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Is the world stumbling into an economic quagmire?

This is the subject header of an email I received from a friend. Full text below:

Paul Krugman: Is the world stumbling into an economic quagmire?
Paul Krugman NYT
Tuesday, May 27, 2003


The meaning of deflation

PRINCETON, New Jersey Suddenly the d-word is on everyone's lips. The
International Monetary Fund has just released a rather ominous report
titled "Deflation: Determinants, risks and policy options." The report made
headlines by suggesting that Germany is likely to join Japan in the
falling-price club.

Alan Greenspan, chairman of the Federal Reserve, hastened to reassure
Americans that the United States isn't at imminent risk of deflation. But
alert Greenspanologists pointed out that he seemed to hedge his bets, and
the fact that he even felt obliged to discuss the issue showed that he was
worried.

Though talk of deflation fills the air, most of that talk is subtly but
significantly off point. The immediate danger isn't deflation per se, it's
the risk that the world's major economies will find themselves trapped in
an economic quagmire. Deflation can be both a symptom of an economy sinking
into the muck, and a reason why it sinks even deeper, but it's usually a
lagging indicator. The crucial question is whether we'll stumble into the
swamp in the first place - and the risks look uncomfortably high.

The particular type of quagmire to worry about has a name: "liquidity
trap." As the IMF report explains, the most important reason to fear deflation is
that it can push an economy into a liquidity trap, or deepen the distress
of an economy already caught in the trap.

Here's how it works, in theory. Ordinarily, deflation - a general fall in
the level of prices - is easy to fight. All the central bank (in America's
case, the Federal Reserve) has to do is print more money, and put it in
the hands of banks. With more cash in hand, banks make more loans, interest
rates fall, the economy perks up and the price level stops falling.

But what if the economy is in such a deep malaise that pushing interest
rates all the way to zero isn't enough to get the economy back to full
employment? Then you're in a liquidity trap: Additional cash pumped into
the economy - added liquidity - sits idle, because there's no point in lending
money out if you don't receive any reward. And monetary policy loses its
effectiveness.

Once an economy is caught in such a trap, it's likely to slide into
deflation - and nasty things begin to happen. Falling prices induce people
to postpone their purchases in the expectation that prices will fall
further, depressing demand today. Also, deflation usually means falling
incomes as well as falling prices. In a deflationary economy, a family
that borrows money to buy a house may well find itself having to pay fixed
mortgage payments out of a shrinking paycheck; a business that borrows to
finance investment may well find itself having to pay a fixed interest
bill out of a shrinking cash flow.

When the prices of goods and services are falling, the prices of assets -
such as houses - must eventually follow suit. So a deflationary economy is
one in which, far from being able to extract cash from their houses by
refinancing, consumers find their equity disappearing.

In other words, deflation discourages borrowing and spending, the very
things a depressed economy needs to get going. And when an economy is in a
liquidity trap, the authorities can't offset the depressing effects of
deflation by cutting interest rates. So a vicious circle develops.

Deflation leads to rising unemployment and falling capacity utilization; this puts
more downward pressure on prices and wages; deflation accelerates, which
makes the economy even more depressed. The prospect of such a
"deflationary spiral," rather than the mere prospect of deflation, is what scares the
IMF - and it should.

A decade ago all of these fears might have been dismissed as mere
theoretical speculation. But in Japan the whole nasty scenario is playing
out, just as the theory predicts. And about five years ago I and other
economists began pointing out that what can happen in Japan can happen
elsewhere. (Part of the IMF report draws on my work on the subject.)

So how seriously should we take the risk that something similar will
happen in the world's other major economies? Neither the United States nor
Europe, outside Germany, is likely to experience serious deflation in the next
year or two. But that's the wrong question - and we should bear in mind that
Japan's economic malaise took a long time to turn into all-out deflation.

In fact, it's striking how gradually Japan's catastrophe unfolded. When
the stock bubble of the 1980s burst, Japan's economy didn't fall off a cliff.

By and large the economy continued to grow, if slowly, and the nation didn't
have a severe recession until 1998. But year after year, Japan
underperformed, growing less than its potential. Though the Japanese
government tried to stimulate the economy using the usual tools - deficit
spending, interest rate cuts - it was never enough. By 1995 or so the
economy had slid into a liquidity trap; by the late 1990s it had entered
into a deflationary spiral.

The American situation is strikingly similar in some ways to that of Japan
a decade ago. Like Japan circa 1993 or 1994, the United States is now facing
the aftermath of a huge stock market bubble. Also like Japan, America
faces a problem not of sharp downturn but of persistent underperformance - an
economy that grows, but too slowly to prevent rising unemployment and
falling capacity utilization.

What's different is that America has Japan as a cautionary example. Is
forewarned forearmed?

Whatever reassurances Greenspan may offer, the staff at the Fed is very
worried about a Japanese scenario for the United States - a concern
reflected in their research agenda. In a major study of Japan's experience
published last year, Fed economists reached two key conclusions. First,
Japan could have avoided its current trap if policymakers had been
aggressive enough, soon enough. But by the time they realized the danger,
it was too late. Second, the Japanese weren't stupid: Their relatively
cautious policies in the first half of the 1990s made sense given not only their
own forecasts, but also those of independent analysts. But the forecasts were
wrong - and the Japanese had failed to take out enough insurance against
the possibility that they might be wrong.

The Fed has taken these conclusions to heart: Once the U.S. economy began
to falter, it cut rates early and often, trying to get ahead of the problem.
Those cuts certainly helped moderate the slump; but at this point, with
the overnight interest rate down to 1.25 percent, the Fed has almost run out
of room to cut. (Fed officials believe, for technical reasons, that going
below 0.75 would be counterproductive.) And the economy remains weak.

The Fed still has some tricks up its sleeve. Now would be a very good time
to announce an inflation target. But it's also clear that the Fed could
use some help, at home and abroad. Alas, it's not getting that help.

The Fed's European counterpart, the European Central Bank, has been far
less aggressive in cutting rates. There are economic, institutional and
psychological reasons for this passivity, but the central bank's
immobility is one main reason why Germany seems set to follow in Japan's footsteps.
European governments aren't much help, either. Bound by the "stability
pact," which limits the size of the deficits they are allowed to run, they
have been cutting expenditure and raising taxes even as their economies
falter.

The Bush administration is, of course, notably unconcerned about deficits.

Aren't the tax cuts in the pipeline exactly what the economy needs? Alas,
no. Despite their huge size - if you ignore the gimmicks, the latest round
will cost at least $800 billion over the next decade - they pump
relatively little money into the economy now, when it needs it. Moreover, the tax
cuts flow mainly to the very, very affluent - the people least likely to spend
their windfall.

Meanwhile, state and local governments, which are not allowed to run
deficits - America has its own version of the stability pact - are
slashing spending and raising taxes. And both the spending cuts and the tax
increases will fall mainly on the most vulnerable, people who cannot make up the
difference by drawing on existing savings. The result is that the economic
downdraft from state cutbacks (only slightly alleviated by the paltry aid
contained in the new tax bill) will almost certainly be stronger than any
boost from federal tax cuts.

In short, those of us who worry about a Japanese-style quagmire find the
global picture pretty scary. Policymakers are preoccupied with their usual
agendas; outside the Fed, none of them seem to understand what may be at
stake.

Of course, it's possible, maybe even likely, that their nonchalance will
be vindicated. Most analysts don't think America will find itself caught in a
liquidity trap. And even the Fed believes - or is that hopes? - that a
surge in business investment will save the day.

But few analysts saw the Japanese quagmire coming either, and there is now
a significant risk that Americans will find themselves similarly trapped.

Even so, America won't have deflation right away. But by the time it does, it
will be very hard to reverse.

Like the Fed, I hope that doesn't happen. But hope is not a plan.


Time Flies..

Time does fly like a breeze. The past 2-3 weeks had been like crazy. My brother had a major op and my uncle passed away. It was crazy planning time to help my brother out and my mom. But it had been worthwhile.

Also in the past week, I have been doing more action than just enjoying leisure. Hey, I realise if I don't, then I am blowing our future away.

Hope you give yours a thought too. Remember, it's not just about you only.