed, who don't believe the deflation story, but they don't include the chairman. He feels strongly about it. You can't win an argument with him. You can try to influence his thinking - I made him think about his reasons."
At the core of Greenspan's argument is uncertainty - that no one knows enough about the working of the modern global economy, not even Greenspan himself, to be sure that a dangerous deflation can be averted.
His thinking seems to have been influenced by an important research paper by 13 Fed staff economists, entitled Preventing Deflation: Lessons from Japan's Experience in the 1990s. It contains a cautionary tale about complacency and intellectual arrogance.
It says: "Japan's deflationary slump was not anticipated. This was true not only of the Japanese policymakers themselves, but also of private-sector and foreign observers, including Federal Reserve staff economists.
"Moreover, financial markets had no better handle on the economy's prospects ... The failure of economists and financial markets to forecast Japan's deflationary slump in the early 1990s poses a cautionary note for other policymakers in similar circumstances: deflation can be very difficult to predict in advance.
"In consequence, as interest rates and inflation rates move closer to zero, monetary policy perhaps should respond ... to the special downside risks - in particular, the possibility of deflation."
In short, the US economy may be in the process of stepping Through the Looking Glass, but you can't be sure about it until you wake up one day and find yourself there, in a strange new world where prices don't go up but down, and banks pay you to take their money.
Sounds wonderful; why is everyone so worried about it? And it's true that deflation is not necessarily a bad thing. The world economy has enjoyed booms while prices were falling - during the 1920s, for example.
But deflation is especially dangerous now because the US has unprecedented proportions of debt. Why does this matter?
In an inflation, money loses value, so the inflation-adjusted value of debt shrinks as the years go by. So inflation is kind to borrowers.
But in a deflation, the opposite holds. Because prices are falling, the real value of money goes up in a deflation. So the value of debt actually rises, and borrowers are punished.
This can create a debt trap, forcing firms and families into a spiral of cutbacks to service a growing burden of debt - even though they're not borrowing a cent more. This pattern of retrenchment and bankruptcy can create recession and depression.
Greenspan is determined to keep the US from passing through into Wonderland, no doubt preferring a place in history as the Cheshire Cat rather than the Mad Hatter.
