Henderson Rowe’s Artur Baluszynski, director and head of research, explains some of the conditions that point the eurozone and US economies down a similar path, and how that could be avoided.
“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 the developed economies, like those in Europe, have been making exactly the same mistakes Japan did in the 1990s. Although the US managed to avoid some of the banking system issues Europe experienced in 2011, its overreliance on the Fed’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 those in Japan 30 years ago, European leaders made a serious policy error when they failed to quickly address the banking crisis emerging at 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 from taking hold.
The eurozone is a bank-financed economy, which means 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 from 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.
When Greece in 2011 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 sector 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 also an important factor. Most developed economies have shrinking populations, creating a strong deflationary headwind. Most people want to pay off their debt before they retire, which usually means higher savings and lower consumption. In the US the babyboomer generation has to retire their debt before they can actually retire, and the average millennial has around $35k 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 it will most likely fail to work in the US and Europe. Yes, quantitative easing in the US and, to some extent, in Europe helped some households and corporates to deleverage smoothly, but one should not hold their breath for any sharp re-leveraging spurred by the low interest rate environment.
Looking at Japan’s example, we see the self-perpetuating cycle of increasing debt, lower interest rates and slower growth. Developed economies with ageing populations have a severe funding problem. As their residents grow 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 less 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 ECB, 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 that can succeed will rely on a consensus for a fiscal solution and for each of its 19 governments to decide to act now.
As debt ratios in Europe (and the US) have picked up again, its 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 like Spain and Italy would stand a better chance at re-inflating their economies.
Countries like 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 have been spent on day-to-day needs, boosting the real economy. Indeed 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, Trump’s election and the backlash against Angela Merkel’s ‘open door’ policy proved that, in practice, higher immigration levels may 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 might change once the global economy rebalances, addressing some of the inequality issues. Countries like the US have a massive pool of young immigrants (read future taxpayers) to tap into, in neighbouring Mexico. It may seem like a distant fantasy, but considering that during the next decade the Hispanic population in some southern states, like Texas, is expected to reach 40%, changes could come quicker than we expect.
By Artur Baluszynski, Head of Research at Henderson Rowe