Last week, when looking back at consensus economist forecasts for Japanese growth as of 1995, we compared what the pundits thought would happen, and what actually did happen: the result was what may have been the worst forecast of all time, leading to a 25% error rate in just five years later. It also unleashed the start of Japan’s three lost decades.
But while laughably wrong economist forecasts are nothing new, a more troubling observation emerges when comparing the evolution of Japan’s 10Y yields start in the 1990s…
…with those in the rest of the western world, which are slowly converging with Japan and the Y-axis.
Looking at Japan’s miserable fate ever since the bursting of the 1980 asset bubble, HSBC’s Stephen Major recently said that “finding an explanation for Japan’s ongoing economic weakness is a bit of a ‘chicken and egg’ problem. Was the high level of debt associated with the bubble the key constraint on subsequent economic expansion? Or was the unexpectedly-weak economic expansion a key reason why debt was so indigestible? In truth, the causality ran in both directions, suggesting that Japan – at least in nominal terms – found itself caught in a ‘doom loop’, a world in which policy stimulus did little to help Japan return to the dynamism seen in earlier decades.“
King then extrapolates the case study of Japan’s “deflationary stagnation” to the “slow puncture” he observes in the rest of the developed world, and provides several ways of previewing of what may lie in store for the world if using Japan as the canary in the coalmine.
As he says, the world economy’s slow puncture reflects five factors:
- Ineffective monetary policy, most likely at the zero rate bound.
- An absence of economic strength in other parts of the world, reducing the efficacy of exchange rate devaluation.
- High levels of debt in both the private and public sectors implying (i) ongoing private sector deleveraging; (ii) limited room for fiscal action; and (iii) low fiscal multipliers as a result of Ricardian behaviour.
- Low rates of nominal expansion and flat yield curves, both of which place downward pressure on bank profitability, thereby limiting the ability and willingness of banks to extend credit, particularly to more risky borrowers.
- Persistent downward pressure on bank share prices, thanks in part to overly-optimistic revenue projections that, in turn, leave costs too high. Put another way, weak nominal growth is likely to leave the industry excessively large.
In Japan’s case, escape from stagnation has proved difficult. Admittedly, the Japanese authorities were slow to recognise the nature of the problem in the early-1990s, cutting interest rates only slowly, offering little in the way of fiscal stimulus and dragging their feet on bank restructuring.
In the late-1990s, however, the Japanese banking system was restructured, removing some of its initial ‘doom loop’ problems. Two decades later, the Bank of Japan, under Haruhiko Kuroda, has done exactly what many thought would eventually deliver results: massive balance sheet expansion, a clearly-articulated ambition to raise the inflation rate and a substantial currency devaluation. Yet, despite all this, the path for nominal GDP has barely changed. Perhaps those policies would have worked in a world where Japan was the only country facing deflationary stagnation. As deflationary stagnation has spread, however, the efficacy of these policies appears to have declined.
This leads us to King’s rhetorical question du jout: “Given this disappointment, what options are available for the rest of the industrialised world?”
This is his extended answer:
Ultimately, policy has to deal with one of two variables. Either debt has to come down or income has to rise. Otherwise deleveraging is likely to persist and the air will continue to escape from the global economy. Low interest rates should, in theory, help on both counts. By reducing debt service costs, they should make it easier to reduce the outstanding stock of debt and, by making saving less attractive, they should encourage people to spend more. Yet if nominal economic activity still remains weak at the zero rate bound – as, indeed, it has in recent years – other options may need to be pursued.
Both quantitative easing and negative nominal interest rates can provide more support. Both, however, have their limitations.
Quantitative easing may have lifted asset prices and stopped a 1930s-style meltdown but households and companies have mostly been unwilling to spend freely. Meanwhile, the main beneficiaries financially are those already asset rich who, typically, have a low marginal propensity to consume.
If, for political, social and reputational reasons, banks find it difficult to impose negative interest rates on their depositors, negative interest rates in effect become a tax on banks.
As a result, the banks’ willingness to take on more deposits will be lowered, limiting their role as financial intermediaries. Other things equal, if banks turn depositors away, the money will end up under the mattress (in which case, the velocity of circulation of money will decline, limiting the impact of negative rates on nominal GDP)
So what else can be done?
The fiscal option
Central to Larry Summers’ argument in favour of ‘secular stagnation’ is the idea that weak demand will, in time, damage supply potential. It’s an old argument, based on the idea that under-utilised resources eventually decay thanks to ‘hysteresis’. Far better, therefore, to deliver a boost to demand that will prevent resources from standing idly by. Higher demand will prevent supply from atrophying. Put simply, demand safeguards its own supply.
It’s an attractive idea, partly because it offers a narrative of hope. Yet it has its weaknesses. Fiscal stimulus in Japan led to accusations of ‘bridges to nowhere’: in other words, infrastructure projects that had poor private and social returns and, on occasion, led to accusations of ‘pork barrel’ politics. Before the onset of the global financial crisis, Spain invested very heavily in infrastructure, yet the returns have been paltry at best given the shortfall in nominal GDP in recent years. Government debt levels across the developed world are already very high, suggesting that any attempt to increase government borrowing could be associated with Ricardian equivalence problems.
Its biggest weakness, however, is that the policy prescription was tried before yet ultimately only brought instability in its wake.
In 2000, the tech bubble burst. For a while, it looked as though the US was heading towards another Great Depression. Certainly, the fall in stock prices was on a similar scale to 1929. The recession that followed, however, was remarkably mild and recovery was soon underway, helped along by aggressive interest rate cuts and huge tax cuts – precisely the combination that supposedly brings secular stagnation to an end. For a while, the policies seemed to work. In hindsight, however, they merely masked early aspects of deflationary stagnation: the housing boom may have led to an acceleration in growth but the pace of economic expansion was weaker than in the 1980s and 1990s. And it all came to a sorry end in 2008. Asset price gains that cannot be validated through a sustained period of economic growth tend, ultimately, to be asset price bubbles.
Put another way, if secular stagnation reflects weak growth, the problem began in the US in the early years of the 21st Century, before the global financial crisis. Yet proponents of secular stagnation argue that it began only with the onset of the financial crisis. The story looks good, but the dates don’t fit.
The helicopter option
The helicopter option is simple, easily implemented and, for some, offers the closest thing to a free lunch. It can easily be explained – if that’s the right word – using the identity found on the first page of a standard monetary textbook, namely MV?PT, where M is the stock of money, V is its velocity of circulation, P is the price level and T is the volume of transactions. In modern-day parlance, PT might best be labelled nominal GDP.
Money doesn’t literally drop from helicopters but the effects are roughly the same. The government sells newly-issued debt to the central bank which, in return, provides newly-created money to the government. This newly-created money is either given away in the form of tax cuts or spent on, for example, infrastructure projects. The newly-created money boosts M while the tax cuts or spending increases more or less guarantee an increase in V. Put the two together and nominal GDP simply has to accelerate. Assuming – consistent with secular stagnation – that there is a sizeable output gap, there’s a good chance that the increase in nominal GDP will be reflected more through an increase in output than an increase in inflation.
If this sounds too good to be true, that’s because it is. Output gaps are notoriously difficult to estimate in real time. The permanent output losses associated with the financial crisis are now considered to be far bigger than had been assumed in its immediate aftermath, suggesting that helicopter money could come with sizeable inflationary risks. Those would be amplified via the foreign exchanges, which would doubtless deliver a ‘crash-landing’ for any currency subject to the helicopter treatment.
In truth, helicopter money is likely to work only if it leads to higher inflation. Its success crucially depends on policymakers committing to being ‘irresponsible’. In the mid-1930s, countries managed to raise both inflation and inflationary expectations even in the depths of depression thanks to their departures from the Gold Standard, freeing them to loosen both monetary and fiscal policy in unprecedented fashion. Higher inflation, in turn, reduced the real value of nominal debts. Deleveraging faded, credit risks shrank, banks’ bad debts became less problematic, lending increased and, before long, recovery was on the way.
Repeating the process today would not be easy. Abandoning – or raising – inflation targets would be no easy task: ageing populations typically are repulsed by inflation, largely because of its effects on fixed nominal incomes. Fear of higher inflation could also lead to panic buying, triggering an uncontrollable rise in V and, hence, a severe inflationary overshoot: it’s no coincidence that helicopter money and hyperinflation are mentioned in the same breath. And, ultimately, higher inflation would only work by penalising savers to benefit borrowers.
Put another way, the pursuit of higher inflation through helicopter money is not much more than a re-distributional fiscal policy dressed up in monetary clothes. It is effectively a tax on wealth – mostly on forms of wealth that come with little in the way of inflation protection. It is therefore more likely to hit small savers and pensioners than property tycoons and those with large equity portfolios (both real estate and equities tend to outperform liquid assets during periods of relatively high inflation). In other words, helicopter money is a stealthy form of organised default, taking money away from creditors in the hope that debtors – faced with now-lower real debts – will spend more freely. Given the maturity of its slow puncture problems, Japan might be more willing than others to fly its monetary helicopters but, given the politics of its demographic situation, it would surely be a reluctant pilot.
The default option
In truth, this is not so different from the helicopter option. It is more relevant, however, for those countries which lack helicopter pilots. Specifically, default is an option for those national governments in the Eurozone that lack a printing press and are unable to prevent government debt from rising ever higher.
To be fair, quantitative easing has, to a degree, reduced pressure on individual sovereigns. The risk hasn’t completely gone, however. At the time of writing, Greek and Portuguese 10 year bond yields were 9.6% and 3.0% respectively, compared with German yields at a remarkably low 0.17%. And the default option may become more pressing in coming years if, as seems likely, government debt levels continue to rise.
Like inflation, default passes the problem from debtor to creditor. In doing so, it raises a whole series of new financial threats, most obviously the danger of a renewed erosion of trust within the financial system. As a result, it would further limit the power of monetary policy. Savers would seek to hide their money under the proverbial mattress and, as a result, velocity might fall further.
Another option might be simply to cancel government debt held on central banks’ balance sheets rather than selling it back to the market. That sounds like a free lunch but it would presumably lead to expectations of higher inflation associated with a reduction in fiscal discipline over the long term: in that sense, the policy would be remarkably similar to helicopter money, particularly in terms of its exchange rate implications.
The ‘liquidate’ option
One of the undoubted triumphs of the post-financial crisis world has been the extent to which unemployment has declined in the US, the UK and Germany. Admittedly, not everyone has shared their good fortune: the increase in Greek unemployment in recent years, for example, is nothing short of scandalous: the lessons of the 1930s were clearly not learnt. Nevertheless, for some of the largest economies in the industrialised world, the employment consequences stemming from the financial crisis have been considerably better than was originally feared.
However, given the slow pace of economic expansion in recent years, good news on unemployment implies bad news for productivity. Perhaps deflationary stagnation partly reflects an absence of supply.
The standard dismissive response to this argument is to note that weaker supply, other things equal, implies a smaller output gap and, hence, higher inflation. And yet, in recent years, inflation has drifted lower. So the explanation for persistently weak growth cannot lie with supply.
At this point, it’s worth coming back to Japan. If supply is weaker than expected, claims on future economic activity need to be reduced. One way to do this is indeed via inflation. The other is via declines in nominal asset values. The 1970s economic slowdown – in response to multiple oil shocks – was associated with inflation. Japan’s lost decades were associated with falling asset prices, deflation and weak nominal GDP growth. Weaker supply potential can thus be associated with both inflation and deflation: it all depends on how claims on future economic activity are reduced.
In an era of rapid technological gains, why has productivity growth been so weak? Of the competing explanations – from mis-measurement through to an innovation shortfall – one is directly related to the amount of stimulus on offer since the financial crisis. Quantitative easing worked domestically through its effect on the value of real estate and financial assets, most obviously corporate bonds and equities. Higher values for financial assets meant that companies which, in other circumstances, would have been under pressure to reduce their costs could carry on with business as usual. Put another way, they could happily employ people who might otherwise have lost their jobs. Capital markets were thus no longer able easily to perform their central function, namely the efficient allocation of capital. Too much capital stayed in bloated and inefficient companies leaving too little to support the growth of smaller, more dynamic, enterprises. It was, perhaps, a western version of the Japanese ‘zombie company’ problem.
At the beginning of the Great Depression, Andrew Mellon, the US Treasury Secretary, famously urged Herbert Hoover to ‘liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.’ To say the least, it probably wasn’t the best strategy. Nevertheless, Mellon still had a point. Zombie companies preserve inefficiencies and dampen enterprise. Their preservation limits the ‘creative destruction’ that Joseph Schumpeter famously described in his ‘Capitalism, Socialism and Democracy’.
Acting on zombie companies may be one way of ending deflationary stagnation but, if badly managed, the situation could become even worse. Imagine, for example, that all companies within a particular industry suddenly recognised that the pace of nominal economic expansion would not be sufficient to support their current cost base. Imagine, as a result, that there was a prolonged wave of restructuring, associated with mass layoffs. The result would be an even lower level of nominal output, triggering a further wave of restructuring – unless, that is, the restructuring led to significant productivity spillovers.
It might, therefore, be better to act on both supply and demand, forcing a greater degree of restructuring while, at the same time, offering a fiscal cushion, perhaps through a range of public works programmes. Put another way, neither supply-side reform nor demand-side stimulus will work unless they operate in conjunction with each other.
The trade option
One of the striking features of the post-financial crisis world has been the slowdown and then shrinkage in world trade. This is highly unusual. Although the pace of economic recovery has been soft, it is typically the case that world trade expands more quickly than world GDP in the recovery phase.
Possible reasons for the weakness in world trade include (i) the attenuation of global supply chains either to reduce their fragility (following, most obviously, the Fukushima nuclear disaster in Japan) or in response to new technologies (3D printing may have led to renewed onshoring) (ii) an increase in ‘hidden’ protectionism associated with the aggressive imposition of ‘standards’ (iii) a reduction in trade finance in the post-financial crisis era; and (iv) an increase in uncertainty associated with the impact of currency wars.
Openness matters. We have surely learnt over the last few decades that economies that trade with one another are more likely to enjoy increases in living standards. We have also found, disappointingly, that global trade deals have become more or less impossible: the Doha trade round is dead in the water and there is nothing waiting in the wings to replace it.
Still, there is hope. The Trans-Pacific Partnership, the Transatlantic Trade and Investment Partnership and the Regional Comprehensive Economic Partnership could lead to more integrated regional economies and, perhaps, greater cooperation between those regions. Over the long term, openness matters more than any variety of monetary or fiscal stimulus. The world needs to be protected from protectionism. Sadly, it’s not obvious that it will be.
The ‘wall’ option
Should all else fail, the political narrative will shift. Indeed, it already is. If economies cannot easily be kick-started, nationalism is in danger of spreading. Whether it’s building a wall to prevent Mexicans from entering the US or passively watching as the Schengen arrangements in Europe slowly crumble, trouble is brewing. Global markets are under threat precisely because policymakers have been unable to deliver the outcomes they had previously promised. Protectionism in all its many forms is never far away: under current conditions, it threatens to make an unwelcome return.
* * *
Which brings us to Stephen King’s rather pessimistic conclusions:
The economic slow puncture was once associated with Japan alone. Persistent undershoots in nominal economic activity since the onset of the global financial crisis suggest that the problem has spread. As more and more countries succumb, so the ability to escape declines – as, indeed, Japan itself has discovered in the light of disappointments associated with Abenomics.
Devaluations simply pass deflationary pressures from one part of the world to another. What was once seen as monetary stimulus is now more typically described as the latest salvo in a protracted currency war. Central banks have seemingly lost the ability to bring inflation back to target.
The good news is that much of the rest of the world does not share Japan’s cross-shareholding problem, reducing the threat from a ‘doom-loop’ intrinsically linked to the banking system. Still, continuous nominal GDP undershoots still create problems for bank profitability, leading to relative share price under-performance and, eventually, to downward pressure on equity markets as a whole, particularly where QE drugs are no longer freely available.
The escape options are a mixture of the ineffectual, the limited, the risky, the foolhardy or the excessively slow. As Japan’s recent experiments have demonstrated, upping the monetary dosage alone is not enough to cure the affliction. Indeed, to the extent that monetary stimulus only encourages a further wave of risk-taking within financial markets – often outside of the mainstream banking system – it may only perpetuate unstable deflationary stagnation. A more sustained recovery is possible but to believe that central banks, on their own, can deliver such an outcome is surely a triumph of false hope over bitter reality.
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