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1. Lombard Street Research Monthly Economic Review - November 1999
Professor Tim Congdon, 29th November, 1999
What is really happening to American inflation?
Puzzling data inconsistencies undermine the New Paradigm's credibility
Perhaps the most important question for financial markets at the end of 1999 is, "how has the USA been able to enjoy a four-year-old boom without any rise in inflation?". Against the background of rapidly rising output and employment, the lowness ofAmerican inflation has been both a surprise and one of the key items of evidence in support of the so-called "New Paradigm". (The kemel of the New Paradigm is the claim that the trend rate of produetivity growth in the USA has improved, so that faster growth can be reconciled with stab le inflation at a low rate.) Widespread belief in the Paradigm has been basic to the persistence of extremely ambitious stock market valuations in the USA and elsewhere.
Financial markets were particularly pleased by figures on 28th October showing that in the third quarter the GDP deflator had inereased at an annualized rate of only 0.9%. As the GDP deflator is a comprehensive measure ofprices in the economy, this was taken as impressive confirmation that inflation is under control. The publication of the GDP deflator coincided with that of the "employment cost index", which was up by 0.8% (i.e., at an annualized 3.2%) in Q3, less than in Q2. But, the optimism generated by these inflation numbers may be exaggerated. They came less than a fortnight after poor figures for the producer price index. The PPI jumped by 1.1% in September, largelybut not onlybecause of higher ou prices. In the three months to September the PPI went up by 1.8% (i.e. annualizing at 7.4%). Which set of statisties is reliable? Is American inflation running at 1% or 7 1/2% a year?
The USA's GDP deflator needs to be interrogated. Data on the growth of personal incomes, and so of the wages and salaries which are their dominant component, are of high quality. They show the total wages and salaries bill advancing at present by 6% - 7 1/2% a year. Company announcements point to large increases in profits, of the order of 15% - 20% a year. As wages and profits constitute the great buik of national income, and as national income moves in tandem with GDP, nominal GDP ought logically to be increasing by at least 6% a year and probably by rather more. But that is not in line with the official figures produced by the Department of Commerce. They say that the USA's nominal GDP went up under 6% in the year to Q3 1999 and at an annualized rate of about 5% in the six months to Q3. This looks odd. Also puzzling are inconsistencies between different series on pay growth produced by the Department ofLabor. Its quarterly survey on productivity and labour costs found that in Q3 1998 compensation per hour in the non-farm business sector increased at an annualized rate of 6.2%. By contrast, its monthly payroll survey estimated that in the same quarter non-agricultural hourly eamings went up at an annualized rate of 3.7%. The uncertainty about what is really happening to American inflation undermines the credibility of the New Paradigm.
Professor Tim Congdon i Lombard Street Research Monthly Economic
Review, July 1988
excerpt
International financial commentators have become so obsessed with Japan’s various failures that a very serious macroeconomic disequilibrium now emerging in the USA has been almost unnoticed. A standard line has been “the American economy will slow down when the full effect of the Asian crisis comes through”. This is tantamount to saying that “the American economy will slow down because the balance of payments is moving heavily into the red”.
Indeed, the deficit on the current account of the USA’s balance of payments in 1998 will be the largest that the world has ever seen. Hardly any concern is being expressed by governments or in financial markets about the medium-term implications of this development.
The scale of the deficit would be remarkable even if the USA were a substantial lie creditor nation. But, in fact, foreign-owned assets in the USA exceeded the USA’s foreign assets by over $1,300b. at the end of last year.
The current arts account deficit in the first quarter (Q 1) was $47b. and will undoubtedly increase, perhaps towards $60b., in Q2.
The current account deficit may be $230b. - $250b. in 1998 and a rather higher figure of, say, $300b. in 1999 and 2000.
The USA’s negative position on its international investments (“its net debt”) may by the end of 2000 be almost $2,OOOb., which would be more than twice the value of its exports.
There is little question that the USA will also have a large and widening deficit on investment income. (See pp. 8 - 9 of this Review.) To prevent the external debt running out of control, exports will need to grow faster than imports for an extended period. But this will require a drastic wrench to the growth pattern enjoyed over the last six years. Net exports were a negative influence on GDP in 20 of the 24 quarters to Q1 1998.
What form will this wrench take? Plainly, the growth of domestic demand will have to run at a beneath-trend rate also for an extended period.
But how likely is that in late 1998 and early 1999 after three years of high money supply growth, vast capital gains from the asset price bubble and an extremely buoyant housing market? (Seep. 5, p. 7 and p. 12.) Also helpful would be a lower dollar.
Sooner or later a fall in the dollar is inevitable, but it probably will not happen in late 1998.
The favourable interest rate differential compared with other leading currencies (apart from sterling) protects the dollar and will widen further when the Federal Reserve tightens.
The resolution of the USA’s external disequilibria will begin to become part of policy-makers’ agenda only next year and thereafter.
But the longer the deficit persists, the greater will be foreigners’ accumulation of claims on the USA and the worse the eventual problem of adjustment.
8th July, 1998
Professor Tim Congdon i Lombard Street Research Monthly Economic Review, May 1988
The project to introduce a single currency is the most daring step so far in European integration. Indeed, it can be correctly described as revolutionary.
… The audacity of the single currency project is the more striking, in that it is a "revolution from above" rather than a "revolution from below". The driving force has not been popular dissatisfaction with the existing currency arrangements, but the integrationist ambition of certain members of the European elite, particularly the German Chancellor, the French President and the President of the European Commission.
… These members of the elite emphasize the political nature of the single currency project, not the economic benefits. For example, Chancellor Kohl has said that European economic and monetary union (EMU) should prevent future wars in Europe.
Despite the clarity of this emphasis on EMU's political objectives, some British politicians - such as Mr. Kenneth Clarke, the Chancellor of the Exchequer in the last Conservative Government - have asserted that monetary union does not imply political union. They have said that Britain could participate in EMU without becoming another state in a newly-created United States of Europe.
This paper's theme is that such assertions are wrong.
Membership of a successful monetary union is also, as a logical inevitability, membership of a political union. In such a union a central government separate from, and in most essential respects superior to, the state governments would quickly emerge.
… At least three strands of argument demonstrate the connection between monetary and political union. They are complementary and reinforce each other, with the key element in common being the interdependence of fiscal and monetary policy. A consequence of this interdependence is that the state is necessarily involved in monetary management, both for good and ill.
The first argument highlights the relationship between budget deficits and money supply growth, and the danger of excessive monetary growth for inflation.
... Once the capital of the bank in question has been exhausted, four links come into play. First, the capital of other banks may be available, either because the central bank coerces them into supporting the failed bank (as in "the lifeboat" in Britain in the mid-1970s) or because they see genuine commercial opportunity in absorbing the failed bank's infrastructure.
Obviously, this first link is reliable only if most of the banking system is healthy and profitable. If not, the first link in the chain is severed.
The second link is the resources of the deposit insurance agency, if there is one. (Note that some countries do not have a deposit insurance system. The UK did not have one until 1979.)
Deposit insurance involves the payment of premiums into a central fund by all banks and a promise by that fund to make good depositors' losses up to a certain figure. Deposit insurance is usually for the benefit of small retail depositors. The fund rarely covers losses incurred by corporate depositors or, indeed, losses on loans between banks. In any case the resources of the deposit insurance agency are in most countries rather small compared with the banking system's capital.
In a big crisis - say, of the kind that hit the American savings and loans industry in the early 1990s, or being experienced in Japan today (RE: eller som i Sverige 1992) – the deposit insurance agency may itself be threatened with bankruptcy.
… The Bank of England has sometimes stepped in to support an ailing institution, but its implied investment has been criticised in parliament as "a waste of taxpayers' money", or something of the sort.
… So - if a banking crisis is systemic and deep-seated, and if the resources of the commercial banks, the deposit insurance agency and the central bank have been swept away by a tidal wave of loan losses - who remains to ensure that depositors are paid in full?
The answer, of course, is the government. It has tax-raising and note-issuing powers so that its support for the banking system is theoretically almost limitless. Whatever the formal position, and despite the existence of deposit insurance and central banking, the underlying reality of deposit protection in a modern industrial state is simple. In the final analysis, it is the government that makes sure bank deposits are repaid in full.
But this liability is not unlimited. Crucially, the government of a particular nation is most comfortable when it protect deposits made by the citizens of that nation. (The citizens are also voters.) It does not like giving similar protection to deposits from foreigners.
… However, under EMU deposit protection is to remain a national responsibility, with the concept of "nationality" determined by the centre in which a bank is registered. In principle all banks could register in Luxembourg, but conduct their business (including deposit-taking) in every country of Europe.
This is a recipe for chaos.
… What would happen in the event of a big crisis, in which bad debts had obliterated the capital of several large banks? It was argued earlier that nowadays the last link in the cha in of deposit protection is the government of the country in question. But there is no European government, only the governments of the various European nations.
No definite prediction can be made about the outcome under EMU, but the tendencies are clear. None of the national governments would quickly and willingly inject capital to overcome a banking crisis; every government would blame bank managements and economic conditions elsewhere in Europe for the bank failures, and try to force other governments to meet the cost. As far as possible, national governments would refuse to bail out "European banks". Parliamentary debates would give ample scope for banker-bashing tinged with nationalism and selfishness.
… At worst, the inconsistency between national responsibility for deposit protection and the increasingly transnational character of European banking could lead to the formation of a number of banks like BCCI. This would be a nightmare for banking supervisors and the national central banks.
The obvious way to end the inconsistency, and to restore the traditional chain of security in deposit protection, would be the formation of a European central government.
… Chancellor Kohl is right: the logical accompaniment of EMU is European political union.
However, it is important to understand precisely what is being said.
The three strands of argument developed in this paper show that monetary union without a central government cannot work. Monetary union requires a central government to decide fiscal policy, to receive seigniorage and determine its distribution between regional governments and central banks, and to protect depositors in the event of a systemic banking crisis.
If monetary union is attempted before such a central government exists, the momentum of events will demonstrate the practical necessity of early political union. Political leaders will soon see that they must form a central government which reduces their still nominally "national governments" to the status of regional governments in a federal union.
But the analysis has another implication. Without a central government of the kind described here, monetary union will fail.
The heart of the problem is that a single authority is essential to set the agenda of fiscal and monetary policy, to carry it out and to be accountable for mistakes.
… None of this might matter, if the governments of Europe had understood the consequences of their decisions. But Europe's leaders have not understood what they have done.
Many of them believe that the essence of monetary union is the change from one unit of account to another. They correctly think that the switch from one unit of account to another is a straightforward matter, like decimalisation or metrication, and does not necessitate a radical institutional upheaval.
… The key conceptual mistake of Europe's elite - the belief that the essence of monetary union is a change in the unit of account - is evident in the Maastricht Treaty itself and in the sequence of new bodies created since the signing of the treaty.
The treaty includes a long period from January 1999 to July 2002 (phase B of stage three) in which the legal unit of account has changed, because the euro is said to exist "in its own right", and yet in which notes and coin, the actual media of exchange, continue to be the old national-currency notes.
… Meanwhile the passage of the Stability and Growth Pact, the formation of the Euro-X committee and the refurbishment of the EU "monetary committee" - all of which post-date the Maastricht Treaty - show that EMU was not well-conceived at the start. Instead of being planned well in advance, vital institutions are being cobbled together almost at random.
In this year's Jubilee Lecture Lord Hurd described the EU's approach to the single currency project as a "Maoist leap forward".
He was worried by our neighbours' embrace of radical change for its own sake, regardless of the exact consequences. EMU could indeed prove to be a catastrophe for the integrationist project.
It can work if it leads quickly to a comprehensive scheme of European political union. But, without European political union, it will prove impractical to the point of impossibility.
If so, its failure will be the greatest setback to the cause of European integration since the formation of the European Economic Community in 1957.
