Conditions suggest that the eurozone and US economies are heading down a similar path to Japan, but this can be avoided, suggests Artur Baluszynski.
“Japanisation” might soon afflict Europe and the US. It describes a stagnating economy that goes down a deflationary spiral with almost no demand for credit or consumption from the private sector. No growth and no inflation.
Among the many factors underlying Japan’s ‘Lost Decade’ (or decades, to be more apt) in the 1990s and 2000s, were bubbles in property and equities. Both speculative bubbles were punctured in 1989 when the Bank of Japan started aggressively raising interest rates. Since then, inflexible economic policy, adverse demographics and deleveraging of the private sector have been keeping Japan’s economy in a deflationary state.
Some of developed economies, such as those in Europe, have been making the same mistakes Japan did in the 1990s. Although the US has managed to avoid some of the banking system issues that Europe experienced in 2011, its overreliance on the Federal Reserve’s monetary policy keeps fuelling a potential bubble in financial assets while driving up wealth inequality. This, in turn, will most likely be a drag on future demand and consumption.
Obsessed with deleveraging
Just like individuals in Japan 30 years ago, European leaders made a policy error when they failed to quickly address the banking crisis emerging in its early stage in 2008. The European political leadership were completely unprepared for the deflation that hit the eurozone and, therefore, had very little chance to prevent it taking hold.
The eurozone is a bank-financed economy, which means that corporates and households could not lend from the banking sector even if the demand were there. Obsessed with deleveraging, its banking sector and some parts of its non-financial corporate sector have been prioritising repairing their balance sheets, showing little interest in lending to the real economy.
Richard Koo, a former economist at the Fed, developed a term for this scenario, called “balance-sheet recession”. If the private sector is paying down debt, the public sector has to be borrowing and spending to prevent prolonged deflation setting in.
The eurozone’s biggest problem is the Maastricht Treaty, which caps the deficit-to-GDP ratio at 3%. Once in a balance-sheet recession, if the private sector is saving 10% of GDP and the government can only borrow 3%, the economy is very likely to experience deflation.
In 2011, when Greece was forced to introduce austerity measures to qualify for more “help” from the troika – the then-decision group on bailouts made up of the European Commission, European Central Bank and the IMF – the banking system experienced an almost complete breakdown. Both the private and the public sectors tried to deleverage, resulting in the collapse of the economy. The Greek economy reached 0.8% surplus in 2018, but with unemployment hovering at around 22%.
Demographics are an important factor. Most developed economies have shrinking populations, creating a strong deflationary headwind. Most people want to pay off debt before they retire, which usually means higher savings and lower consumption. In the US, those in the baby boomer generation have to retire their debt before they can actually retire, while the average millennial owes around $35,000 (£27,000) in student loans. Both are damaging for future consumption.
Monetary policy is impotent when dealing with a structural problem such as demographics. It failed to work in Japan in the 1990s, and will most likely fail to work in the US and Europe. Yes, quantitative easing in the US and, to some extent, in Europe has helped some households and corporates to deleverage smoothly, but don’t hold your breath for any sharp re-leveraging spurred by the low interest-rate environment.
Looking at Japan’s example, we see a self-perpetuating cycle of increasing debt, lower interest rates and slower growth. Developed economies with ageing populations have a severe funding problem. As the population grows older, the government cost per capita – or more accurately, the cost of healthcare – accelerates. With fewer young people in the workforce, the tax base keeps shrinking. To close the funding gap, the government has to issue bonds, increasing its debt-to-GDP ratio.
For Japan, that ratio is at 236%, but because most of its debt is held domestically, chances of an outright default are pretty slim at the moment. However, because the government relies so heavily on Japanese savers, of whom there are fewer every year, it might need to tap into external funding at some point. This is when the situation can deteriorate very quickly, as foreign investors will most likely ask for higher interest to reflect the Japanese credit risk.
While the US and the EU, with their debt ratios at 106% and 80%, respectively, are still far behind Japan, their population age profiles are not that dissimilar.
The (mostly) good news
The outgoing head of the European Central Bank, Mario Draghi, and his successor, Christine Lagarde, are now openly calling for member governments to step in and use fiscal measures to reinflate the eurozone. Whether it succeeds relies on a consensus for a fiscal solution and for each of the 19 governments to decide to act now.
As debt ratios in Europe and the US have picked up again, niche and mid-size institutional investors are willing to step in and fill the gap left by the banking system deleveraging. However, a substantial amount of new financing is funding stock buybacks, acquisitions and financial assets, not the real economy.
If the budget rules of the Maastricht Treaty are relaxed, allowing for a fiscal solution in Europe – and as a bonus, if private sector domestic savings are forced to stay in their respective economies instead of flowing into German bunds – countries such as Spain and Italy would stand a better chance at reinflating their economies.
Countries such as Poland have been trying to stimulate population growth by “subsidising” families with more than one child. While one could argue that it is a wasteful form of fiscal stimulus that adds to the already elevated debt levels, the short-term effects have been promising. Poland’s fertility rate has been rising (whether that’s sustainable will require more data points), and the money received by multi-child families has been spent on day-to-day needs, boosting the real economy.
It will be years before we are able to judge the real success of this policy, but if it’s unsuccessful, the higher debt level will have to be paid back or rolled over on higher interest rates.
In theory, a more natural solution to the demographic problem in the developed world is to increase immigration levels. However, Brexit, Donald Trump’s election and the backlash against Angela Merkel’s “open door” policy proves that, in practice, higher immigration levels might be too difficult to stomach for most domestic constituencies.
With rising inequality in almost every developed country, native populations are not ready to absorb younger, more motivated, and often cheaper, workers from the developing world.
Things could change once the global economy rebalances, addressing some inequality issues. The US, for example, has a huge pool of young immigrants (read future taxpayers) to tap into in Mexico. Considering that during the next decade the Hispanic population in some southern US states, such as Texas, is expected to reach 40%, changes could come quicker than we expect.
Artur Baluszynski is head of research at Henderson Rowe.