Tuesday, May 15, 2012

Draghi and Bernanke: A study in contrasts

Barry Ritholz pointed out that the ECB is becoming concerned that Europe is becoming like Japan (see ECB: EU Economy Strikingly Similar to 1990s Japan).
The ECB appears to be understating the similarities between the weak growth outlook in Japan after its domestic asset bubbles popped in the early 1990s and that for the euro area in the present crisis. The performance of the Japanese economy 20 years ago was better than that of the euro area more recently. The Nikkei 225 peaked at the start of 1990. GDP was 7 percent higher 4.5 years later, according to the IMF’s measure in constant prices.

They diagnose the problem as the lack of structural reform:
European policy makers have failed to implement some of the reforms that also proved elusive in Japan. The staff economists stated: “The strong emphasis traditionally placed on job security in Japan may have reduced flexibility by hampering sectoral adjustments in the economy.” This time, only one word needs to be changed to describe the euro area. That is “Japan”.

And the fiscal problems plaguing Japan (and Europe):
The fiscal problems are also comparable. The analysts in Frankfurt said “deteriorating revenues and rising social security spending also contributed to the increase in the fiscal deficit in the early 1990s. To consolidate public finances, the government raised value-added taxes in 1997 with the onset of the Asian crisis, which some observers regard as having postponed the recovery.” Demographic similarities are striking as well.

While the diagnosis is interesting, what's more interesting is the study in contrast in proposed response between the Draghi ECB and the Bernanke Fed, which is also concerned about the United States falling into a deflationary trap, to the problem in Japan.

Mario Draghi's approach is to pressure member states to address these issues directly by offering an implicit carrot and a stick. The carrot the ECB can offer is easy monetary policy should eurozone governments implement these policies. The stick is that, should member governments stray from the prescribed course, to leave them to the mercy of the bond market vigilantes.

On structural reform, which he branded as a "growth compact", he wants governments to implement structural reforms, or what amounts to an internal devaluation in the peripheral eurozone countries (see Draghi's "growth pact" = Internal devaluation). In effect, he wants governments to change the rules so that it's easier to fire people, to take away their pensions, etc.

On the fiscal problem, he wants governments to reduce their deficits through "good austerity", namely lower government spending and lower taxes. Together, these two initiatives form his Grand Plan, which appears to have been endorsed by Angela Merkel, to rescue the eurozone and put it on the path of sustainable growth again.

Bernanke on Japan: Monetary policy can do it all
While the Draghi ECB prefers to operate indirectly, the Bernanke Fed's approach is more direct. Ben Bernanke is known as a academic for his work in the Great Depression. His subsequent work on Japan also reflects his views on what is the appropriate central bank action in the face of deflation. An excerpt from his 1999 paper entitled Japanese Monetary Policy: A case of self-induced paralysis summarizes his opinion quite succinctly [emphasis added]:
I will briefly discuss the evidence for the view that a more expansionary monetary policy is needed. As already suggested, I do not deny that important structural problems, in the financial system and elsewhere, are helping to constrain Japanese growth. But I also believe that there is compelling evidence that the Japanese economy is also suffering today from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult.
In other words, Bernanke acknowledged that there are "important structural problems" in Japan, but he also wrote that monetary policy could conceivably address most of those seemingly intractable structural problems. In a recent news conference on April 25, 2012, Bernanke expanded on his views of what should have been done in Japan [emphasis added]:
Q: [S]pecifically, could you address whether your current views are inconsistent with the views on that subject that you held as an academic?

A: So there’s this view circulating that the views I expressed about 15 years ago on the Bank of Japan are somehow inconsistent with our current policies. That is absolutely incorrect. My views and our policies today are completely consistent with the views that I held at that time.

I made two points at that time to the Bank of Japan. The first was that I believe that a determined central bank could and should work to eliminate deflation, that is, falling prices. The second point that I made was that when short-term interest rates hit zero, the tools of a central bank are no longer — are not exhausted. There are still other things that — that the central bank can do to create additional accommodation.
In other words, do whatever you have to in order to avoid deflation. Lower interest rates. If rates are at zero, then go to quantitative easing and other additional tools to print money - all in the name of avoiding deflation.

Today, both the US and Europe appear mired in a deflation trap. The Draghi solution is to prod member governments to become more Austrian - lower deficits through "good austerity" and structural reforms at the microeconomic level so that it's easier to do business and be competitive. The Bernanke solution is for the Fed to avoid deflation at all costs - ease and print money whenever its specter appears.

By contrast, the current wave of anti-austerity movement in Europe seems to be embracing the Richard Koo solution to Japan's Lost Decades. Richard Koo, who is Nomura's chief economist, has said that monetary responses don't work because in a balance sheet recession, no one wants to borrow and therefore the economy will not grow. His prescription is extremely Keynesian. He calls for the government to spend until it hurts to stimulate aggregate demand - and then spend some more (see his recent presentation slides at an economic conference in Berlin).

It will be years before we know whose approach wins out.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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