European, Japanese, and Ukrainian-Russian deflation
This isn’t a theme post. It is more like the posts I now do on Friday with a bunch of different ideas on important topics. But the underlying theme that interconnects the ideas is a deflationary-style slowdown.
First, in Europe, the CPI is now at a 5-year low of 0.5% for Euroland. Everyone is talking about the prospects of deflation and wondering when the ECB is going to go for QE. I have a slightly different take here. The austerity pill is first and foremost about internal devaluation, which by definition is a deflationary economic policy. So it is to be expected that the periphery is suffering from deflation. That’s the whole point of the last 4 years of hardship.
So I am not concerned about deflation yet. In particular, deflation is aiding the recoupling of periphery bond yields to core bond yields. And that is bullish for European bank capital. On that front, look at Greece for example. Ekathimerini is saying the bond markets are ready to welcome Greece back to market with up to 5-year paper. That was exactly my prediction in February. And this will mean a collapse of 2-year Greek yields out to two years, I have said. Moreover, we have already seen Greek banks go to market for paper. So the reality here is that even Greece, the worst of the lot in the periphery, has partially recoupled and is being treated as a normal debtor.
The question is the real economy. Bank deposits in Greece for example are contracting. And I do not believe this is as much because the banks are stuffed as it is because income and wages are poor and joblessness is high. Deflation is a non-issue at this point, given what has happened in the periphery to date. The question is not about a debt deflation; we have had that. The question is recovery in the real economy.
And to the degree we care about deflation in Germany or other core European countries, you should note that German city house prices are soaring. That speaks more to asset price inflation than consumer price deflation as the real worry in Germany.
In Japan, the fight against deflation has taken on a very monetarist bent, meaning the Bank of Japan has done massive QE. But this time it has been done in conjunction with fiscal stimulus. The result has been rising GDP, rising asset prices and rising inflation. So far, so good. The problem of course is that the unease with deficit spending is still great – especially in the face of government debt to GDP of 230%. So the fiscal side of this policy is now reversing. Tomorrow a huge increase in sales taxes goes into effect. And my prediction is that this will seriously damage economic growth such that deflation once again becomes an issue.
Is Japan where Europe is headed? Perhaps, yes. But is monetary policy the right way to deal with these issues when we are nowhere near full employment. I am sceptical. Just as in Europe, the core issue here is wages and income. Until they rise, any inflation is effectively a tax. And now the consumers in Japan are doubly taxed by inflation and sales tax. That cannot be good for growth.
Now, the Ukraine issue is not really about deflation except regarding the real economy deflating. We are likely to see CPI go up a lot in Ukraine due to the end of subsidies. But I wanted to bring Ukraine into the picture because the FT had a very good article on Russia’s policy toward Ukraine that I think highlights the geopolitical problem there. It is titled, “Who is Vladimir Putin?”
The crux of the Putin story is that despite his flaws and the undemocratic nature of his reign, Putin has brought Russia back to economic power, reducing corruption in the process. On the whole, the Russia of today is a place where the west should want to do business, as compared to Russia at any point over the last century.
Yet the West has always acted as if Russia was an enemy. And to the degree that Russia was prostrate, as it was under Yeltsin, the West treated Russia with disdain. You can still see this in Barack Obama’s words when he recently said that Russia was not a global power that concerned him as a powerful adversary. Obama called Russia a regional actor with limited geopolitical importance. That’s the attitude. And it comes across negatively in Russia in light of the West’s power grab in Eastern Europe.
I think the FT article does a great job highlighting these themes with specific detail. I very much agree with the FT article and think it is a must-read piece to understand why Putin felt provoked into acting in Crimea.
The question now is what Putin does next. If he goes into eastern Ukraine, we will be in another more sinister world, geo-politically, militarily and economically. That’s when deflation would be a real issue. Sanctions against Russia would be justifiably severe and the impact on Russia and the boomerang back onto the EU would also be severe. An economic crisis would be likely, not to mention the likelihood of military conflict and a re-ordering of the geopolitical scene.
The West has no one to blame but itself. The FT points out that:
Two themes run through the souring of the relationship between Russia and the west. The first is the latter’s refusal to countenance Russia’s interests, and the second is its failure to encourage and develop economic ties based on anything deeper than commodities.
Putin got fed up with this and decided to seize the initiative. I believe the West is too wedded to its view that Russia is now a second-rate commodities dependent proto-democracy to take the country seriously. I believe the US will continue to balk at making any concessions to Russia’s interests and diplomacy will go nowhere as a result. Read the comments to the article to understand the viewpoints most Westerners have toward Russia. These people see the article as “nonsense” and “Russian apologist one-sidedness”. That is the same view in US policy circles. And that means the US will not cede any ground to Putin after Russia annexed another European country’s territory, the first time this has been done since World War 2. There is and will be no understanding of Putin’s grievances in the West. Nor will the US cede any ground diplomatically. Putin’s response to American intransigence will be unpredictable.