Financial News, a Dow Jones Company, 20th September 2010
The dramatic change that has taken place in the world’s economic pecking order has been widely publicised. While the political consequences have been much discussed, the consequences for economic policy have been almost entirely ignored. This failure has severely limited the relevance of the current economic debate, which has centred on the risks of a double dip recession and whether there should be either a fiscal or a monetary response to it.
The main protagonists in the debate think that deflation is dangerous and that the policy targets for developed economies should be falling unemployment with inflation around 2%. They assume, without seeming to give much thought to the matter, that there exists a set of economic policies which will meet these targets in developed economies, independent of developments in the rest of the world. It is, however, necessary to question this assumption in view of the change in the relative importance of the developing economies.
In 1950 G5 countries accounted for almost half the world’s output and only a little less of its growth. Today they produce only a third of the output and a fifth or less of its growth.
When the US dominated the world, its economic policies were set with only domestic considerations in mind. This worked, but only by borrowing increasing amounts from the rest of the world as the US current account changed from an annual surplus of 4% of GDP to a deficit of 6%.
Policies which ignore the rest of the world are no longer sustainable. One consequence is that without a major change in policies, the developed world must have a much lower inflation rate than developing economies.
At the same time, budget deficits in G5 countries must be brought down. In the world as a whole, an improvement in government finances must mean an exactly equal deterioration in those of the private sector. This can be modified in different parts of the world, by shifting the burden between countries. For the developed world, which has the big government deficits, it is essential that part of the burden is shifted to the developing world. Otherwise profits will fall too much to allow for recovery.
An improvement in international current account balances is thus essential and cannot occur without either the introduction of major protectionism or a fall in the real exchange rates of the developed world. So long as there is little change in nominal exchange rates, this means that G5 inflation must be much lower than in the rest of the world.
How low G5 inflation has to be is of course uncertain. It depends on several factors, including how much the Chinese exchange rate is allowed to rise in nominal terms, and how fast inflation occurs in the developing world. But it is very unlikely that much more than zero inflation is compatible with recovery under current policies. As this will involve a fall in the real exchange rate of the developed world, it implies that import prices will be rising and this must be offset by the prices of domestic services and property falling.
The assumption that we should aim for inflation of around 2% should therefore be questioned. As a paper published by the BIS makes clear, deflation has not historically been bad for economies. The 19th Century was a time when world growth was accelerating and inflation falling. Economies tend to be unstable during periods of either rapid inflation or deflation, but there is little evidence that mild deflation is any less desirable that mild inflation. The great monetarist, Milton Friedman, thought that deflation should run at the same rate as real growth so that nominal GDP would be unchanged. It is widely believed that Japan’s recent experience is evidence against deflation, but in fact the economy only moved into deflation after the lost decade of the 1990s and its performance has improved during the period of falling prices.
The Federal Reserve doesn’t have an official inflation target, but it is probably more wedded than other central banks to the idea that inflation is a good idea. If this remains its policy, then the conflict between this target and the realities of the world today will have to be resolved and this could happen in several different ways. It could simply fail or it could be achieved by a mixture of domestic deflation and rising import prices. As recovery requires real wages to be at least maintained, this would mean that wages would rise significantly faster than the prices of domestic services, so that profit margins would both narrow and shift. While profits would fall in aggregate, manufacturing companies would suffer much less than services. This would be a most desirable development for several reasons. It would be helpful in supporting overall demand as manufacturing is much more capital intensive than services, particularly financial ones, and this would support investment, even though profits were falling generally.
Both failure to achieve this implied 2% inflation target and success combined with falling service prices and corporate profits are therefore compatible with the need to improve the international competitive position of the developed world. It provides hope for a sustainable recovery, but one where growth would be slow and accompanied by a continued high level of unemployment. At the moment it seems unlikely that changes in either fiscal or monetary policy would be capable of creating a sharper recovery, but slow growth may create growing impatience. If it does, then one of the existing constraints will come under pressure. The most benign would be a more rapid rise in the Chinese exchange rate and the most malign a rise in protectionism.
The relatively benign outlook provided by slow growth and falling profits is not the only possible outlook, even excluding a sharp recovery. It is of course possible that growth will not just be slow, but negative. But we should not be excessively worried by this risk. It would encourage politicians in the developing world to stimulate demand, and
it would probably speed up the fall in prices which is needed for an improvement in real exchange rates. The fear of deflation is probably more dangerous today than deflation itself, which in a mild form for the developed economies would help the essential progress towards a more balanced world economy.
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This article first appeared in Financial News.
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