Uncertainty, deflation and interest rates question

[DRumsfeld2000]

The information below is from an article by AE-P of the Daily Telegraph. In the situation described below I would like to know what people think would happen to European interest rates. If it is like Japan then one would expect them to remain low for a long time, but with the possibility of the European Union breaking up this may not happen as each country will have to raise funds in an environment of uncertainty.



Mr Legrain said the failure to stress test for deflation is a grave error. Given that it would wreak havoc with banks’ balance sheets, it is a farce. Deflation raises real interest rates and it raises the debt burden,” he said.

Even “lowflation” of around 0.5pc is already causing debt ratios to shoot up across southern Europe, rising by 5pc of GDP each year in Italy despite a large primary surplus. A deflationary trap would revive fears of a debt crisis in these countries, with contagion effects for banks holding government bonds. The “vicious circle” between the states and banks remains despite talk of a banking union.

“It is very telling that the ECB chose to ignore deflation because they themselves are responsible for it,” said Professor Richard Werner, from Southampton University and a former adviser to Japan.

“What we learned in Japan is that deflation automatically leads to bankruptcies because nominal GDP is shrinking. Japan had 20 big banks in 1990 and now it has three. Deflation was the mechanism that brought this about. The ECB is following exactly in the footsteps of the Bank of Japan,” he said.

[GRG55]

Re: Uncertainty, deflation and interest rates question

The information below is from an article by AE-P of the Daily Telegraph. In the situation described below I would like to know what people think would happen to European interest rates. If it is like Japan then one would expect them to remain low for a long time, but with the possibility of the European Union breaking up this may not happen as each country will have to raise funds in an environment of uncertainty.



Mr Legrain said the failure to stress test for deflation is a grave error. Given that it would wreak havoc with banks’ balance sheets, it is a farce. Deflation raises real interest rates and it raises the debt burden,” he said.

Even “lowflation” of around 0.5pc is already causing debt ratios to shoot up across southern Europe, rising by 5pc of GDP each year in Italy despite a large primary surplus. A deflationary trap would revive fears of a debt crisis in these countries, with contagion effects for banks holding government bonds. The “vicious circle” between the states and banks remains despite talk of a banking union.

“It is very telling that the ECB chose to ignore deflation because they themselves are responsible for it,” said Professor Richard Werner, from Southampton University and a former adviser to Japan...

Perhaps the reason they ignore deflation scenarios is that there is no adequate policy response in the Central Bank arsenal once it gets underway in earnest in an economy?

...“What we learned in Japan is that deflation automatically leads to bankruptcies because nominal GDP is shrinking. Japan had 20 big banks in 1990 and now it has three. Deflation was the mechanism that brought this about. The ECB is following exactly in the footsteps of the Bank of Japan,” he said.

Maybe the reason there were 20 big banks in Japan in 1990 has something to do with this?

Bubble period (1982 to 1990)

Real-estate prices across Japan rose by as much as six to seven times during the 1980s asset bubble. Confidence was strong as the Japanese economic model, often referred to as “Japan Inc.” seemed to be invincible. Japanese corporations awash with cash made speculative purchases of real-estate and corporate assets all over the world. At home in Japan, low interest rates and loose monetary policy fueled a strong economy and high stock prices. Following the Plaza Accord in 1985, the yen appreciated from around 240 yen to the USD to about 120 yen in less than a year. In response, the Bank of Japan lowered interest rates from 5.5% down to 2.5% in 1987. This dramatic easing of monetary policy at a time of economic strength sparked an explosion of real-estate transactions and high stock prices. Adding fuel to the fire, the government under Prime Minister Nakasone, reduced corporate tax rates from 42% to 30% and slashed top marginal income tax rates from 70% to 40%. It was said at the time that the value of the Imperial Palace in Tokyo exceeded the value of all the real-estate in California. Land in Ginza 4 Chome was reported to have traded at JPY 90,000,000 ($750,000 at the time) per square meter.

And once that great bubble bursts, there isn't a need for so many banks now is there? Unless, of course, they are SIFI, in which case they get bailed out by politicians at taxpayer expense.

[jk]

Re: Uncertainty, deflation and interest rates question

i would think that draghi's "anything it takes" approach obviates any need to think about deflation, at least in theory. it is one of many scenarios that are NOT officially analyzed. you mentioned the one with the most impact- the breakup of the eu or at least the withdrawal of e.g. the uk. such an idea is a double-plus ungood thought crime, so it will not be analyzed or discussed in any official forum or report.

[EJ]

Re: Uncertainty, deflation and interest rates question

i would think that draghi's "anything it takes" approach obviates any need to think about deflation, at least in theory. it is one of many scenarios that are NOT officially analyzed. you mentioned the one with the most impact- the breakup of the eu or at least the withdrawal of e.g. the uk. such an idea is a double-plus ungood thought crime, so it will not be analyzed or discussed in any official forum or report.

The anti-deflation policy tool that cannot be explicitly discussed in policy circles is The Foolproof Way of currency depreciation.

An increase in a country’s money supply causes interest rates to fall, rates of return on domestic currency deposits to fall,
and the domestic currency to depreciate.



Money supply up, USD down, imports price inflation up, inflation expectations up, CPI up. And vis versa.

I understood in 2007 that The Foolproof Way was certain to be deployed in the future in order to prevent the U.S. economy from falling into a deflationary liquidity trap as Japan's economy did when it's bank-financed property bubble collapsed. Unlike the Bank of Japan, that for political reasons dithered and argued with the legislature as the ship went down, the Fed was ready with it's fingers on the keyboard.

Also keep in mind that today the management of policy is entirely computerized whereas in the early 1990s the tools and models were relatively primitive. The software the Fed uses to model the economy and markets today has been described to me as "the best that billions in R&D can buy."

Back in those days when I was forecasting currency depreciation as a policy tool the other major economies of the world were not so much in need of currency depreciation themselves to stay out of the deflation zone. How does The Foolproof Way work when inflation is low in major economies, which economies are also trying to work their way out of output gaps?

The answer is that they take turns. Since early 2013 it's been Japan's turn.

A concerted effort to weaken the yen has produced the desired inflation rise.

But what about in the case of a new global credit market crash and deflationary shock? Can every economy depreciate at once?

They cannot. Instead only one country will depreciate -- the U.S. again -- and the rest will reflate via fiscal policy and QE.

Why will the U.S. get to depreciate when the others cannot?

Because if the U.S. goes down it's game over for the IMS.

[Milton Kuo]

Re: Uncertainty, deflation and interest rates question

The answer is that they take turns. Since early 2013 it's been Japan's turn.

Holy cow. Was it only Japan's turn last year or were they sharing a turn with the U.S.? If over one trillion dollars of QE by the Federal Reserve does not constitute a turn for the U.S., I cannot imagine how much funny stuff is going to happen when it is the U.S.'s turn and we choose not to pass.

[EJ]

Re: Uncertainty, deflation and interest rates question

Holy cow. Was it only Japan's turn last year or were they sharing a turn with the U.S.? If over one trillion dollars of QE by the Federal Reserve does not constitute a turn for the U.S., I cannot imagine how much funny stuff is going to happen when it is the U.S.'s turn and we choose not to pass.

QE does nothing to expand the money supply. Ignore the repeated nonsense in the business media about QE as "printing money." QE stimulates demand via a separate asset price inflation channel through wealth effects.

[porter]

Re: Uncertainty, deflation and interest rates question

QE does nothing to expand the money supply. Ignore the repeated nonsense in the business media about QE as "printing money." QE stimulates demand via a separate asset price inflation channel through wealth effects.

EJ, can you explain how this works, step-by-step?

[astonas]

Re: Uncertainty, deflation and interest rates question

duplicate

[astonas]

Re: Uncertainty, deflation and interest rates question

i would think that draghi's "anything it takes" approach obviates any need to think about deflation, at least in theory. it is one of many scenarios that are NOT officially analyzed. you mentioned the one with the most impact- the breakup of the eu or at least the withdrawal of e.g. the uk. such an idea is a double-plus ungood thought crime, so it will not be analyzed or discussed in any official forum or report.

I'm partly with jk on this one. Brexit may still be officially anathema. But that is different from saying that it is universally seen as a bad thing in private. I would argue that many smaller northern nations would privately welcome less Anglo-Saxon interference as they join in pursuing their own, very different, vision for the EU. The EU would certainly be smaller, but it would also be able to finally reign in some egregious practices that City of London vetoes currently safeguard.

However, while Draghi's "anything it takes" line is often cited, doesn't it rather depend on him still being there when the pinch comes? Rumors are of course just that, but this one has been around a while. I think I first heard it around the French elections in March:

http://www.marketwatch.com/story/hol...fts-2014-03-31

One possibility is that sweeping personnel changes could take place in the next two years under which Jens Weidmann, the Bundesbank president, becomes head of the ECB. Mario Draghi, could before too long face persistent calls to return to Rome to take over the presidency of Italy from Giorgio Napolitano, the 88-year-old head of state. Napolitiano and many others may believe his replacement by a younger man with a reputation for international economic management could accelerate Italy’s tenuous progress in economic reforms — arguably the euro area’s most difficult and crucial economic task.

If Draghi were to bow out in 2015, halfway through his eight-year term, he would depart as a much-feted euro savior after his so far (and probably never to be) unrequited 2012 promise to purchase unlimited quantities of government debt. As a former governor of the Banca d’Italia, Draghi would follow in the footsteps of Carlo Ciampi, the former central bank governor who was prime minster in 1993-94 and head of state between 1999 and 2006.

Draghi would certainly leave Frankfurt with Germany’s blessing, all the more because this would pave the way for Weidmann to take over at the ECB.

[astonas]

Re: Uncertainty, deflation and interest rates question

However, while Draghi's "anything it takes" line is often cited, doesn't it rather depend on him still being there when the pinch comes? Rumors are of course just that, but this one has been around a while. I think I first heard it around the French elections in March:

And just in case anyone still questions whether Europe is capable of kicking the can down the road long enough for the leadership change to take place, a legal challenge that could do it has already been outlined:

http://www.businessweek.com/videos/2...ds-to-eu-court

[jk]

Re: Uncertainty, deflation and interest rates question

I'm partly with jk on this one. Brexit may still be officially anathema. But that is different from saying that it is universally seen as a bad thing in private. I would argue that many smaller northern nations would privately welcome less Anglo-Saxon interference as they join in pursuing their own, very different, vision for the EU. The EU would certainly be smaller, but it would also be able to finally reign in some egregious practices that City of London vetoes currently safeguard.

However, while Draghi's "anything it takes" line is often cited, doesn't it rather depend on him still being there when the pinch comes? Rumors are of course just that, but this one has been around a while. I think I first heard it around the French elections in March:

if draghi is replaced by weidmann eurozone stock markets, and every sovereign eurozone bond market save germany's [maybe the netherlands too?] will crash. the euro itself will rise and deflation will be on weidmann's doorstep.

[charliebrown]

Re: Uncertainty, deflation and interest rates question

Please correct me if I am wrong, but QE would expand the money supply IF the banks would use the cash to make loans instead of parking it as excess reserves at the fed.

Our friend Mr. Bart shows M1, M2 and M3 increasing 5% Y-o-Y, however YOY rate is decreasing starting in 2014. Any Ideas on a target rate, and how long does it take increases in the money supply to start effecting CPI. Billion Price shows 2%+ inflation and trending down since the beginning of the year.

[astonas]

Re: Uncertainty, deflation and interest rates question

if draghi is replaced by weidmann eurozone stock markets, and every sovereign eurozone bond market save germany's [maybe the netherlands too?] will crash. the euro itself will rise and deflation will be on weidmann's doorstep.

I agree that it would be the culmination of a slow but massive shift in the European power structure, which will of course be reflected in the markets, just as any similarly large shift is, once it becomes apparent.

I'm not sure if you are arguing that this means that it can't happen.

I certainly don't think it's a forgone conclusion, but I can't imagine that Draghi hasn't been tempted by Napolitiano's rather overt hints. This gives him an out before things get really ugly, and gives the Germanics what they want as well. If you were Draghi, would you choose to stay and be a symbol of the bleakest times, or would you leave while you can claim to have fought the good fight while you could?

I also don't think the crash will be be quite so extensive as to only exclude Germany and the Netherlands. People always seem to forget the large number of other voting member states that tend to support the same basic monetary philosophy, many of whom could wind up net winners for that very reason (if perhaps at others' expense):

Austria, Estonia, Finland, Latvia, Luxembourg, the Netherlands, Slovakia, and Slovenia all have their reasons to favor Germany's approach some, if not all, of the time. And they do get to vote. (For those counting, that's 9/18 Eurozone members right there.) Even Belgium sides with them on occasion, as do other states depending on the issue at hand. And the ECB Governing Council heavily represents the philosophy as well:

Mario Draghi, President of the ECB	Vítor Constâncio, Vice-President of the ECB	Benoît Cœuré, Member of the Executive Board of the ECB
Yves Mersch, Member of the Executive Board of the ECB	Sabine Lautenschläger, Member of the Executive Board of the ECB	Peter Praet, Member of the Executive Board of the ECB (Chief Economist of the ECB)
Luc Coene (Belgium)	Jens Weidmann (Germany)	Patrick Honohan (Ireland)
George Provopoulos (Greece)	Luis María Linde (Spain)	Ardo Hansson (Estonia)
Christian Noyer (France)	Ignazio Visco (Italy)	Panicos O. Demetriades (Cyprus)
Gaston Reinesch (Luxembourg)	Josef Bonnici (Malta)	Klaas Knot (Netherlands)
Ewald Nowotny (Austria)	Carlos Costa (Portugal)	Boštjan Jazbec (Slovenia)
Jozef Makúch (Slovakia)	Erkki Liikanen (Finland)	Ilmārs Rimšēvičs (Latvia)

So often Europe gets oversimplified down to Germany vs. the south, or vs. France, or the UK. If this was just about Germany, I would completely agree Weidmann couldn't get the post, that other nations would stop it. But it's not just Germany, is it? It's the germanic monetary philosophy, which extends well beyond the borders of Germany itself. That is the "conquering army" here, not any given nation.

Germany does get the attention, as someone must. But if it were alone, it wouldn't be able to wield even a fraction of the influence it regularly demonstrates, economic strength notwithstanding. If it were just Germany driving this, there wouldn't even BE an ongoing Eurozone crisis, only a sacking and distribution of Berlin's gold reserves.

And of course, all of the above is asserted with the caveat that Europe is too complicated to be encapsulated by ANY brief answer. (if nothing else, take a look at "map" number 3 for a glance at all the additional nations outside the Eurozone that exert varying degrees of external influence on Eurozone policy, and apply their own pressures on nations within it through EU actions.)

[jk]

Re: Uncertainty, deflation and interest rates question

i think draghi's self-image is beyond my imagining. he may think that staying in his current position, being ready to do "whatever it takes," and keeping weidmann out of it is the greatest service he can do. who knows?

[icm63]

Re: Uncertainty, deflation and interest rates question

EJ..."Because if the U.S. goes down it's game over for the IMS."..

IMS = What? Increase Money Supply ???? Correct