Stephen King: The West has not learnt the vital lessons from Japan's economic travails
Outlook: The Western world is facing a nominal crisis: too much debt, too little inflation and an absence of effective conventional policy levers
Monday 20 September 2010
Are things getting any better? Those who focus only on the direction of change compared with the last quarter or the last year will doubtless say that, yes, there has been an improvement. Western economies have turned a corner. No longer are they shrinking. They appear, instead, to be recovering.
This recovery, however, is a very strange affair. Since the end of the Second World War, simple rules governed the economic cycle. Deep recessions were followed by strong recoveries. Shallow recessions were followed by limp recoveries.
Given the depth of the credit crunch recession, we should now be in the middle of a particularly strong recovery. But we're not. The recovery so far has been remarkably soft, despite all the interest rate cuts, the fiscal boosts and the unconventional policies. These policies may have prevented a Great Depression Mark II but they haven't been potent enough to deliver a standard economic rebound. It was a non-standard recession and it's proving to be a non-standard recovery.
The lack of a decent rebound has consequences. In the US, the unemployment rate is depressingly high and the long-term unemployment rate, for those out of work for six months or more, is off the scale. In Europe, tax shortfalls have left governments borrowing more and more, triggering a series of fiscal crises. In the UK, last year's rebound in the housing market, fuelled by amazingly low interest rates, is beginning to splutter.
Put another way, the level of economic activity is far too low. Measured by past recoveries, this latest effort has delivered very little. Economies may be moving in the right direction but many of the problems associated with recessions are still there. Consumer confidence is at rock bottom. Small businesses cannot easily access credit. People the world over are talking about the dreaded "double-dip".
These difficulties emphasise the importance of talking about levels rather than rates of change. Those who focus only on the latter fail to recognise that most of us have "absolute" standards for economic performance. Doubtless, they would congratulate little Johnny for the doubling of his school marks even if most of us would argue that a score of 2 out of 10 is really not that much better than a score of 1 out of 10. The big challenge for policymakers is to stop economies settling down at these thoroughly miserable levels of activity.
In the 1970s and 1980s, the chances of remaining economically depressed were very low for the simple reason that each recessionary cloud was accompanied by a disinflationary silver lining. Back then, inflation was mostly too high. Each recession pushed inflation back down again and, in time, economic performance began to improve. Lower inflation was typically less volatile. Lower volatility, in turn, reduced uncertainty for businesses and households, leading to increases in capital and consumer spending.
Today, inflation is not too high. It is mostly too low. Admittedly, the UK is an exception, most likely a reflection of the lagged effects of sterling's collapse in 2008. For the majority of countries in the Western world, however, the bigger danger confronting policymakers is deflation, not inflation. The annual rate of US core inflation, excluding the volatile food and energy components, is down at just 0.9 per cent and has been stuck there for five consecutive months, the longest period of sub- 1 per cent inflation in the US since records began in the late-1950s.
This wouldn't matter quite so much if interest rates weren't already down at zero and if debt levels weren't quite so high. But given that they are, we're stuck in a very fragile economic world. The more inflation falls – a consequence of low levels of activity – the higher zero interest rates become in real terms. If prices and wages rise at 2 per cent per year, zero interest rates are -2 per cent in real terms. If prices and wages rise at 1 per cent a year, zero interest rates are -1 per cent in real terms. And should prices and wages fall by 1 per cent a year, zero interest rates rise to +1 per cent in real terms.
In other words, a central bank finds the setting of monetary policy increasingly difficult in a world of zero interest rates and excessively low inflation. Moreover, if a heavily indebted public begins to fear the onset of deflation when interest rates are already at zero, the rational response is to start repaying debt with ever-greater enthusiasm. And, by doing so, deflation becomes even more likely, delivering a rise in real interest rates which will encourage even more debt repayment (or, as the situation deteriorates, a significant increase in defaults and bankruptcies).
Perhaps the best way to express this is to argue that we have a crisis of the nominal, not the real, economy. Focusing on jobs growth, business confidence and retail spending is all very well but, on their own, these indicators say little about whether a recovery in current circumstances will be sustained.
Uniquely, the Western world is facing a nominal crisis: too much debt, too little inflation and an absence of effective conventional policy levers.
No one in policy circles has had to come to terms with these kinds of challenges before. No one, that it, except the Japanese. Japan has been heavily criticised by Western policymakers over the years. It was too slow to cut interest rates at the beginning of the 1990s after its stock market crash. It was too quick to raise interest rates later in the decade when its deflationary crisis was not yet over. It began to pursue unconventional "quantitative easing" policies over a decade too late.
Yet it increasingly appears that Western policymakers have been slow to apply the lessons of Japan to their own economies. Even if activity is incredibly depressed and inflation worryingly low, central bankers cannot help but reach for the interest rate trigger at the first sign of recovery. Earlier in the year, for example, all the talk was of so-called "exit strategies" and many in financial markets thought interest rates might be rising by the end of the year in a bid to prevent inflation from re-emerging.
These beliefs spread because too many people thought the lessons of Japan had been learnt and that the West could not possibly head in a Japanese direction. This was foolish. As 2010 has progressed, the West has taken on more and more symptoms with a distinctly Japanese flavour.
Given all this, central bankers should have indicated that there was no chance whatsoever of interest rates rising purely in response to the first signs of a cyclical pick-up in economic activity. If that pick-up is to be sustained, it's vital that interest rates remain low until there are clearer signs that activity is operating at a much higher level, that inflation is not too low and that the private sector isn't still desperately repaying debt. Otherwise, like the Japanese, we'll be stuck with a 2 out of 10 economy.
Stephen King is managing director of economics at HSBC
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