Stephen King: A 'NICE' lesson for the UK from Japan

Mervyn King, the Governor of the Bank of England, once referred to the past 10 years as the NICE decade. By NICE, he was referring to a period of Non-Inflationary, Consistently Expansionary economic activity.

Back in 2003, when he first used the acronym, he warned that NICE-ness wasn't always guaranteed. Policymakers had enjoyed a relatively easy time, with few inflationary risks and only modest shocks to economic activity. Arguably, they had been helped in their quest for macroeconomic stability through a series of beneficial supply shocks: globalisation and new technologies had both led to faster growth for a given inflation rate or, turned around, lower inflation for a given growth rate.

But how can we tell when the world isn't looking quite so NICE? A casual glance through economic history provides plenty of examples of countries whose economies seemed to be ticking along quite NICEly only to come to an abrupt, and unexpected, halt. Might there, once again, be some signs telling us there's trouble ahead?

The most obvious worries are those associated with inconsistent data that leave all of us, central bankers included, frowning with puzzlement. Normally, we think of faster growth as being an inflationary threat and of slower growth helping to reduce inflation. What happens, though, if growth slows down because of an unwelcome supply-side shock - a big increase in oil prices, for example - that, simultaneously, seems to raise inflationary pressures? What happens if a rise in inflation is accompanied by weakening activity in the housing market?

Faced with these puzzles, central bankers are forced to take risks: the range of possible interpretations of data begins to widen, thereby increasing the dangers of policy failure. Last week's Monetary Policy Committee minutes show that the Bank of England really doesn't know what to think at the moment: the majority of Committee members may have agreed to leave interest rates unchanged but, with one vote in favour of a cut and another in favour of a rise, the only thing that's clear is that there is a lack of clarity on how to interpret the data. At the same time, the Federal Reserve is aware that inflation keeps edging higher in unwelcome fashion, but recognises that the housing market is looking distinctly ropey. As a result, poor Ben Bernanke is finding it hard to persuade markets that he has a clearly defined monetary plan.

Financial markets really don't like it when the data begins to throw out inconsistent messages. Over the past few weeks, we've had rising bond yields, a falling dollar, big declines in equity prices and a host of other worrying signs. Suddenly, the confidence, the oomph, that seemed to support persistent gains in all varieties of financial assets, seems to have ebbed away.

Of course, market reversals are fairly frequent occurrences. Most of them don't, ultimately, amount to very much. Sometimes, however, there are doubts revealed by market movements that, in turn, suggest there may be more than one possible explanation as to what, economically, may be wrong.

An outstanding example of this kind of uncertainty lies with the performance of Japanese financial markets after the stock market bubble burst at the end of 1989. In 1990 and 1991, Japanese investors were convinced that Japan's big problem was one of inflation. They had good grounds for doing so. At the beginning of 1989, the annual rate of Japanese inflation was a paltry 1 per cent. By the end of 1990, inflation had risen to an unwelcome 4 per cent, despite the earlier weakening of the stock market. Faced with this evidence, Japanese government bonds collapsed, with their yields rising from 5 to 8 per cent. Land prices kept rising and the yen fell. In response, the Bank of Japan progressively tightened the monetary screws.

Inflation, however, wasn't really Japan's underlying problem. Arguably, inflation was part of a transition from one set of problems to another. To understand why, it's worth taking a leaf out of the textbooks of the Austrian school of economics.

The Austrians took the view that economic booms typically result from allowing the cost of capital to be too low relative to the expected future return on capital. By doing so, asset values rise rapidly in the short term, provoking increases in leverage and, hence, big increases in spending power. Consumption and investment boom. In effect, people "borrow from the future": while asset prices rise, the economy does very well, but when asset prices subsequently fall, the economy suffers from excessive levels of debt.

In Japan's case, the transition from NICE-ness to DICE-ness (Deflation In a Contracting Economy) was initially associated with higher inflation. In an Austrian world, overly inflated asset prices eventually have to fall. They can either come down in nominal terms - the familiar crash - or they can come down in real terms through higher-than-expected inflation. In Japan's case, both effects happened at the same time. To take Mr King's acronyms a stage further, this transitional period might be known as ICE - Inflation with Constrained Expansion. All you then need is a central bank that hates inflation to ensure that, ultimately, most of the Austrian adjustment has to come through declines in nominal asset values. Then, as surely as night follows day, NICE-ness is replaced by DICE-ness.

The Austrian approach, therefore, sees inflation as no more than a staging post in a transition from balance-sheet-fuelled economic expansion towards balance-sheet-starved economic contraction. Central bankers who regard higher inflation as the central problem, as opposed to a sideshow, may miss the underlying economic challenge: how do you deal with the aftermath of a period of balance sheet inflation when assets and liabilities have risen to excessively high levels? In the early-1990s, the Bank of Japan, under the tough anti-inflation leadership of Governor Mieno, found to its cost that aggressive monetary tightening designed to deal with inflation probably contributed to a an even bigger deflationary effect than might otherwise have occurred.

It might seem odd to be worrying today about the peculiarities of the Japanese economy back in the early-1990s. After all, the UK and the US have more flexible labour and product markets and, arguably, have emerged from their own stock-market weakness relatively unscathed. House prices, however, have risen rapidly in recent years, helped along by unusually low levels of interest rates. Household debt levels have also increased. To an Austrian, these are not good signs. By all means, central banks should worry about higher inflation. But they also need to recognise that higher inflation might be merely a symptom of underlying balance sheet difficulties that could be made a great deal worse should interest rates be raised too far.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com