THE DEFLATION FEAR: Finally, a big factor persuading authorities in industrial countries to push for higher growth is the fear of deflation. The canonical example here is Japan, where many are persuaded that the key mistake it made was to slip into deflation, which has persisted and held back growth.
A closer look at the Japanese experience suggests that it is by no means clear that its growth has been slower than warranted let alone that deflation caused slow growth. It is true that after its devastating crisis in the early 1990s, Japan may have prolonged the slowdown by not taking early action to clean up its banking system or restructure over-indebted corporations. But once it took decisive action in the late 1990s and early 2000s, Japanese growth per capita or per worker looks comparable with other industrial Spectre of deflation haunts central bankers
countries (Table 1). Slow aggregate Japanese economic growth may simply be because its population is shrinking, and fewer people are entering the labour force rather than because it is underperforming other developed economies.
What about the deleterious effects of deflation? One worrisome effect of deflation is that if wages are downwardly-sticky, real wages rise and cause unemployment. Yet Japanese unemployment has averaged 4.5 per cent between 2000-2014, compared to 6.4 per cent in the US and 9.4 per cent in the Euro area during the same period. In part, the Japanese have obtained wage flexibility by moving away from the old lifetime unemployment contracts for new hires to short-term contracts. Indeed, with the decline in union power across industrial countries and the increase in temporary or even "zero hour" workers, downward wage flexibility may be significantly higher than previously estimated. While not without social costs, such flexibility allows an economy to cope with sustained deflation.
Another concern has been that moderately low inflation spirals down into seriously large deflation, where the zero lower bound on nominal interest rates keeps real interest rates unconscionably high. Once again, it is not clear this happened in Japan. In the years 1999 to 2012, average CPI deflation ranged between -0.01 per cent in 2004 to -1.3 per cent in 2009, but without any clear spiralling pattern (Figure 1).Spectre of deflation haunts central bankers
Even if deflation is moderate, it may cause customers to postpone purchases and increase savings in anticipation of a lower price in the future, especially if the zero lower bound raises real interest rates above their desired value. In Fig 2, we plot household savings as a share of GDP in Japan against the deflation rate. Again, it is hard to see a sustained pattern of higher savings with higher deflation.Spectre of deflation haunts central bankers
This chart plots the deflation rates and savings ratios for Japan for all years with negative inflation rates since 1980 -1995, 1999, 2000-2005, 2009-2014.
Finally, it is true that deflation increases the real burden of existing debt, thus exacerbating debt overhang. But this is true of any unanticipated disinflation, and is not specific to deflation. If debt is excessive, a targeted restructuring is better than inflating it away across the board.
Regardless of all these arguments, the spectre of deflation haunts central bankers. When coupled with the other political concerns raised by slow and unequal growth listed above, it is no wonder that the authorities in developed countries do not want to settle for low growth, even if that is indeed their economy's potential.
So the central dilemma in industrial economies has been how to reconcile the political imperative for strong growth with the reality that cyclical stimulus measures have proved ineffective in restoring high growth, debt write-offs are politically unacceptable, and structural reforms have the wrong timing, politically speaking, of pain versus gain. There is, however, one other channel for growth - exports.
EMERGING MARKET RESPONSE: If industrial countries are stuck in low growth, can emerging markets (I use the term broadly to also stand for developing or frontier markets) take up the global slack in demand? After all, emerging markets have a clear need for infrastructure investment, as well as growing populations that can be a source of final demand. Why cannot industrial countries export to emerging markets as a way to bolster growth? After all, they have done so in the past.
Emerging markets have no less of an imperative for growth than industrial countries. While many do not have past entitlement promises to deliver on, some have ageing populations that have to be provided for, and many have young, poor, populations with sky-high expectations of growth. Ideally, emerging markets would invest for the future, funded by the rich world, thus bolstering aggregate world demand.
The 1990s were indeed a period when emerging markets borrowed from the rest of the world in attempting to finance infrastructure and development. It did not end well, with credit booms, large unviable prestige projects, and eventual busts. The Mexican Crisis of 1994, the Asian Crisis of 1997-98, and the Argentine Crisis of 2001 highlighted the inability of emerging markets to manage large increases in domestic investment funded by foreign capital inflows. The lesson from the 1990s crises was that emerging market reliance on foreign capital for growth was dangerous. With investment prudently limited to domestic savings, this naturally curtailed their ability to serve as growth engines for the world.
Following the 1990s crises, as the dotted line in Figure 3 indicates, a number of emerging markets went further to run current account surpluses after cutting investment sharply, and started accumulating foreign exchange reserves to preserve exchange competitiveness. Rather than generating excess demand for the world's goods, they became suppliers (or equivalently, savers), searching for demand elsewhere. And the debt-fuelled demand from the industrial countries before the Global Financial Crisis, as indicated by their current account deficits, spilled over into a demand for emerging market goods. The years before the crisis were years of plenty for countries like China that catered directly to industrial country demand, and countries in Africa, Asia, and Latin America that sold commodities and intermediate goods to the direct suppliers.
In 2005, Ben Bernanke, then governor at the Federal Reserve, coined the term "Global Savings Glut" to describe the current account surpluses, especially of emerging markets, that were finding their way into the United States. He argued that these depressed U.S. interest rates, enhancing consumption, and the U.S. current account deficit. Bernanke pointed to a number of adverse consequences to the United States from these flows including the misallocation of resources to non-traded goods like housing away from tradable manufacturing. He suggested that it would be good if United States' current account deficit shrank, but that primarily required emerging markets to reduce their exchange rate intervention rather than actions on the part of the United States.
So pre-global financial crisis, emerging markets and industrial countries were locked in a dangerous relationship of capital flows and demand that reversed the equally dangerous pattern before the emerging market crises in the late 1990s. Sustained exchange rate intervention by emerging market central banks, as well as an excessive tolerance for leverage in industrial countries contributed to the eventual global disaster. But post-financial crisis, the pattern is reversing once again.
Post global financial crisis, much like the emerging markets in the early 2000s, industrial countries have curtailed their investment without increasing their consumption (as a fraction of GDP), thus reducing their demand for foreign goods and their reliance on foreign finance. Spectre of deflation haunts central bankers
Indeed, as the solid line in Figure 3 indicates, advanced economies ran current account surpluses in 2013 and were also projected to do so in 2014, a shift in current account balances of about 1.5 percentage points of GDP since 2008.
The counterpart of this shift of advanced economies from current account deficit (demand creating) to surplus (supply creating) has been a substantial fall in current account surpluses in emerging markets over the same period. This relative increase in demand for foreign goods from emerging markets has come about through a ramp up in investment from 2008, rather than a fall in savings - a shift of 2.7 percentage points of GDP in current account balances between 2008 and 2014. Facilitating or causing this shift has been a broad appreciation of real effective exchange rates in emerging markets and a depreciation in industrial country rates between 2006-2014.Spectre of deflation haunts central bankers
Have industrial country central banks policies, similar to the sustained exchange rate intervention by emerging market central banks in the early 2000s, accelerated this current account adjustment? Possibly, and likely candidates would be what are broadly called unconventional monetary policies (UMP).
A presentation by Dr. Raghuram Rajan, Governor, Reserve Bank of India, at a Public Lecture on 'Going bust for growth: Policies after the global financial crisis' held on June 11, 2015 in Dhaka and organised by the Bangladesh Bank. Dr. Rajan thanks Dr. Prachi Mishra of the Reserve Bank for very useful comments and research support.