Disinflation, Again

In comments at the beginning of this week about the battle being waged by central bankers in Western economies and Japan to avoid the onset of deflation, this writer noted that the European monetary authorities particularly may have to loosen policy even further. Statistics for October that had just been released indicated a clear disinflationary trend, with prices rising a mere 0.7% in the eurozone as a whole, the lowest rate in over four years, and easily one of the lowest in the entire post-war period.

Today, the European Central Bank (ECB) did just that - it dropped its key re-finance rate, from 0.5% to 0.25%. Further, ECB head Mario Draghi indulged in a bit of "forward guidance", stating that he expects rates to be very low, or lower, for a long time. The timing of the move has taken markets by surprise, although there had been some talk of a cut later this year. But this further easing of monetary policy should be anything but surprising, given that the economies of southern Europe (Portugal, Spain, Italy, Greece and Cyprus) remain mired in recession and unemployment (quick primer: Italy's finance minister, Fabrizio Saccomanni, last week revised downward his estimate of economic performance to -1.8% for 2013, indicating that the country's longest recession since the second world war was not bottoming out). And because these countries are part of the eurozone currency bloc, individual currency devaluation - a traditional tool for stimulating growth - has not been available to their respective national authorities.

Ultra-low and declining rates of inflation (disinflation) - and the very real threat of this morphing into deflation, which has already started in Greece, which Japan has been fighting for 15 years, and which the world faced in the 1930's - are clearly the principal backdrop for today's ECB action. But the move has had an additional, fully-intended effect today - that of lowering, swiftly and substantially, the value of the euro against other major world currencies. This lowers the price, and hence boosts the competitiveness, of exports from all European countries (even, of course, those from Germany, which hardly need any additional boost).

There is just one risk to this devaluation strategy - that other countries enter the game. (Watch Japan in particular.) Competitive devaluation of the world's currencies, and deflation, are helpful to no one.

Spring No Longer

The unraveling of Egyptian society since the downfall of Hosni Mubarak's regime nearly three years ago - a period which began hopefully, and was even described as an Arab Spring - has taken a further turn this week. The interim army-backed government, that in July deposed Egypt's freely-elected President, Mohammed Morsi, and kept him hidden and under house arrest ever since, yesterday brought the former President and fourteen other leaders of the Muslim Brotherhood into an improvised court room in a police academy, on charges of murder and instilling violence that led to the killing of at least ten protesters last December. This was to be a big, political show-trial, designed to cast an air of legitimacy over the military's removal and arrest of the President.

But the proceedings didn't go well - in fact, they lasted a little over thirty minutes before chaos in the court finally forced an adjournment until early in the new year. Mr. Morsi, refusing to wear a prisoner's uniform, interrupted the proceedings repeatedly, calling the trial and the charges illegitimate, stating that he was the legitimate President of the republic, and protesting that he was forced into the courtroom against his will. A group of journalists then made clear their opposing view, shouting out, "Hang him! Hang him!". No wonder, then, that the judge gave up and postponed the proceedings.

America was evidently concerned - as it turned out, unnecessarily - that the trial would lead to the sort of widespread and violent demonstrations seen so often over the past two years throughout Egypt. Secretary of State John Kerry arrived, unannounced, Sunday night in Cairo, for the first time since Morsi's ouster, meeting with General Abdul-Fattah el-Sisi and his interim government. His message was direct, but hardly intrusive - to not lose sight of scheduling new elections, thereby restoring the democratic process. He urged officials to avoid further politically-motivated arrests, but tellingly made no mention at all of the Morsi trial. Seems that the Secretary did not want to distance America very far from the military government, noting innocuously that "there are questions we have here and there about one thing or another".

So, it appears that Egypt's Arab Spring remains, at best, on hold, with an almost absurd degree of polarization - Islamists on one side, more secular Egyptians on the other - unresolved and, seemingly, unresolvable. The world's attention is focused on General el-Sisi - can he, and will he begin to draw back the army's influence, permitting Egyptians another chance to freely chose a government that can be not only inclusive, but also effective in restoring a battered Egyptian economy.

In/Dis/De-flation

For much of the post-WWII period, the principal challenge facing most world central bank authorities - indeed their sole mandate - was the containment of general price inflation. The apogee of this chronic battle in America was reached during the 1970's, when it became acute: inflation accelerated to reach a peak of over 13% by the end of that decade. Fed Chairman Paul Volcker, appointed in 1979, fought back furiously, raising the federal funds rate continuously to as high as 20% by June 1981. He won his fight - inflation, which peaked at 13.5% in 1981, dropped to 3.2% by 1983. It remained below 5% for the rest of the 1980's and the 1990's, and annual increases in consumer prices through the first decade of this century were similarly modest. Of course, certain asset prices in America - notably house prices - bubbled up through the early 2000's, and then burst in 2007. Near-financial-collapse, and recession, ensued throughout the world economy.

Half a decade later, economies are either growing grudgingly, as in America - well below trend - or remain mired in recession and debt, within either or both the public and private sectors, as in Europe and Japan.  And imagine this: price inflation - of just 2% - is now a goal of policy-makers, rather than an enemy to be struck down. Price deflation (defined simply as a persistent decrease in the level of prices for goods and services) is the new bete noire of central bankers, especially given the lessons of the nearly three decades of deflation/stagnation in Japan, and more recently, given the price disinflation (that is, a slowing in the rate of general price increase) dramatically evident in virtually all developed economies. (Here are the latest statistics: late last week, the euro zone released figures for October indicating that the inflation rate for the region fell to 0.7%, the lowest for almost four years; similarly, a comparable measure of inflation in America was 0.8% in September, compared with 2.1% a year earlier.) 

So, in the wake of unprecedentedly low interest rates and quantitative easing in America, Europe and Japan, the price inflation that many predicted as an inevitable result seems a very long way off - indeed, it seems now that authorities everywhere will need to at least maintain their loose monetary policy for much longer - or, as in Europe, loosen even further - to mitigate unemployment, especially that of the young. Equity prices, and real bond yields, are the benefactors of such an environment. 

Try This

America's economy continues its recovery from the 2007/08 near-collapse of the financial system and the attendant recession, but at a rate persistently below the 3.5-4.5% required to stimulate sustained and substantial employment growth. Further, the notion of America emerging as an engine of world economic growth, as China, India and Brazil slow, Europe stays moribund, and Japan is still rousing itself from its decades of lost growth, seems similarly ethereal. Consumer and especially business confidence are anything but buoyant. And of course the public sector in America seems barely capable of just keeping itself open, to say nothing of running efficiently (think the roll-out of the Affordable Care Act as just one example). This past month, the Federal Reserve became so concerned with this pervasive sluggishness, and political dysfunction, that it stepped back from its plan to begin withdrawing its unprecedented monetary stimulus - indeed, it may now be several quarters before the Fed deems it propitious to taper.

So, within this environment, is it possible to think that there may still be a way to provide the needed spark? In a word, yes. To a significant extent, it is the lack of political leadership and policy direction in Washington that is inhibiting what is always the prime source of employment growth - American corporations, both large and small. These are poised, almost like never before, to invest, because years of aggressive cost-cutting have produced record profits and robust balance sheets. (It is no accident that equity prices are at all-time highs.) But private business investment never occurs solely as a result of financial strength - it is as importantly a function of confidence that, among other things, tax and regulatory rules are clear and stable. And therein lies the rub (think, as just the latest example, the epic, shamefully unfair and unnecessary pursuit of JPMorgan Chase by the Justice Department).

Here's a solution. President Obama should contact Republican House Budget Committee Chairman Paul Ryan and propose a series of five, weekly luncheon meetings with himself, Mr. Ryan and his Democratic Senate counterpart, Chairwoman Patty Murray - just these three. (Such meetings would run concurrently with those of the Congressional Budget Conference, that begin tomorrow and are charged with devising a bi-partisan budget by December 13.) Further, Mr. Obama should set one goal only for the luncheon meetings - a legislative outline for corporate tax reform. Much of the detail has already been properly thought out and presented in the Simpson-Bowles report, so it would be simply a matter of writing the corresponding framework for new tax law.  

At 35%, the United States has the highest nominal corporate tax in any of the world's developed economies, with the inevitable result that American corporations have reported and retained significant profits in more favorable overseas' tax jurisdictions, such as Ireland. Lower the rate, close the outdated loopholes, and watch as profits are repatriated to America, private business investment - and hence employment - surge, and corporate tax revenue received at both the federal and state levels rebounds. No other single policy initiative, short of a fiscal "Grand Bargain", could come close in its impact on the vibrancy of the American economy.

None of this is innovative, or conceptually difficult. But with a President who thinks of himself as a Democrat, rather than the nation's leader, it won't happen.   

Reversed Fortunes

First, a little history. Some 600 years ago, sailors took a final look at the mouth of Lisbon's Tagus River, then set out on what was to become two centuries of Portuguese maritime exploration, trade and colonization. The period - which historians call The Discoveries - was initiated by an aggressive monarchy (beginning with the Kingdom of Dom Joao I in 1415) and a connected merchant class willing to step up and assist the Crown in financing expeditions. It was fueled, as so often was the case, by religious fervor. But the enabler was emerging technology, including the mariners' quadrant and radically new ship and sail design. This was exploited by a remarkable community of Christian, Jew and Arab scholars who descended on Sagres, at the most south-westerly point of Portugal, to develop a new school of navigation, focused on penetrating Prince Henry's obsession - the unknown world beyond the cliffs of Sagres. And, with this support, fearless explorers, with names like Gil Eanes, Bartholomew Dias, Pedro Cabral, Vasco da Gama and Ferdinand Magellan, would burst through one exploration barrier after another to eventually establish a Portuguese empire stretching from Brazil across the Atlantic, to West Africa, around the Cape of Good Hope to India, and then to East Timor and Macau in the Far East. The era was Portugal's apogee; even the Spaniards and Venetians couldn't compete. 

But the Portuguese would never again achieve such heights after the 16th century. The Spaniards, the Dutch, the English, then the Japanese, the Americans and the Chinese, all entered the world trading markets as effective competitors. Fast forward to the 20th century, and Portugal's world dominance had long faded away, to be replaced by a series of assassinations and coups d'etat, fascist and military dictators, the persistent threat of a communist take-over through the 1970's, and desperate, ultimately unsuccessful, attempts to hold on to its remaining African colonies of Angola, Mozambique and Guinea-Bissau. Economic growth over these decades was fitful at best, and by 1986, when Portugal joined the European Economic Community (known today as the European Union), it was the poorest country of Western Europe. It had, however, finally transitioned to a parliamentary democracy.

It remains democratic, and poor, in the 21st century.  Like its much larger Iberian neighbor, Spain, the Portuguese economy is only now beginning to show tentative signs of recovery from its deepest and longest recession in over 40 years. Prime Minister Pedro Passos Coelho and his coalition government ( comprised of center-right and far-right parties) are in the third year of an austerity program, imposed by the so-called Troika of creditors ( the EU, European Central Bank and IMF), in return for a bail-out loan of 78 billion euros.

Massive sovereign debt (127% of GDP), annual budget deficits (falling, but still above 5% of GDP), massive private sector debt (255% of GDP), an unemployment rate of 18%, and political fragility remain the central features characterizing Portugal as 2013 nears an end. Even if the governing coalition manages to hold together, few believe that the country will be able to withstand the further austerity outlined in the 2014 budget without a second bail-out loan. 

Prime Minister Coelho, in announcing the austerity program in 2011, predicted that the country faced two truly "terrible years" as it attempted to comply with the terms. He was right. But he could have just as correctly looked back to the nearly four centuries of decline since the era of The Discoveries and described them, as well, as truly terrible years for a once mighty Portugal.