U.S. war on deflation threatens global economy

["Gary Santos" <evs@xxxxxxxxxxx>]

U.S. war on deflation threatens global economy



Jesper Koll Special to The Daily Yomiuri

Around the world, a growing number of economists are trying to forecast
movements in financial markets on the basis of predictions about what will
happen to economies. Unfortunately, much of this may be a waste of time.
More often than not, the financial markets determine the future course of
economies.

Given the dramatic decline in global stock markets and the relentless drop
in interest rates during 2002, this should make economic forecasting for
this year easy: The world economy may be headed toward a deflationary
decompression. The good news is that central banks around the world are on
to this and are beginning to mobilize for a fight against it. The prospects
for a real fight are serious because the war is being led by the U.S.
Federal Reserve--the very center of the global financial system.

On Nov. 21, Ben Bernanke, who was appointed to the U.S. Federal Reserve
Board in August, made an extraordinary speech titled "Deflation--making sure
it does not happen here." Bernanke made it very clear that the Fed would not
hesitate to implement radical and unorthodox policy to ensure that "any
deflation would be mild and brief."

Bernanke stated that the Fed would not hesitate to buy corporate bonds or
make zero-rate loans to banks against corporate commercial paper collateral,
in addition to being ready to buy foreign government debt.

These are important policy statements that mark a true regime shift. The
U.S.-centered war against deflation is starting. Global central bankers will
have no choice but to follow.

For Japan, the key implication could be negative. There is no historic
precedent of an economy pulling out of deflation, however mild, without a
currency depreciation. So the greater the risk of deflation in the United
States, the harder it will be for Japan to prevent an appreciation of the
yen. The coming U.S.-centered war against deflation may very well force a
sharp acceleration in deflation in both Japan and Europe.

Downward pressure on the dollar is indeed mounting. For years, global
investors put their trust in the United States' future. They regarded the
United States as the best bet for a combination of new technology, new
entrepreneurs and solid policymaking to pull off a super productivity and
growth cycle. They regarded it as the world's largest and richest developing
economy and emerging market.

Think about it: The U.S. economy has low savings and lots of potentially
profitable investment opportunities. Return on capital must thus be high to
attract this investment. In contrast, Japan and Europe are mature developed
economies ensnared in a combination of high savings, excessive domestic
investment and inflexible labor markets.

As a result, Japan and Europe offer a relatively low rate of return on
capital. In the real world, surplus savings thus flow from where returns are
low to where they are high. This was the fundamental bullish case for the
dollar.

Whether a strong dollar is in the best interests of the United States or not
is debatable, but a strong dollar certainly reflects global confidence in
U.S. economic leadership.

However, before long, the dollar may become an overvalued currency, with an
unsustainably large current account deficit and falling import prices
fueling deflation. Thinking the unthinkable, the real concern for the global
economy at the start of 2003 is that the United States will be the last and
largest economy to suffer an emerging market crisis, in which foreign
capital inflows become outflows and the dollar collapses. To defend the
currency, Fed Chairman Alan Greenspan would have to raise rates, causing
Wall Street to crash and the property bubble to burst, and other negative
side effects.

One prescription for such a U.S. crisis would be an International Monetary
Fund-style package. The IMF approach to crisis-hit developing economies says
that the elimination of a current account deficit must be achieved through
deflation rather than through devaluation. The IMF would almost certainly
mandate that the Fed raise interest rates even further, and the budget
deficit be cut to reduce excessive domestic demand.

In reality, of course, the opposite is poised to happen. This is because the
Fed's primary focus is the opposite of the IMF prescription. It wants to
inflate and will do so in a clear, decisive and ruthless manner. Too much
has been learned about the collapse of asset bubbles and the threat they
pose in destabilizing the financial system and unleashing unpredictable
forces of deflation through negative wealth effects.

No, the most likely response to a crash on Wall Street is that rates will be
slashed even further and the world will be flooded with U.S. dollars. The
yen could shoot to 80 yen to the dollar or even higher. This really would
kill any hopes of a global recovery.

Clearly, the United States will not lift a finger itself to stop the
dollar's fall. It has not got sufficient foreign currency reserves to do so.
If private borrowers of nondollar currencies go bankrupt, the U.S.
government will not take responsibility for these private foreign
liabilities--it will simply allow them to default.

Unlike poorer and smaller developing countries such as Thailand, South Korea
or Russia, the United States as the world's largest developing debtor
country can and will force its creditors to deal with the problem.
Specifically, if default causes problems for Japanese banks and life
insurers, the Japanese will have to bail them out. If the yen gets too
strong, the Japanese will have to intervene to support the dollar. The
United States will not borrow from the IMF or deflate domestic demand to
bail out foreign lenders. Instead, the United States will force creditor
countries to reflate demand.

Already over the past few months, the global decline of the dollar may be
signaling that Japan and Europe will be forced to shrink their trade
surpluses--exporting less and importing more--while the United States
exports more and imports less.

To make up for their loss of exports, both Japan and Europe will have to
reflate domestic demand. In other words, right now the world economy is
under the threat of major deflation risk stemming from the U.S.-centered war
on deflation.

Of course, none of this will happen as long as global and U.S. investors are
willing to finance the dream of the United States' superior entrepreneurs,
relentless technological innovation and outstanding policy leadership.

However, if the enthusiasm stops--and history suggests that the higher the
expectations, the greater the room for disappointment--the world's central
bankers and policymakers will have a real policy coordination problem to
deal with.

The best safety net for both Japan and Europe is to speed up deregulation
and foster an entrepreneurial revolution that creates jobs, wealth and the
dream of a productivity explosion. Japan and Europe must start beating the
Americans at their own game and become emerging markets offering high
prospective returns. The more Tokyo and Brussels do to create domestic
growth opportunities, the less they have to fear from U.S. growth
sputtering--and the dollar falling.

Koll is chief economist of Merrill Lynch Japan Securities Co.