August 18, 2002
Paul Krugman Sounds Nervous
Paul Krugman sounds nervous. Paul Krugman sounds very nervous. I think he's right: I'm very nervous too--especially given the whispers I hear from Wall Street which suggest that our current problems in corporate reporting may drive large wedges between the interest rates the government can borrow at and the terms on which businesses can raise capital.
SOME DEFLATION THOUGHTS: (8/17/02) A followup on Friday's NYT column: first, Brad DeLong is quite right that there's no such thing as excess capacity for the economy as a whole. I've been vociferous about that myself in the past. What I meant to say was over-investment in short-lived business capital, mainly tech, relative to other resources - which is the sense in which an over-investment model of the business cycle can be justified - the same sense in which business as a whole can find itself with excess inventories. That's a longish story, and quite tricky to model - more when I have some spare time (hahaha!).
Now, about the risks. My back-of-the-envelope estimate of the current output gap is the same as his - 4 percent. That could be wrong - we don't really know how overheated the economy was at its peak. But let's take that number for a minute. Let's also notice that inflation, as measured by the GDP deflator, has come down quite a lot already. It was more than 2 percent in 2000-2001, now it's about 1 percent.
The experience of disinflation during the 1980s suggested that the economy's "sacrifice ratio" - the number of point-years of output gap needed to bring inflation down by one point - was about 4. That number may well have fallen since, as the economy has become more flexible. Now suppose that the average output gap over the next year is at least as high as it is now, surely a realistic possibility. Then by a year from now we could be looking at zero inflation as measured by the GDP deflator - we could indeed be looking at mild deflation.
In short, concerns about future deflation in the U.S. are not wild and crazy: you can quite easily construct a deflation scenario using completely conventional models and not-too-pessimistic numbers. Is this a bad thing? Zero inflation is not a cliff-edge, with an abyss on the other side. But the lower the inflation rate embedded in peoples' expectations, the higher the real interest rate when the Fed funds rate is zero - that is, a slide from mild inflation into mild deflation makes a liquidity trap that much more likely.
Every time I read a news report describing low inflation numbers as good news, I shake my head in disbelief. The more I think about it, the more baffled I get by the Fed's relaxed attitude. (Ben, are you reading this? Shake some sense into your new colleagues!) Nobody expects the output gap to decline much for the next few quarters; the Fed doesn't have an explicit inflation target, but if it did it would be something like the Bank of England's 2.5 percent. Isn't the case for action getting pretty strong?...
The answer is, "Yes."
Posted by DeLong at August 18, 2002 08:05 AM
What do you mean by the Wall Street whispers about corporate reporting? Is Wall Street still more nervous about legal but obscuring reporting than the press might lead us to believe? I know that risk premiums on corporate bonds of all grades are higher than at any time in at least a decade.
What might the problems be: corporate pension fund accounting, options expense, comntinued use of pro forma numbers,...?
Krugman also said to Charlie Rose last week that we should not be misled to thinking that strong productivity growth will automatically translate to strong GDP growth.
Another point about numbers that you and Krugman have mentioned is the extent to which earnings might have been over reported by S&P companies from 1998 to 2001. Could that sill account for the astonishing S&P price/earning ratio?
Also, though we are running a Federal deficit so too has Japan for a decade. While Federal spending is increasing, states and cities are cutting spending. Unless the tax cut were designed anew there seems little room for fiscal stimulus. Perhaps a temporary payroll tax cut.
Consumers need to keep spending but also need to increase savings to offset the investment loses they have experienced. Tricky.
(Tangentially, Paul Krugman's final sentence, itself a correction, needs further correction: as Lord Bubble of Bubbleonians isn't a British citizen, he's Alan Greenspan-san KBE. Krugman doesn't have an email address, with good reason, so here's as good a place as any.)
I think PK and you need to explain why the prospect of deflation is something to be feared in the light of this:
"The fourteen years between 1865 and 1879 represent the longest period of sustained deflation in US economic history. During these years, wholesale prices, on which there are good data, fell at an annual rate of over 6 per cent. The same item that cost $1-00 1865 cost only $0-42 in 1879. This deflation wasn't caused by a decline in the money stock. On the contrary, the nominal stock of money rose by about 15 per cent between 1865 and 1879. The cause was the substantial growth in US real GDP which drove up the demand for money. Between 1965 and 1879, the US population rose almost one third and per capita real GDP rose at roughly 4 per cent per year." [AJ Auerbach and LJ Kotlikoff: Macroeconomics; MIT Press (1998), p. 187.]
Bob Briant (UK)
There had been a rapid runup in prices from 1861 to 1865: a deflation that follows a period of rapid inflation is unlikely to be damaging.
The big reason to be scared, however, is the fear that the structure of the economy has changed a lot since 1879--and the experience of the Great Depression and of Japan in the 1990s both suggest that in a modern economy with a sophisticated and complex web of financial interactions deflation is a dangerous thing.
the whispers I hear from Wall Street which suggest that our current problems in corporate reporting may drive large wedges between the interest rates the government can borrow at and the terms on which businesses can raise capital.
Uh, Brad, are you in possession of "material non-public information"?
Several categories of private credit spreads are now, and have been for a while, at all time highs. This ain't news.
If you know something the market DOESN'T know, I suggest you keep it to yourself, buy some default swaps, and get rich.
If your sources are "whispering" to a politically-connected academic whose writings are (for the all the right reasons) widely followed, I suggest you ask them if THEY are long said derivatives. That's the only reason for them to be whispering this stuff.
Or perhaps you can steer them to folks in the current administratio who might use this kind of information constructively, perhaps to head off a major calamity.
True or Not??
Deflation increases the burden of carry ing debt on a borrower. Debtors notonly see the value of the asset they borrowed money to purchase decrease, but they have less cash to pay off the debt. In a highly leveraged economy(ours?) this could cause a strong cutback in consumer spending.
With ripple effects on the rest of the economy.
I think that deflation is a concern and that lower interest rates are warranted, but the market may be taking care of this. Brad, it says in your textbook that the rate that affects the economy is the real long-term rate. And as you know, that rate has fallen sharply recently. What Edward Yardeni used to call the "bond market vigilantes" are doing Greenspan's job for him, in my opinion.