Saturday, July 23, 2005

Roubini Global Economics (RGE) Monitor

Roubini Global Economics (RGE) Monitor

Inflation - Deflation?

Stephen Roach

The more I ponder the inflation story, the more I become convinced that we need to come up with a new approach. In two earlier essays, I addressed the shifting composition of inflation (see “Inflation Phobia” July 15, 2005) and the cross-border convergence of pricing (see “Inflation Convergence, July 18, 2005). In what follows, I explore some important shifts in the macro relationships that have long been at the heart of the inflation process. What emerges from this trilogy is a strong conviction that increasingly powerful forces of globalization have fundamentally altered the inflation outlook. Barring a setback to globalization or a major policy blunder, low inflation could well be here to stay for the foreseeable future.

Globalization is all about the cross-border integration of economies, markets, trade and financial capital flows, and information. Ultimately, it also entails increased mobility of the factors of production -- capital, labor, and technology -- thereby forcing us to think about the production process and the dissemination of services in an increasingly global context. That means the pricing of goods and services must also be examined in the same broader framework -- in essence, determined by the market-clearing balance between globalized supply and demand curves. The rapid expansion of global trade in recent years underscores the need to accept this analytical leap of faith in assessing inflation risk. By our calculations, global exports will exceed 28% of world GDP in 2005 -- easily a record and more than ten percentage points above the 17% share that prevailed as recently as 1986. As global trade continues to power ahead, the forces of globalization -- and their impacts on real economic and financial market activity -- can only intensify as a result.

It’s easy to be awestruck by the anecdotes of globalization; look no further than Tom Friedman’s latest best-seller, The World Is Flat (Farrar, Strauss and Giroux, 2005). As macro practitioners, however, we need to dig deeper. In particular, it is critical to assess whether cross-border integration has had a major impact on time-honored macro relationships that drive economic growth, employment, income generation, and inflation. I am very sympathetic to that possibility. I first explored such an outcome in the context of shifting global trends in employment and labor income generation (see my 5 October 2003 essay, The Global Labor Arbitrage). More recently, I have generalized this framework to include the cross-border arbitrage of saving and pricing (see my 6 June 2005 essay, The New Macro of Globalization). Some fascinating new research just published by the Bank for International Settlements adds further evidence to this debate. In particular, it sheds considerable light on how globalization is challenging the macro relationships that have long been at the heart of our understanding of the inflation process (see especially Chapter II of the 75th Annual Report of the BIS, June 2005). The BIS research provides a goldmine of evidence in the laboratory of globalization.

Three findings by the BIS strike me as especially noteworthy in revealing the impacts of globalization on inflation (see accompanying table): First is the link between exchange rates and import prices. Currency depreciation has long been perceived as an inflationary development. Unless foreign exporters are willing to compromise their profit margins, it makes sense for them to maintain price targets in home-currency terms -- thereby allowing external pricing to fluctuate with shifts in foreign exchange rates. While that’s still the case to some extent, BIS researchers have found that this relationship has become far less robust as globalization has taken hold. They compare this relationship over two periods -- the modern-day globalization era of 1990 to 2004 and the “pre-globalization” era of 1971-89. An examination of trends in six major developed countries -- the US, Japan, Germany, France, the UK, and Italy -- finds that the sensitivity (elasticity) of import prices to a one percentage point change in the nominal effective exchange rate has diminished sharply between the two periods. In the US, for example, the exchange-rate-import-price elasticity over the most recent 15 years was more than 60% below the elasticity of the preceding 20 years. Declines of varying magnitudes were also evident in the other five countries -- led by France and followed in descending order by Japan, the UK, Italy, and Germany.

Second, the BIS also finds that that the pass-through of import prices into the domestic price structure has been seriously curtailed as globalization has taken root. With the exception of Italy, all of the six countries examined have experienced a dramatic decline in the sensitivity between fluctuations in import prices and domestic prices in the past 15 years. I suspect this underscores the increased power of the global price-setting mechanism: Even if import prices rise due to currency fluctuations or market conditions in foreign economies, the lack of pricing leverage in a world with a hugely-expanded global supply curve now constrains domestic producers from passing through these higher external costs. In all six countries, this constraint has been evident in the form of reduced elasticities as globalization has taken off over the 1990 to 2004 period.

Third, there is also solid evidence of sharply diminished linkages between inflation and the broadest gauges of market pressures. This shows up in the form of reduced sensitivities between fluctuations in core inflation and changes in the so-called output gap -- the difference between actual and “potential,” or full-employment GDP. The UK experience is an exception to this trend, but sharp reductions in this elasticity were evident between the globalization and pre-globalization periods for Japan, France, Italy, the US, and Germany. Not surprisingly, this result fits well with equally-impressive declines in the linkages between unit labor costs and core inflation that I noted in the second installment of this trilogy (see my 19 July dispatch, “Inflation Convergence). If the broadly-based output gap has lost its potency in driving fluctuations in inflation, it stands to reason that a similar result can be expected from the linkage between inflation and the cost pressures that arise from cyclical fluctuations in the labor-market piece of the output gap.

Don’t get me wrong -- this is not ironclad evidence that globalization has repealed the macro rules of inflation. However, there can be no mistaking the evidence of a sharp reduction of the linkages between price setting and several of its key determinants -- namely, currencies, import prices, output gaps, and labor costs. It’s the timing of these diminished linkages that brings globalization into the story. For six major developed economies, the elasticities and correlations have declined during the same period when globalization has burst forth with extraordinary scope and speed. Maybe that’s just a coincidence. After all, there could certainly be other powerful forces at work. Central bankers would like you to believe that they deserve credit for their success as inflation fighters. In addition, the explosion of the Internet points to a new technology of price setting. These developments can hardly be dismissed as inconsequential events on the inflation front. But, in my view, they are dwarfed by the far more powerful market-driven forces of globalization. I do not think it is a coincidence that global inflation convergence has occurred at the same time when the roles of currencies, import prices, and labor costs have all diminished in importance in shaping inflation. Nor do I think it is a coincidence that these developments have all occurred during a period when global trade has soared repeatedly to new records as a share of world GDP.

At work, in my view, is the globalization of disinflation. Our old closed-economy models have been rendered increasingly obsolete by the emergence of far more powerful cross-border influences on pricing. As a result, in making inflation calls, we now need to pay less attention to country-specific shifts in unemployment and capacity utilization rates. Instead, we need to focus more on the global balance between supply and demand that shape the far more open models of globalization. In that broader context, the outlook for inflation remains very constructive, in my view. After all, it’s hard to have bottlenecks without a bottle.

Saturday, July 16, 2005

The Demise of The Euro


Back in 1999, I gave the euro five years at most. My prediction might have worked out if the goal posts, in particular, the Stability and Growth Pact, had not been shifted. Milton Friedman gave himself more wriggle room by forecasting the euro’s demise within ten years. The euro project is now being seriously questioned, and its possible demise actively canvassed, as Joachim Fels notes:

A full-blown political union in Europe is not only unlikely, it is also undesirable. Europe’s cultural, political and institutional diversity should be seen as a strength rather than a weakness because it encourages institutional competition for ideas and for mobile capital…

The euro’s founding fathers assumed that monetary union would over time quasi-automatically lead to political union and thus didn’t spend much time worrying about the long-run viability of the euro. But their assumption is clearly no longer valid…

As long as all euro members agree that higher inflation and fiscal deficits are desirable or at least unavoidable, this does not yet put the euro at risk. Each euro would merely buy less domestic and foreign goods and services. However, some member states’ tolerance for inflation and fiscal deficits is likely to be lower than that of others, especially if the euro would turn into a mini-lira. In this case, the more stability minded members might decide to introduce a harder currency. Needless to say, a break-up of EMU would be economically very costly for all parties involved. But that doesn’t mean it cannot happen.

These costs need to be balanced against the reduction in macroeconomic policy risk that would occur with the demise of the euro, in particular, the risk of serious monetary policy mistake by the ECB being propagated across the euro zone.

Friday, July 01, 2005

Thinking Minsky - D.Noland


“Capitalism is essentially a financial system, and the peculiar behavior attributes of a capitalist economy center around the impact of finance upon system behavior.” Hyman Minsky, “Financial Intermediation in the Money and Capital Markets,” 1967

“The financial structure of the American economy has undergone significant evolution over the history of the republic. In the initial era of commercial capitalism, external finance was used primarily to facilitate commerce by financing goods in process or in transit. The present period, in contrast, is one of money-manager capitalism, where financial markets and arrangements are dominated by institutional investors.” Hyman Minsky, “Economic Insecurity and the Institutional Prerequisites for Successful Capitalism,” Journal of Post Keynesian Economics, Winter 1996/97

“Looking at the economy from a Wall Street board room, we see a paper world – a world of commitments to pay cash today and in the future. These cash flows are a legacy of past contracts in which money today was exchanged for money in the future. In addition, we see deals being made in which commitments to pay cash in the future are exchanged for cash today. The viability of this paper world rests upon the cash flows…that business organizations, households, and governmental bodies, such as states and municipalities, receive as a result of the income-generating process. The focus will be on business debt, because this debt is an essential characteristic of a capitalist economy.” (p. 63)

“Central Banking has always been a major determinant of what is known with certainty, what is probable, and what is purely conjectural in financial markets. The evolution and development of central banking has not been solely a reaction to an independently-evolving financial structure, but has been also a determinant of this evolution.” Hyman Minsky, “The New Uses of Monetary Power,” 1969

“It should be noted that [the] stabilizing effect of big government has destabilizing implications in that once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt-finance. If the cash flows to validate debt are virtually guaranteed by the profit implications of big government then debt-financing of positions in capital assets is encouraged.” Minsky, “Inflation Recession and Economic Policy,” 1982 (p. 43)

“As the period over which the economy does well lengthens, two things become evident in boardrooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event it becomes apparent that the margins of safety built into debt structures were too great. As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal-making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activities and positions increase. This increase in the weight of debt financing raises the market price of capital assets and increases investment. As this continues the economy is transferred into a boom economy… Innovations in financial practices are a feature of our economy, especially when things go well… In our economy, it is useful to distinguish between hedge and speculative finance.” “Inflation Recession and Economic Policy,” (p. 66)

“Three financial postures for firms, households, and government units can be differentiated by the relation between the contractual payment commitments due to their liabilities and their primary cash flows. These financial postures are hedge, speculative, and ‘Ponzi.’ The stability of an economy’s financial structure depends upon the mix of financial postures. For any given regime of financial institutions and government interventions, the greater the weight of hedge financing in the economy, the greater the stability of the economy whereas an increasing weight of speculative and Ponzi financing indicates an increasing susceptibility of the economy to financial instability.” Hyman Minsky, Finance and Profits: The Changing Nature of American Business Cycles, 1980

(Simplifying the analysis, a hedge unit enjoys cash inflows above contractual payment commitments in all periods. A speculative financing unit’s cash flows are positive in most periods, although the unit must speculate that additional finance will be available for those occasional deficit periods. A Ponzi unit lacks sufficient cashflows to service its debt. Its debt level must increase to successfully meet its commitments, irrespective of income generating capacity.)

“Viability of a representative Ponzi unit often depends upon the expectation that some assets will be sold at a high enough price some time in the future.”

“The debt structure is a legacy of past financing conditions and decisions. The question this analysis raises is whether the future profitability of the business sector can support the financial decisions that were made as the current capital-asset structure of the economy was put into place.” “Inflation Recession and Economic Policy,” (p. 25)

“For speculative and especially for Ponzi finance units a rise in interest rates can transform a positive net worth into a negative net worth. If solvency matters for the continued normal functioning of an economy, then large increases and wild swings in interest rates will affect the behavior of an economy with large proportions of speculative and Ponzi finance.” “Inflation Recession and Economic Policy,” (p. 29)

“The big conclusion of these papers (combined in “Inflation, Recession and Economic Policy”) is that the processes which make for financial instability are an inescapable part of any decentralized capitalist economy – i.e., capitalism is inherently flawed – but financial instability need not lead to a great depression; ‘It’ need not happen…”

The brilliant Hyman Minsky viewed Capitalism as “a dynamic, evolving system… Nowhere is this dynamism more evident than in its financial structure.” He saw long periods of stability as breeding grounds for increasingly destabilizing behavior. Economic agents progressively reach for profits, risk and leverage, in the process constructing more fragile debt structures. When he died in 1996 he had spent much of his life hypothesizing as to whether the financial backdrop could reach a sufficiently fragile state where “It” (a depression) could happen again. If only he had lived another decade.

I have proposed a “Minskian” evolution from Money Manager Capitalism to “Financial Arbitrage Capitalism.” Command over the Credit system – hence the “capitalist economy” – has shifted away from “corporate boardrooms” and “institutional investors” to investment bankers, derivative players, and the “leveraged speculating community.” Moreover – and in a momentous departure from Minsky’s era – the consumer loan has become the locus for system Credit creation, supplanting business borrowing to finance capital investment. Thinking Minsky, one can confidently suggest that such historic financial system change provides monumental implications for the nature of both economic development and system stability.

The current environment is remarkable in so many ways. For one, many knowledgeable and seasoned analysts speak today of a “secular decline in volatility.” After the global tumult experienced during the second half of the nineties and the first few years of the new millennium, there is now expectation that we have commenced a period of financial and economic stability (confirmed by economic resiliency and minimal marketplace risk premiums and “implied volatilities”). Yet, Thinking Minsky, the extraordinary advance in risk-taking and debt that transpired over the past decade is much more consistent with mounting financial fragility and system instability. Indeed, one can make a strong “Minskian” case for the progression over the past decade to a perilous state of Systemic Ponzi Finance. What gives?

Evolution to Financial Arbitrage Capitalism gained significant momentum during the early nineties. A flurry of major financial innovation was well underway, with securitization, derivatives and securities-lending operations beginning to gain clout on Wall Street. This process then accelerated rapidly when the banking system’s hangover (from late-eighties excesses) provoked a remarkable response from the Greenspan Fed (Fed funds declined from 9.75% in June of ‘89 to 3% by Sept. ’92). Powered by cheap and abundant liquidity, Wall Street was willing and able to step into the Credit system void created by bank and S&L impairment. Moreover, easy money provided a bonanza for the fledgling hedge fund community, borrowing artificially cheap short-term "money" and lending long. Treasury bonds and mortgage-backed securities quickly became coveted commodities for the leveraged players. Leveraged speculator and derivative player tumult in 1994 only conditioned the Fed to approach future rate increases in a more cautious and transparent manner. An audacious symbiotic relationship was born.

And if Fed policies played the leading role in nurturing the evolution to Financial Arbitrage Capitalism, the government-sponsored enterprises were right on their coattails. Wall Street and the fledgling arbitrage establishment were in need of a securities boom that only “big government” could bestow – while savvy politicians were keen for a booming economy. The GSEs provided government backing for the blossoming MBS marketplace, at the same time offering huge quantities of perceived government guaranteed debt (with a stable spread to Treasuries!) as they ballooned their balance sheets. GSE liabilities actually increased $1.269 Trillion during the nineties, expanding 280% to $1.723 Trillion. GSE debt expanded 24% ($151bn) during the hedge fund rout of 1994, with a 28% gain ($305bn) during infamous 1998 and 23% in less infamous 1999 ($317bn). Not only had the burgeoning leveraged speculating community received the bounty of unlimited low-cost and predictable short-term finance, the GSEs offered central bank-style “buyers of first and last resort” operations for the entire MBS marketplace.

The character of the marketplace – the nature of financial arrangements as well as market perceptions of risk and uncertainty - was altered radically. A revolutionary new type of Credit system emerged. “Big government” pegged the cost of cheap liquidity, while at the same time cultivating “The Moneyness of Credit.” Innovations in securities finance provided unlimited capacity to leverage financial instruments, while no quantity of MBS or GSE debt issuance would put at risk their coveted AAA rating (and stable spread/risk premium!). There were no restraints on liquidity creation. Better yet, Wall Street had developed its own system to create its own liquidity. All it lacked was an unlimited supply of new loans (enter asset-based lending and The Mortgage Finance Bubble!).

Financial history had witnessed nothing remotely similar. Not only had Financial Arbitrage Capitalism ushered in a New Era of Credit Availability, the capacity for unrestrained marketable securities-based Credit expansion divorced the demand for borrowings from its cost. Instead, the price of finance was set through interplay between the Federal Reserve and the expansion of leveraged speculating community holdings. And the greater the system succumbed to speculative and leveraging excess, the more the Fed pandered to The New Capitalists. The more powerful the “arbitrageurs” the more expedient it became for the Greenspan Fed to use them as the key mechanism for stimulating/inflating the markets and economy. (I am, strangely enough, reminded of the Aaron Neville lyrics “Oh just keep on using me until you use me up.”)

Especially after the telecom and corporate debt debacles of 2001/2002, the financial arbitrageurs needed no further convincing that mortgage and government debt were superior to corporates for leveraging and trading. And with the Fed again collapsing interest rates, The Crusade for Yield harbored unprecedented demand for subprime, ARM, and increasingly exotic mortgage loans. Then later, when the Fed forewarned of a gradual increase in rates, the entire Credit system had adequate time to gravitate to adjustable-rate loans (no '94 crisis here!). The speculative mania for mortgage paper in the financial sector was, predictably, matched by an unfolding National Housing Mania altering the underlying structure of the real economy. By the time the GSEs stumbled, ongoing rampant mortgage Credit and housing inflation assured that “private label” MBS and ABS garnered “moneyness” attributes (and predictable spreads!).

The new financial apparatus has made certain that mortgages and consumer spending have ridden roughshod over the traditional mainstay - business loans and investment. This has been a profound development with respect to both the nature of economic development and system stability, although the ramifications are today barely noticeable. After all, an unprecedented explosion in mortgage debt, huge government borrowings, ballooning central bank balance sheets, and untold speculator leveraging together provide a seductive wall of liquidity/cash flow to corporate America. This has given the New Paradigmers a new (short) lease on respectability, this time mistakenly believing that “productivity,” “efficiency,” superior investment and “intellectual capital” are responsible for the American profit windfall. Market analysts are wont to extrapolate today’s abundant liquidity, low rates and reduced “volatility,” while leading policymakers trumpet a “global savings glut.” Caution and previous thin margins of safety are deemed dangerous to one’s financial health.

Thinking Minsky, today’s Mortgage Finance Bubble is history’s most spectacular bout of Ponzi Finance. Household Net Worth has never been higher, as huge increases in borrowings are rewarded with multiples of nominal dollar asset inflation. Still, massive and unrelenting debt growth are necessary to sustain the housing mania, while the U.S. Bubble economy is vulnerable to any reduction in mortgage Credit growth or reversal in housing price inflation. The Credit losses associated with atrocious lending standards and inflated prices are held at bay only by expanding quantities of Ponzi Mortgage Credit. Narrow risk premiums – and the viability of mortgage securities “arbitrage” – are dependent upon unending mortgage lending excess.

Meanwhile, maladjusted U.S. and global financial markets are susceptible to any compression in marketplace liquidity. And, “If solvency matters for the continued normal functioning of an economy, then large increases and wild swings in interest rates will affect the behavior of an economy with large proportions of speculative and Ponzi finance.” Sure enough, system fragility has the Fed Locked in Feeble Baby-Step Tightening-Lite and the speculators fat, happy and complacent. And, curiously, the inflationists – so Enthusiastically Cheerleading the Evolution to Precarious Mortgage Ponzi Finance Excess – today argue that the economy is too vulnerable and the system too leveraged to raise short-term rates above 3.5%. Apparently, these Proponents of Perpetual Ponzi believe it is preferable public policy for this scheme to grow to eternity.

Minsky wrote that “Ponzi financing units cannot carry on too long.” In his analytical world, the inflationary boom would abruptly run up against overheated demand for borrowings and resultant upward pressure on interest rates - the kiss of death to Ponzi Finance units. Ironically, “Minskian” innovation in central banking and financial arrangements abrogated a central facet of his analysis. And Minsky’s analytical framework also did not incorporate $700 billion U.S. Current Account Deficits or $3.8 Trillion global central bank holdings of foreign reserve assets.

Minsky was, however, keenly focused on how central bank validation of speculative practices guaranteed a more precarious inflationary boom. Never has such excess been “validated” and on such a global scale. Financial Arbitrage Capitalism, with its fixation on asset-based lending, leveraged speculation, U.S. consumption and massive Credit inflation, has taken the world by storm. Finance has evolved from vulnerable and less than “robust” to exceedingly “fragile” on a global scale, although this fragility is masked by robust housing inflation, ballooning central bank balance sheets, and overly-abundant global liquidity.

Until rising rates, a dollar crisis, or some other major development exposes the acute frailty inherent in Historic Systemic Ponzi Finance, we should be on guard for fascinating developments. Sixty dollar crude is indicative of the swapping of inflating global monetary units for less abundant real things with inherent value and inflating market prices. This could prove contagious. And while the Japanese were content to trade our IOUs for Pebble Beach, Los Angelles office buildings, movie studios, and other overvalued properties, the Chinese are keen on energy, commodities, capital equipment and other resources.

Thinking Minsky, he was keen to have policymakers recognize the “flaw” in Capitalism. I am more inclined to underscore Capitalism’s “vulnerabilities.” However, the critical flaw in Financial Arbitrage Capitalism is that speculation and leveraging excess begets greater excess, with the marketplace woefully incapable of self-adjustment and central banks unwilling to risk reining in The Powerful Speculator Class. And while the leveraged speculating community may be indefinitely satisfied to expand leveraged holdings of increasingly suspect and fragile U.S. (“Ponzi”) mortgage securities and instruments, the rest of the world surely is not. Moreover, the risks associated with a higher cost of finance may have been taken out of the equation, but this only elevates the key issue of how overly abundant cheap finance is utilized in regards to economic development. A prolonged period of Systemic Ponzi Finance – with all the associated weakened debt structures and global financial and economic fragilities - ensures that “It” can happen again.