Stephen King: Western economies are still in danger of sinking under an ocean of self-created debt
As the UK's new Government delivers unprecedented austerity, the great deleveraging will affect the UK as much as everyone else
Monday 19 July 2010
Does Ben Bernanke suffer nightmares? Does Jean-Claude Trichet have sleepless nights? Does Mervyn King wake up in a cold sweat, his pyjamas soaking wet? I wouldn't blame them if they did because after the biggest policy stimulus known to man, Western economies appear to have hit a brick wall.
Last week, the Federal Reserve revised down its projections for US economic growth in 2010, a response to an unexpected "soft spot" in the American economic recovery. European policymakers, meanwhile, worry about the impact of the sovereign debt crisis on the eurozone's recovery. And Mr King has, to date, managed only to pump up the volume of inflation: the underlying real economy remains very soggy.
None of this was supposed to happen. Western policymakers thought they knew how to solve serious economic problems. Their economic weapons were regarded as highly potent and, over the past three years, were used with maximum force. Yet the results have been disappointing. The hoped-for recovery has not materialised. Instead, Western economies are languishing at the bottom of a cliff. Having fallen a long way, the renewed ascent is proving to be remarkably taxing.
Not all have suffered the same fate. Although there are plenty of worries about the ongoing pace of China's economic expansion, Asian economies have rebounded with considerable ease over the past year or so. The same is broadly true of other emerging nations. How have they managed to pull off a trick which the magicians of Western policy making are still attempting to master? What sleight of hand have policymakers in the emerging world achieved? And why can't the same ploy be replicated in the West?
Let's go back to my cliff analogy. I'm reliably informed by those who go mountaineering that it's easier to climb up a rock face with a light, rather than a heavy, backpack. The emerging nations have learnt that lesson the hard way. In the 1980s and 1990s, over-burdened with debt, they would all-too-frequently lose their grip, weighed down by their profligacy. More recently, however, they have mostly behaved in conservative fashion, refusing to carry the debts of old. Like others, they succumbed to the global economic crisis. Unlike others, they were able to climb back up the cliff with relative ease. They didn't have to carry the burden of earlier excesses with them. Western nations are in a less fortunate position. Their backpacks are weighed down with both pre-crisis and now post-crisis debts. True, additional government borrowing prevented economies from completely falling onto the rocks of a Great Depression Mark II. Yet the costs have been substantial. Household and financial sector debt is still high but we now have to cope with excessive government debt too. These debts may be preventing a normal recovery from materialising.
This is all very disturbing. Back in 2002, Federal Reserve economists wrote a paper arguing that Japan's economic stagnation in the 1990s and beyond, was largely the result of a failure to loosen monetary policy sufficiently. Specifically, they argued that an additional 2 per cent reduction in Japanese interest rates at any time between 1992 and 1995 would have slain the deflationary beast, allowing room for Japan's economy to rebound relatively easily.
Put another way, the Japanese were stupid enough not to have recognised the deflationary pressures which were about to engulf their economy. As a consequence, they failed to take the medicine necessary to restore their economy to its earlier vigour. The Japanese got it wrong but the West, apparently, knows how to get it right. It's a view that has become part of popular (and convenient) opinion amongst the chattering financial classes and, of course, amongst policymakers who, frankly, should know better. The West just loves to patronise the rest.
Japan's problems ultimately stemmed from the excesses of the 1980s. Japan was a nation living beyond its means. A simple steak sandwich at Tokyo's Palace Hotel cost the equivalent of £35, a totally silly price, which those participating in the late-1980s boom were mad enough to pay. Japan's economy had taken leave of its senses, helped along by a stock market and real estate bubble which allowed access to ever more debt.
When the bubble burst and economic reality slowly dawned on a nation of fantasists, the great deleveraging began. Austerity wasn't forced on the Japanese. Instead, they chose austerity, recognising that the era of ever-rising wealth was over.
No amount of policy stimulus was likely to alter this perception, in large part because the perception was true. Interest rates did fall, and perhaps might have fallen further, but why would people borrow any more if they already were awash with debt?
To offset the private sector's caution, the Japanese government eventually chose to borrow more but, as it did so, companies merely accelerated their repayment of debt. For every stimulus measure, there was an off-setting leakage somewhere else. Keynesian policies didn't appear to be working. The lesson from Japan is surely that policymakers should stop bubbles, and their associated debts, from happening in the first place. In the West, that lesson wasn't heeded. During the late-1990s stock market bubble, policymakers were keen to declare the arrival of the so-called "New Economy". When that story went wrong, the stock market bubble was merely replaced with a housing bubble which, ultimately, proved to be far more damaging.
All the while, debts continued to rise as economies defied economic gravity. Western policymakers, with their fondness for continued economic expansion, flew too close to the economic sun and, like Icarus, have come crashing down to earth.
And now the Western economic patient is in big trouble, seemingly unable to respond to the pills and procedures administered by increasingly desperate policymakers. Indeed, the longer the crisis lasts, the more it's beginning to look like a repeat of the Japanese crisis of the 1990s, only on a much grander scale.
Western equities are in the tenth year of a bear market. The US housing market is in decline again, emulating the falls in Japanese land prices. Long-term interest rates on government debt are extraordinarily low, even though government borrowing is seemingly out of control. They're low because no one else is keen to borrow in a world suffering from the uncertainties associated with excessive debts. In the majority of Western nations, inflation is absent, threatening a repeat of Japan's deflationary despair. And money-supply growth has collapsed, even though central banks have pursued all manner of unconventional policies to kick-start the credit system.
The only exception to this deflationary misery is the UK which, remarkably enough, has managed to create inflationary angst instead. Two years ago, the Government and the Bank of England thought a rebalancing of the UK economy away from financial services towards manufacturing might be a rather good idea. As a result, a policy of benign neglect towards the exchange rate was adopted, with the unsurprising consequence that sterling dropped like a stone. Yet the result was not a pick-up in activity but a rise in prices.
As a mechanism to avoid a Japan-style deflation, sterling's earlier decline has, therefore, been rather too successful. But unless sterling carries on falling or, instead, the public's price expectations become dislodged, it's doubtful that higher inflation will be around for very long. As the UK's new Government delivers unprecedented austerity, the great deleveraging will affect the UK as much as everyone else, leaving us ultimately with too little, not too much, inflation. The Western economies are all in the same boat full of debt-induced holes. Maybe that's the real reason why Mervyn King's pyjamas are soaking wet.
Stephen King is managing director of economics at HSBC
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