The theme of a lot of your research at the moment has been "inflationary tailwinds and deflationary headwinds". How close is the world to entering a bad deflationary environment?
Donovan: The world economy is suffering from a lack of aggregate demand which means people aren't buying enough, or there is spare capacity. We expect this to continue for the next couple of years. Throughout 2003 and 2004 we expect the global economy to perform below trend and downwards pressure on prices will start to come through. The question is, does this downwards pressure on prices lead to a deflationary spiral like it in Japan? It could, but we are expecting policy makers to follow through with their promises and offer reflationary stimulus to counter this deflationary tendency. We have heard clearly from the Federal Reserve in the US that it is prepared to do this to stop deflation from taking hold.
How will they achieve this?
Essentially by lowering interest rates further and boosting the economy. They will also offer tax cuts and increase government spending. This increased support for the economy will fill the void of the wary consumer.
Why hasn't this worked in Japan?
Japan's problems arose when the country started to go into its deflation spiral. There was policy error at this time. There were interest rate hikes as late as 1992 and other appropriate fiscal stimuli were not forthcoming. There was inappropriate stimulus in the form of road and infrastructure construction, when what the country really needed was tax cuts for consumers. The second problem that is specific to Japan is a paralysed financial system. The banking system is not passing money onto the economy. This is seen by looking at a chart of narrow money supply which is controlled by the Bank of Japan and broad money supply which is controlled by the banks – narrow money supply has been growing by about 20% per year as the central bank expands its disbursements, but the banking system is only growing at about 2% a year, so the stimulus that is being supplied by the central bank is stopping at the domestic banks; the money is not getting out into the economy and boosting demand.
Are the banks still nervous about accumulating bad loans, or is there something else at work?
Yes, it is related to the bad loan situation. They are not willing to lend or take on the credit risk. The balance sheets of the banks are still in disrepair and there are some desperate attempts to raise capital at the moment. We might end up with a situation where the banking system has ground to a halt. The problem is that the banking system is the nervous system of the economy and if it is not functioning property then the economy is paralysed.
Could this sort of thing happen in Western markets; where banks become afraid to lend?
It could but I don't think it will. The banking systems in America and Europe are sufficiently sound so there is no threat of this at the moment. And the policy makers understand the threat of deflation so well that there is little risk of policy error. What the Bank of Japan did years ago was deny that there was anything wrong and failed to stimulate the economy. This was their downfall.
Do the Europeans share the Federal Reserve's commitment to fending off deflation?
We're not convinced that the European Central Bank (ECB) is prepared to go down this route yet, but there are promising signs that it is considering the options. Our worry in Europe is Germany. The common interest rate that is currently set for Europe as a whole is not helping Germany which is the sick economy of the continent. Spain probably needs an interest rate about 1% above the ECB rate, the Italians also need a higher interest rate and France is happy with the current level, but Germany really needs a rate lower than the current level. If the ECB rate was set just for Germany and not for the group of economies then we think it would be a whole lot lower than it is now.
Why does this concern you?
Well we think it is a case of policy error. Germany is in such a bad way at the moment and things will get worse if the interest rate doesn't come down. There are a few people in Europe who are now suggesting that the ECB rate be set at a level that is just appropriate for Germany because of its importance in the region. The more help that Germany can get from an aggressive monetary policy, the better. It may lead to more inflation in places like Spain and Ireland but that is a price worth paying to avoid the deflation trap in Germany.
What happens to companies operating under this threat of deflation?
Some companies have been facing deflation for some time. The goods sector has suffered falling prices for quite a while now. So there are companies that have adjusted already by instituting a flexible approach. In some cases this has meant sacking staff but in other cases there has been retention of full-time jobs but a cut back in part-time and contract workers. Companies are also making better use of the equipment that they have bought, they are getting more efficient and they are looking at outsourcing which means jobs may have been lost in one company, but they are gained in another company. In a broad global economic sense employment doesn't suffer in that case. 65% of American workers now have an element of performance related pay which is also making companies more efficient. Lastly companies are seeking cheaper ways of financing themselves to become more adaptable. So flexibility is the key.
Will the US continue to be the benchmark for the world economy or will smaller economies start to divorce themselves from what happens in New York overnight?
It is now impossible for individual economies to divorce themselves from the wider global economy, and the US is extremely important in this global economy. Globalization has taken hold to such an extent; greater than at any time since World War II. If, for example, Irish labour productivity improves this is good news for Ireland but it is also good news for Intel because it is the largest employer in that country. This global integration means that economies are moving in a band that didn't exist 20 or 30 years ago. Countries can't really grow independently anymore.
So what will be the trigger that will encourage the Fed to step in and avoid deflation?
If the Fed does jump in to divert deflation I think this will happen quite late in the day but it will take a very aggressive stance. It will first wait to see if the economy goes into recession and then it will cut rates even further. Then if it sees a sharp increase in corporate bankruptcies, disorderly financial markets that aren't clearing properly and increased defaults in the bond markets this will be a sign that the economy is in a deflationary environment. At that point the Fed will start to buy equities and bonds and take rates down to zero; it will take the radical route.
Is Asia likely to suffer less because it has been working its way out of its own crisis for the last few years?
The way Asia reacted to the crisis has certainly put it in a far better position now and the health of the Asian economy is a lot firmer. Because policy makers acted the way they did and put in the right checks and balances, Asia is likely to cope better with this global situation.
Is China going to be immune to the global downturn?
Possibly. There is a lot of increased production in China and the country offers companies a cheaper place to do their manufacturing at a time when they are looking for efficiencies. So yes it will be immune to some extent.
