Center for Financial Economics

CFE and SPF Comparison

Note: This table compares the CFE and SPF forecasts for real GDP growth (Q/Q at annualized rate), unemployment rate (percent) and nonfarm payrolls (month-over-month change in thousands) as of early May 2013.

Discussion

A great debate still rages about the causes of the Great Recession in the U.S. and around the world. Similarly, what constitutes the right remedies for dealing with the global collapse of activity and employment continues to be vigorously debated. Nonetheless, if we step back from the particulars, some things seem unassailable:

Financial markets, housing prices and banking system net worth collapsed in 2008-2009. Amid this financial market debacle, U.S. production, employment and income contracted more dramatically than at time since the Great Depression.

Massive Federal Reserve Board intervention, alongside explicit large government cash infusions where necessary, short circuited the debt/depression dynamics that made the 1930s Depression ‘Great’.

Fiscal expansion did more than prevent a domino chain of financial company failures. Via automatic stabilizers, fiscal expansion cushioned the blow to household incomes from the deep recession. Explicit fiscal stimulus, in 2010, temporarily gave some lift to the economy.

Fiscal rescue efforts, quite predictably, led to a violent rise in the deficit and the trajectory for the growth of U.S. public sector debt.

Economic contraction ended, mid-2009, but the recovery trajectory, with real GDP gains averaging only 2.1% through Q1:2013, has been disappointing.

Unemployment peaked at 10% in Q4:2009 and has declined to 7.5%. This occurred amid weak real GDP growth and modest growth in jobs. Some not insignificant part of the decline reflected a fall for labor force participation.

Inflation’s performance frustrated theoreticians on both ends of the spectrum. It failed to fall into deflation, as Phillips curve proponents would have predicted, despite four years of very high joblessness and widespread excess capacity. But inflation has drifted down to below 2%, and that represents a much bigger challenge to those who predicted that four years of zero interest rates and spectacular Federal Reserve balance sheet expansion would lead to a return to the inflation levels of the1970s, or worse.

The U.S. in a Global Context

Baseline expectations for forecasts are created painfully simply. Expect more of the same. Changes to ongoing trajectories sometimes are expected based upon rest-of-world dynamics. What are today’s first order international anxieties? Europe, in stark contrast to the USA, has reentered recession. Reasonable men and women conjecture about the risks of a Lehman like event emanating from across the pond. We give Draghi credit for being creative enough to stem financial system dysfunction in Europe for now. Additional economic contraction, though a brutal ongoing reality for Europeans, only modestly affects USA economic prospects. Spillovers from Europe that stem from trade linkages have limited effects on the US, but if severe financial turmoil were to re-emerge, that would be a different question altogether.

China’s coming to terms with the end of its export/infrastructure boom also keeps forecasters up at night. Investigate the long string of double digit growth rates for the Chinese economy, starting in the mid-1990s. Surging exports to the U.S. and then Europe provide the first engine. A spectacular expansion of real estate and industrial production capacity restarted the Chinese boom, after the Great Recession ended the export boom to the U.S. and Europe. Capital spending amounts to half of China’s GDP. And by many measures it needs to contract not grow more slowly. If half your economy, the part that has been growing at a 15% rate, will be flat going forward, it is nearly impossible to imagine that China can return to 10% growth rates any time soon.

For the USA, however, China’s slower trajectory offers both pluses and minuses. Multi-national firms helping foster China’s investment boom have had to ratchet down their rest-of-world expansion and profit expectations. That said, China’s infrastructure boom, late 2009 through early 2012, was a central driver in the rise for global commodity prices. Moreover, the China boom lifted Chinese wages and forced Chinese manufacturers to lift export prices. The faltering Chinese economy has reduced pressures on commodity prices. U.S. core consumer goods prices—in many instances made in China—have been slipping over the past several months, after climbing amid the China boom of 2010-2011.

U.S. Policy Makers: Not Great, but Better than Generally Appreciated

Absent a calamity emanating from abroad, is the USA likely to suffer from self-inflicted policy wounds? As we noted above, there is violent disagreement about what constitutes the right policy admixture to deal with today’s challenging economic circumstances. We think, however, that policy steps taken, and policy pitfalls avoided, over the past six or so months, lend support to the notion of an extension of recovery from a low base, with a somewhat better trajectory.

Fiscal Policy in 2013: First Do No Harm

As 2012 came to a close Washington policy makers ran the genuine risk of imposing a potentially deadly policy change. If policy makers had taken no action, tax rates would have skyrocketed. Forecasters of all stripes, correctly, we believe, looked at this potential blunder as one that would all but assure a return to a USA recession.

The deal to reinstate the lion’s share of the Bush tax cuts, therefore, has to be labeled ‘excellent news’. Those inclined to point out that only a severely misguided governmental group would agree to dramatic tax increases amid economic duress need only look across the pond to recall that insane policies can be enacted.

What about the spring sequester that did, in fact, come into being? The imposed cuts are a drag on the economy, but are small when compared to the potential fiscal cliff tax increases.

In combination, avoiding the cliff and accepting some tax increases and defense cuts improves out year deficit trajectories while slowing, but not derailing, the ongoing USA recovery.

What about monetary policy? How do we feel about QEs? Simple. In the current circumstances the Fed is right to aggressively pursue pro-growth strategies. And four years into this effort, with inflation running less than 2%, we would submit that some of the critics need to acknowledge that their fears of inflation have been at the least very premature—and more likely, simply unfounded.

The aggressive pursuit of easy money, by the FOMC, is an attempt to counter the violent shift to risk aversion that gripped companies and households in the aftermath of the Great Recession. As risk anxieties recede and unemployment continues to fall the Fed will have to reverse its easy money policies. And, there is no doubt that this will be a herky jerky unsettling period. But the signal for an end to these extraordinary measures will be evidence of more substantial recovery from the Great Recession. In other words, success will lead to a return to a more reserved Fed.

And in Conclusion

So, we assume an absence of first order distress arriving from abroad. While fiscal policy is not helping, we take comfort in what did not go wrong on the U.S. fiscal front. The sequester isn’t big enough to derail the recovery. Conversely, we think monetary policy stimulus is working. And we think that housing, the not so little engine that couldn’t, offers the economy the economy a bit more pop in the quarters ahead. Consider the chart below. Spending on housing investment, as a share of nominal GDP, even after a few strong quarters, remains well below the lowest levels witnessed a the bottoms of all other post-war recessions. A rebound for housing, now clearly unfolding, offers the U.S. an opportunity for somewhat faster employment and GDP growth in the quarters ahead.

Bob Barbera and Jonathan Wright

 ”A Euro in Cyprus is not the same as a Euro elsewhere”…Olivier Jeanne.

A debt crisis in the island nation of Cyprus threatened to blow into Europe as a full-blown financial hurricane this spring. How could trouble in such a small economy pose so much risk – and what do the EU’s stumbling efforts to avert the disaster mean for the future of the Euro?

The rolling crisis in the Eurozone remains one of the biggest threats to global growth and stability. The Center for Financial Economics is convening regular discussions of the unfolding drama among four Hopkins faculty members – economists Robert Barbera, Olivier Jeanne, and Jonathan Wright and political scientist Nicolas Jabko. The four recently talked about the turmoil that seized the Mediterranean nation of Cyprus earlier this spring and what it could mean for the future of the Euro. David Dagan, a graduate student in political science, moderated the conversation.

Last time we spoke, European Central Bank President Mario Draghi had just announced a massive new commitment by the ECB to backstop the Euro. Where do we stand now, six months later?

RB:   They seem to have avoided an Armageddon-kind of financial outcome but are going into what looks like a second recession for all of Europe. And most interestingly, (the) unambiguous commitment to austerity and tough measures is now losing momentum because Germany is losing momentum. And what’s good for you turns out to not be good for me.

Of course, the big story in the interim was the crisis in Cyprus. How would you explain what happened there?

RB:  We should start with the size of the banking system versus the size of the economy. So you have a very small economy with a banking system that’s much larger than the internal economy would justify. And you have a system where you get a lot of deposits from Russia, from outside of Cyprus, and they put those monies to work to a meaningful degree in … Greek sovereign debt (that Greece defaulted on).

OJ:  And so that’s the reason why the banking system in Cyprus was insolvent.

NJ:  There are two questions. First, should they have made these investments in Greek sovereign debt, and should they have been prevented by regulators in Cyprus? And then there’s the prior question of, should Eurozone countries be allowed to develop tax-haven strategies? And the first question is easier to resolve than the second, because … well, if this strategy is not acceptable, then what Luxembourg is doing may not be acceptable.

JW:  The problem had been simmering for a long time. But in actually creating a response, the first version of it was to have a tax of about 7 percent on insured deposits and just under10 percent on uninsured deposits. And that would have to be ratified by the Cypriot Parliament – which it wasn’t. And then very quickly they moved to Plan B, which was more akin to a conventional bank failure, where the deposit guarantee would stay in place, but the uninsured deposits would have haircuts and the bondholders would also take a hit. And most significantly, this Plan B imposed capital controls – limits on taking money out of Cypriot banks, limits on taking money out of Cyprus.

NJ:  So as to avoid the complete meltdown of the Cypriot financial system.

OJ:  There was a tension between two approaches. So one approach is to say, ‘It’s important to ensure that one Euro in Cyprus is the same as one Euro everywhere, and it’s important to avoid a bank run in Cyprus because there is a risk of contagion to other countries.’ If you follow this logic, then the implication is to do whatever it takes to make the Cyprus banking system safe for depositors. But for the reasons we said before, there was not a lot of sympathy in the rest of the Europe, particularly in Germany, for Cyprus and its banking model – which leads us to the second approach. Which is to say:  ‘No, you have to make the agents who took excessive risk pay.’

So based on that theory, the Troika imposed a strict limit on how much money it was going to put up for the bailout and required Cyprus to come up with the rest.

OJ: Yes. But once you do that, you have bank runs in Cyprus. To deal with the bank runs you have to impose limits on withdrawals of cash and capital controls …. And once you do that, then you are saying a Euro in Cyprus is not the same as a Euro elsewhere.

JW:  You know, the thing that struck me in Cyprus was (that) there is – and it’s not the first case – there is this tension that Europe will say that they are worried about moral hazard but also that ‘this is a one-off thing for this country only.’ Well, if it is really meant to be that, then how are you teaching anybody a lesson by doing it?

RB: Cyprus is (a) rounding error. So it’s costless in the grand scheme of things to solve the problem. If you then say (that) you don’t want to make this a precedent, then you really have to say, ‘Well, what in God’s name would cause you to impose these draconian terms, to invite a bank run?’ And the answer, unambiguously, is the German election. OK, you’ve got a German election (this fall). (German Chancellor Angela) Merkel has to be perceived as (saying), ‘No more. We are anti-bailing out the south.’

NJ:  I agree to that, but there is the added subtext of, ‘This is a tax haven, we don’t like tax havens. We don’t like the Cypriot tax haven any more than the one we have at our doorstep, namely Luxembourg.’ It’s really a message against the business model behind Cypriot banking. It’s a conjunction of bad decisions, but the motivations are a little more complex than just the German election. There was also this sort of bad blood against tax havens in general, and then there was probably some blunder initially on the part of the Cypriot government in allowing small depositors to be taxed because they wanted to save the business model of getting Russian depositors to save money in Cyprus.

RB:  It all speaks to the sort of impossibility of resolving this when you don’t have a federal system and you don’t have a federal banking system.

OJ:  A common currency means that a Euro of banking deposit in Country A is the same as a Euro of banking deposit in Country B. And they can be the same if, and only if, they are guaranteed in the same way. But they can’t be guaranteed in the same way unless you have some kind of collective guarantee at the European level. If you don’t have that collective guarantee, then there effectively is an exchange rate between the bank deposits of different countries even though they are denominated in the same currency. This makes the system vulnerable to crises that follow the same logic as the currency crises that were periodically hitting the system before the creation of the Euro, which is precisely what the Euro was supposed to make impossible.

RB: And that’s it, right? Cyprus is insanely unimportant, except to the extent that it’s another poster child for the idea that what we purport to have, we do not have.

CFE Advisory Board Member and Chief Global Economist at Deutsche Asset and Wealth Management, Josh Feinman, wrote the following commentary on the current US fiscal situation:

Deficits and debt, government spending and taxes: few issues command so much attention, and generate such heated debate.  It’s little wonder; virtually everyone has a stake in the outcome, and much of the battle occurs along the seismic fault lines where economics meets politics – and reason often succumbs to passion.

The US has rung up record peace-time deficits in recent years, cumulating huge debt in the process. That much we can all agree on. Beyond that, though, consensus starts to fray. What’s behind recent fiscal trends, whether they’re likely to persist, and what it all means are subjects of fierce controversy. Some people have been frantically ringing alarm bells, warning that the US faces a fiscal denouement – an imminent crisis born of unsustainable government debt that will cause interest rates to spike and the dollar to plunge, with all manner of dire implications. But the much-anticipated fiscal calamity has (repeatedly) failed to arrive. On the contrary, the dollar has remained broadly stable, and Treasury yields persist near record lows, suggesting the US government is having no trouble borrowing.  

Why have the alarmists gotten it so wrong? For starters, because recent deficits have not occurred in a fully-employed economy with robust private demand for capital, where a lot of government borrowing likely would have driven up interest rates and crowded out investment. Instead, they’ve occurred in – actually been caused by — a depressed economy, where the private sector has been aggressively trying to save more (borrow less). So there just hasn’t been much private spending or investment to crowd out. Put differently, households and businesses have been trying to tighten their belts, which has kept the economy in the doldrums and driven up federal deficits, yet also made it easy to accommodate all that government borrowing without an increase in interest rates. In fact, interest rates have fallen, suggesting that deficits haven’t been too big they’ve been too small — insufficient to offset the private sector’s reluctance to borrow, lend, and spend. That reluctance is why the recent recession was so severe, why the recovery has been so incomplete, why rates of resource utilization are still well below pre-recession norms, why inflation remains dormant, and why the Federal Reserve, in an effort to restore full employment and price stability, has pursued an accommodative monetary policy. It’s all resulted in falling, not rising interest rates. 

The doomsayers have also underestimated some structural advantages the US enjoys. Issuing debt denominated solely in its own currency – and the global reserve currency no less, without any credible rival on the horizon – backed by an independent monetary policy, with a long history of honoring its debt obligations, deep and well-functioning capital markets, stable government, the rule of law, and a still-vibrant, innovative economy, affords the US substantial latitude to borrow in global capital markets, especially when the economy is temporarily depressed. The US should take full advantage of that flexibility. At a minimum, it should avoid tightening fiscal policy too soon, before the private sector is on sounder footing.  On this score, the tax hikes and spending cuts enacted this year seem needlessly risky. The US has to look no further than Europe for examples of self-defeating, premature fiscal tightening – and also for reminders of why it helps to have an independent currency and monetary policy.   

But perhaps the most compelling reason it is not only unwise but also unnecessary to move quickly to bring down deficits is that they’re already coming down. The federal deficit is on track this year to be less than half as large, as a share of GDP, as it was at the peak in fiscal 2009. And that’s with only a tepid economic recovery. If the economy picks up a bit of steam over the next few years as the bubble-era headwinds continue to fade — which seems likely, provided fiscal tightening doesn’t get in the way – the deficits will come down further, enough to start reducing the debt-to-GDP ratio and quelling the fears of all but the most unrepentant fiscal curmudgeons.    

That’s the good news. The bad news is that the US is not permanently out of the fiscal woods.  Far from it. Because no sooner will the cyclical deficits of recent years melt away than the long-anticipated, structural budget problems will begin to surface. Indeed, starting later this decade, and increasingly in the 2020s and 2030s, the aging population (in particular, the retiring of the baby boomers), coupled with rising health-care costs, will relentlessly drive up spending for programs like Social Security and especially Medicare and Medicaid. Left unchecked, this inexorable increase in entitlement spending will eventually force a most-unpalatable choice: either all other federal spending will have to be cut to its smallest share of the economy since before WWII; or the federal tax take will have to be raised to the largest ever seen; or federal debt will have to explode to all-time highs relative to GDP; or some combination of the three. This – and not the temporary deficits of recent years that have caused such unnecessary and counterproductive angst – is the true fiscal time bomb the US faces. 

Fortunately, that bomb still has a long, slow-burning fuse. The US has time; it can (and should) implement changes gradually. After all, it faces no imminent debt crisis, the economy is still struggling to recover, and many of the budget pressures build up only slowly over many years. Still, tough choices will eventually have to be made. To put federal finances on a long-term sustainable trajectory – that is, to stabilize the debt/GDP ratio over the long haul, or preferably  bring it down a bit to leave room for potential future exigencies – will ultimately require fundamental changes to spending and/or taxes for almost all Americans, especially the “middle class.” The benefits and services that most people have come to expect from the government will eventually have to be trimmed, and/or the costs they incur to pay for them will one day have to rise. Doing nothing – letting the debt/GDP ratio surge unchecked — is hardly a cost-less option; even if it never provoked a financial crisis (unlikely), it couldn’t continue indefinitely without eventually crowding out private, productive investment, reducing the size of the economy and lowering living standards.  

There is no easy way out. But there are some palliatives. Revamping the tax code by scaling back deductions and lowering marginal tax rates could raise revenue while mitigating some of the deleterious effects of higher taxes on economic incentives and activity. For entitlements, reforms that encouraged people to work more, save more, and be more efficient in their health spending and delivery could also help, at least in terms of macroeconomic performance. Still, magic bullets are in short supply.

In the end, it will largely come down to normative, political choices. The American people will have to decide how large a government they want to fund, and what role they want it to play. Finding common ground here won’t be easy. It’s a good thing the US still has time to choose.

CFE Advisory Board Member and Chief Global Economist at Deutsche Asset and Wealth Management, Josh Feinman, wrote the following commentary on the current US fiscal situation:

Japan: changing course? 

For years, Japan has languished in the background of the global economy and financial markets, more a follower than a leader of key trends. Although it still boasts the world’s third largest economy, with a high standard of living and some first-rate export industries, Japan has been mired for so long in a stagnant, deflationary rut that it rarely garners much attention anymore — except as an example of what can go wrong in a wealthy, advanced economy, and as a potential warning to others. Indeed, after two “lost decades,” Japan has become a virtual emblem of inexorable decline. The contrast with the heady days of Japan’s spectacular performance in the decades following WWII, when the country was often in the spotlight, considered by many a model to be emulated and an economic rival to be feared, could hardly be more vivid.

Recently, though, Japan has begun to re-appear on the global radar screen, if only as a faint blip. The catalyst for the renewed interest in the country has been the election of Prime Minister Abe and the Liberal Democratic Party (LDP), who’ve pledged to reorient Japanese policy toward breaking the grip of deflation and restoring stronger growth. Structural reforms and fiscal stimulus are part of the agenda, but the main emphasis is on monetary policy. Here, the government has advocated that the Bank of Japan (BoJ) adopt a formal 2% target for inflation and initiate aggressive, open-ended asset purchases until that target is achieved. Perhaps most crucially, the government has just appointed new leaders at the BoJ who firmly believe that the central bank can and should end deflation. Financial markets have taken notice, with the stock market rallying and the yen losing ground since the fall, when investors first began to price in the likelihood of the election result.

But Japan has seen its share of false dawns before – times when policy initiatives were proffered, optimism was on the rise, and economic conditions seemed to be improving, only to peter out. Whether this time proves different depends most crucially on two questions: will policymakers really chart a new course of action and stick with it? And if they do, will it be effective? For the first time in ages, the answers may be “yes.”  

Deflationary stagnation

There is no denying Japan’s long struggles. Since the early 1990s, the country’s real GDP has increased at a meager rate of only ¾% per year. And the country’s footprint on the global economy has steadily diminished over the past two decades; measured at market exchange rates, Japan’s economy has slipped from the second to the third largest in the world, and its share of world output has declined from a peak of around 18% in the mid-1990s to little more than 8% today (IMF estimates). Similarly, while its living standards remain high by broad international standards, and continue to increase incrementally, they’ve been slipping relative to many other countries. For example, Japan’s per capita GDP, valued at PPP exchange rates (which are better suited for comparing international living standards because they adjust for cross-country differences in costs of living), peaked at over 85% of US levels in the early 1990s but has declined to about 72% today.

Japan has also endured a persistent deflation. The GDP price index has fallen for 15 consecutive years (17 out of 18), at an average annual rate of just over 1%. This chronic deflation, coupled with the country’s paltry real growth, has left nominal GDP today lower than it was in the mid-1990s. And it has created a pervasive deflation psychology, as consumers and businesses widely expect the price level to fall and build those expectations into their planning. No other major nation has suffered such a long period of grinding deflation and feeble growth since the Great Depression.

What’s behind Japan’s woes? On the growth front, a big part of the problem seems structural, due to problems on the supply side of the economy. Estimates from the IMF and OECD suggest that Japan’s potential growth has slowed more or less continuously since the 1980s, to as low as ½% or so in recent years. Part of the reason is demographics. Japan’s working-age population began to slow in the 1990s, and by the end of that decade was in decline – a decline that has accelerated of late, recently exceeding 1% per annum. Worse, the changing age composition of Japan’s population may also be putting downward pressure on the country’s per capita growth. The share of Japan’s total population that is of working age has been falling since the late 1990s, and increasingly so in recent years, while the share that is elderly has been soaring. This shift has likely been depressing per-capita growth through several channels: directly, by reducing the size of the labor force that has to support a growing dependent population; and indirectly, as lower working-age population shares, and higher elderly shares, tend to reduce aggregate savings rates (because the elderly usually save less), constraining the pool of national savings available to finance capital investment and hence adversely impacting productivity and per-capita income.

Demographics are not the whole story. The chronic weakness in growth is also a residue of the excesses of the bubble years, which took a heavy toll on activity for years. Moreover, Japan’s labor markets and many of its industries – especially services, distribution, retailing, and agriculture – have long been considered over-regulated, insufficiently flexible, and excessively insulated from competition. Also, deflation itself may be impeding growth. Since nominal interest rates can’t fall below zero, expectations of falling prices imply that real interest rates have remained stubbornly high in Japan, even in the face of the global crisis of 2008-’09 and its aftermath, likely making the decline in aggregate demand steeper and more difficult to reverse in Japan than in countries not suffering deflation, where real rates have been able to fall more sharply. Deflation has also raised the real burden of Japan’s debts, and may be encouraging households and businesses to delay spending and investing because they anticipate lower prices in the future. And since workers tend to resist cuts in nominal wages, deflation makes it more difficult for real wages to decline in contracting industries, reducing the economy’s ability to transfer resources toward new growth areas, thus further impeding efficiency. To top it off, Japan was also hit hard by the global recession of 2008-’09, and its subsequent recovery was temporarily interrupted by the earthquake of 2011.

This may explain Japan’s growth struggles. But what’s causing deflation? Why has Japan been the only major economy to see its price level relentlessly decline? Although the recession of 2008-’09 opened up a sizable output gap in Japan, increasing unemployment, idling capacity, and likely putting downward pressure on prices, other countries were damaged just as badly (if not worse), yet avoided deflation. What’s more, Japan’s deflation began long before the Great Recession, and has persisted even when the economy was growing relatively briskly and was estimated to have been operating near or even above its potential, like 2004 through 2007. Deflation did seem to ease in that period – and again in the past year or so, as the economy has recovered – but it has never completely gone away. The strengthening of the yen, and the downward pressure this may have imparted on import prices, can’t explain it either. For one, imports are too small a share of Japan’s economy (only about 15%) to be the key to the inflation/deflation process. And the yen hasn’t even been rising consistently throughout Japan’s deflationary episode. If there’s any compelling causality here, it more likely runs from deflation to the stronger yen rather than the other way around. The persistent decline in Japan’s prices relative to those in its trading partners would naturally be expected to put upward pressure on the yen; otherwise, Japan’s products would become excessively cheap to foreigners, and foreign products might be priced entirely out of Japanese markets, creating unsustainable trade and capital flows.

At its core, deflation is a monetary phenomenon (and currency movements are one of its consequences). It is widely accepted that a central bank is able to control the price level over the long haul, so the persistence of deflation for such a long period in Japan ultimately reflects a failure of monetary policy. The BoJ has not been sufficiently accommodative, and the result is that deflation has become embedded in the fabric of Japan’s economy, built in to the expectations of households, firms, and investors in ways that have made it self-fulfilling.

What can be done?

Japan needs a multi-faceted approach. Structural reforms to boost potential growth, short-term fiscal stimulus to help boost the cyclical recovery and, most importantly, a more aggressive monetary policy aimed at breaking the deflation mentality. The new government has pledged actions on all these fronts. Ultimately, though, it’s a question of commitment and efficacy. Will they really adopt new policies and stay the course?  And if so, will it work?

On the question of policy change and commitment, there is certainly reason to be skeptical. Japan has rolled out countless policy initiatives in the past, with limited success, either because the policies were insufficient to combat whatever headwinds the economy was facing at the time, or because they were not sustained long enough to finish the job (or both). It could surely happen again this time. After all, many of the country’s challenges are not easily remediable. There is little that can be done in the short-run, for example, to change the country’s demographic profile. Easing immigration rules would help, but for cultural reasons seems highly unlikely. Policies to encourage more women and older people to work would be beneficial too, and there has been some progress in these areas, but more rapid change is needed to mitigate the adverse effects of the country’s aging. There are other changes that Japan could adopt to help lift the country’s growth potential, like making labor markets more flexible, the tax code more efficient, and insulated industries more open to competition, but these reforms require overcoming strenuous social and political objections, so progress is likely to be modest.

Fiscal policy is also constrained, again more by politics than by economics. Although the country does have an enormous government debt outstanding, that debt is held almost exclusively internally, so the interest that will have to paid by future Japanese taxpayers will just go to future Japanese taxpayers. And the debt is all denominated in yen, the supply of which the BoJ can increase to buy the debt if need be, so the government never has to default. The government is having no trouble borrowing right now, and the country is still running current account surpluses, meaning that the private sector is saving sufficiently more than it invests not only to cover the government deficits but to accumulate assets abroad, adding to the country’s already positive net international investment position. Of course, if government debt continues to rise forever, it will eventually crowd out private, productive investment, making the country’s capital stock and overall economy smaller than it would otherwise be.  So someday, the government will need to pare back its borrowing and trim its debt. But that day is not today. With the economy still struggling to recover from recession, there is little risk that government borrowing is crowding out much private investment now. On the contrary, some additional fiscal stimulus could be helpful, and the new government has talked of some fresh initiatives. But political concerns may limit their actions. In fact, a fiscal tightening is in the works for 2014 and 2015, when the consumption tax is scheduled to rise. Probably the best that can be hoped is that other measures will be taken to offset the impact of this tax hike and keep overall fiscal policy from tightening.

Monetary policy

There is more room for maneuver on monetary policy. The BoJ has already followed the new government’s lead by adopting a formal 2% inflation target and agreeing to initiate an open-ended asset purchase program. A skeptic might argue, though, that there is less here than meets the eye. For one, the new 2% inflation target may not be that revolutionary given that the central bank already had a long-term inflation goal of “2% or less.” Also, the new asset purchases aren’t slated to begin until 2014, and even then are still planned to be concentrated at the short-end of the maturity spectrum, where they have the least ability to affect longer-term rates, and in amounts that will boost the BoJ’s net holdings only modestly.

Perhaps most importantly, policymakers at the central bank have been unwilling to take responsibility for deflation. Instead, they’ve persistently argued that deflation is mostly due to the country’s inadequate growth, so curing it will require the government to adopt policies to boost growth. This thinking is out of step with mainstream economics, which holds that over the medium- to longer-term, the price level is determined by monetary policy – full stop. That by influencing interest rates, financial conditions, the supply of money and credit, and inflation expectations, the central bank can get the inflation rate it wants, at least on average over time. Monetary policymakers can’t determine the economy’s real growth trend – that depends on things like demographics and productivity – but they can pin down inflation over time. Failing to accept that Japan’s deflation is largely a monetary phenomenon not only bucks mainstream economics, it’s also self-defeating. By denying that monetary policy can defeat deflation, the central bank has inadvertently been reinforcing the psychology that makes deflation harder to root out.

Fortunately, winds of change seem finally to be blowing at the BoJ. The biggest shift is the new leadership at the top. Signaling their commitment to fundamental reform, the Abe administration just nominated Haruhiko Kuroda to be governor of the BoJ, and Kikuo Iwata to be deputy governor. Both men have strongly advocated that the central bank pursue much more aggressive reflationary policies. Along those lines, the BoJ should first and foremost take ownership of the inflation process – publicly stress that it has the ability and willingness to end deflation and achieve the new 2% inflation target. Policymakers need to back that up with prompt, aggressive actions, including large and open-ended asset purchases to begin immediately, and preferably to be targeted toward the longer-end of the maturity spectrum and even branching beyond government bonds to private securities and foreign currency government bonds. The specifics are probably less important than the commitment to do “whatever it takes,” and to stay the course.  Too often in the past, BoJ policymakers have taken tentative steps toward more forceful easing but then failed to follow through, undermining their credibility and ultimately making it harder to achieve their goals. The new leadership must break this vicious cycle.       

Assuming they do, the question turns to efficacy: will it work? In principle, it should. Deflation ought to be correctable by concerted central bank action. When a central bank wants to generate inflation, it should be able to do so. After all, there is little practical limit to how large the BoJ can make its balance sheet, and how many yen it can effectively create. By buying bonds, the BoJ should help lower nominal interest rates, support risk assets, weaken the yen, and generally ease financial conditions. And if the whole package succeeds in boosting inflation expectations – i.e., if the BoJ’s 2% inflation target is credibly believed – that alone will help end deflation, not least by purging it out of people’s wage considerations, price decisions, and investment planning. Moreover, expectations of rising prices will help push down the real cost of borrowing (provided that BoJ bond purchases help restrain nominal rates), and this should foster more consumption and investment spending today, while also easing real debt burdens. Expectations of inflation might also encourage people to spend a bit more now, before prices rise later.

It all sounds fine in theory; but in practice it may prove more difficult. Japan has been stuck in deflation for so long that expectations of falling prices have become deeply embedded in all aspects of economic life – indeed, in the Japanese psyche. They may take time to overturn. Still, that just means the BoJ has to push harder for longer. In some ways, Japan could be an interesting test case of how difficult it is for a determined central bank to reverse a deflationary psychology. But if the BoJ has the will, there should be a way — not only to break deflation, but also to help support a cyclical recovery in the economy. Ending deflation might even boost trend growth a bit, though the kinds of structural reforms really needed on this front are largely beyond the purview of a central bank. 

Conclusion

The leaders of Japan’s new government are pushing hard for fundamental reform.  And the early indications, especially at the BoJ, are encouraging. It won’t be easy, though; Japan still faces formidable challenges that make a return to the pre-bubble glory days virtually impossible. And it will take time and perseverance by the central bank to end an entrenched deflation. But for the first time in years, there is a ray of hope in Japan.

Joshua Feinman

Chief Global Economist

Deutsche Asset & Wealth Management

Phone: 212-454-7964

e-mail: josh.feinman@db.com

The  spring 2013 issue of the JHU magazine contains an interview with Lou Maccini and Chuck Clarvit about the establishment of the CFE in 2007.

http://hub.jhu.edu/magazine/2013/spring/center-financial-economics

The JHU Career Center invites you to join

Charles Clarvit ’78, University Trustee and CEO of Vinci Partners-US
and
Patrick Ambron, Co-founder & CEO, BrandYourself.com

As they share how to monitor, optimize, and protect your online reputation through BrandYourself.com.
Patrick will also discuss developing and launching BrandYourself from his firsthand experience as an entrepreneur.

While this event is open to all students, students who:

• Are applying for internship or full-time opportunities;
• Have ever wondered how to monitor or improve their online presence or search results;
• Are interested in learning how to create, launch, and grow a successful internet startup

are especially encouraged to attend!

Tuesday, March 12
6:30 p.m.
Mason Hall Auditorium

A reception with lite fare will follow

The CFE is delighted to sponsor a series of lectures by JHU alumni currently at the IMF.  We will kick off with a talk by Min Zhu, Hopkins PhD, who is now Deputy Managing Director of the IMF.  The title is  “A changing World: Interconnectedness and the new world structure; The shifting global growth gravity; Deleveraging and growth”

The talk will be in Gilman 50 on Thursday February 21 from 4:30pm to 6pm.

We’d strongly encourage graduate students with macro interests to come.

Bob and Jonathan

http://econ.jhu.edu/profiles/min-zhu

Bloomberg Magazine asked CFE Co-Director Bob Barbera if the current low level of the VIX and high hedge fund leverage meant that the economy was on the brink of another Minsky moment.  Here is his reply.

The late economist Hyman Minsky brilliantly documented that attitudes toward risk taking evolve in a predictable pattern over the course of business cycles. In the aftermath of a recession, bankers, borrowers, business leaders and heads of households all decide that SAFETY is the paramount. As economic recovery takes hold and memories of retrenchment recede, economic decision makers, collectively, begin, slowly but surely, to move toward strategies that promise more return but are inherently riskier.

Where do we stand in early 2013? The 2008-2009 financial crisis and Great Recession delivered asset market mayhem not seen since the Great Depression. Quite predictably, this produced a collective leap toward SAFETY of unprecedented proportions in the Post-Depression period. Household debt as a share of income fell for four years. Bankers radically tightened lending standards, resulting in loan growth well short of deposit gains and an explosion of excess reserves. Corporations accumulated an unprecedented cash hoard. This deep seated angst no doubt played a significant role in the tentative nature of economic recovery. In response to both financial system angst and sub-par recovery, central banks around the world have embraced super easy monetary policy stances.

Now, however, there are signs of some renewed optimism. Residential real estate in the United States, the centerpiece of the financial market crisis, appears, at long last, to be mounting a genuine recovery. Bankers are relenting, a bit, from deeply restrictive lending practices. Investors, faced with de minimis nominal return prospects, have been forced out the risk curve. Corporate borrowing costs and some risk measures, as a consequence, now look low.

A Minsky moment in the making? Not so fast! The deadly admixture that elicits Minsky like financial system crises is a combination of risky finance and CENTRAL BANK TIGHTENING OF MONEY AND CREDIT.

It is true, at present, that some financial market measures are looking relatively risky. But the economic backdrop, to date, simply haven’t signaled that easy money will soon be reined in. Paradoxically, a spate of much better than expected economic news–six months of 300,000 per month jobs growth?–and the world would have to radically recalculate the timing of Fed tightening. Boom, and the prospects of tighter Fed policy, would invite serious financial market redress.

The delicious Minskyian irony? Angst about a return to recession, which has persisted in this recovery for four years, keeps the Fed on hold and the asset market recovery on track. Unambiguous economic strength, and the recognition that Fed largess is no longer needed on Main Street, is the more serious threat to asset market returns

CFE co-director Bob Barbera spoke at the Hyman Minsky Conference on Financial Market Instability in Berlin on November 27 and 28.  Here is a link to the conference program.

http://www.levyinstitute.org/conferences/berlin2012/

and here is the text of Bob’s remarks

Bob Barbera Remarks

CFE co-director Bob Barbera writes a piece digging into the sharp rise in employment in the September employment survey:

Much Ado About Not Much