It is almost four years since central banks in the Western world first adopted near-zero interest-rate policies – alongside the implementation of substantial quantitative easing measures – intended to halt the sharp and swift decline in economic activity that followed the acute myocardial infarction that struck at the heart of the global financial system. The prescribed medicine successfully revived the ailing advanced economies, but failed to restore the patient to full health, as the deterioration in vital signs in the years leading up to the crisis, precluded a rapid and robust recovery, no matter how high the dosage.
The lacklustre recovery – characterised by persistently elevated levels of unemployment, and subpar business investment rates – has seen central bankers reaffirm their commitment to do “whatever it takes,” in the words of the European Central Bank’s President, Mario Draghi, to return the industrialised world to a more familiar growth-setting. The rhetoric has been followed by action, as monetary policymakers in Frankfurt and Washington have reached into their medicine chest, and upped the dosage in an effort to remove negative fat-tail risks, and keep their economies afloat.
Return-starved investors’ anticipation of further monetary stimulus fuelled an unseasonal rally in the world’s major stock market averages during the summer that has seen prices advance to within touching distance of multi-year highs. Surprisingly, the robust double-digit, percentage-point gain in equity values has taken place in spite of mounting evidence that suggests global economic growth has slowed to stall-speed, which is often a prelude to recession.
Further, stock market indices have moved higher on economic data, both ‘good’ and ‘bad,’ which means investors must believe central bank action will ultimately, result in a significant improvement in economic activity. The conviction is difficult to fathom, given that the ambitious monetary policies pursued in both Europe and the U.S. post-crisis, have already failed in igniting anything like a standard economic recovery, and that further life-support operations are required simply to sustain economic growth not too far below trend.
The evidence of the past four years is virtually a carbon copy of the Japanese experience following the collapse of its twin property and stock market bubbles in the early-1990s. The Bank of Japan reduced short-term policy rates somewhat belatedly to zero in 1996, and launched the first in a series of quantitative easing programmes early in the new millennium.
However, the unconventional policies adopted in Japan did not produce any real traction in the economy, and the nation’s economic output is now forty to fifty per cent below the level that reasonable forecasters would have projected it to be way back in 1991. Ultra-accommodative monetary policy was unable to prevent two decades of economic stagnation, as the banking crisis and private sector deleveraging that followed the implosion of the credit-fuelled asset bubbles, seriously curtailed its potency.
Investors refuse to acknowledge the possibility that the Western world might succumb to a more than decade-long, Japanese-style stagnation, even though the starting points were much the same, and the recovery to date has followed a similar path in the presence of equally expansive monetary policies. The notion that the advanced economies in the West merely skipped a heartbeat, and did not suffer a cardiac arrest, does not stand up to serious scrutiny.
The euro-zone, the U.S., and the U.K. all entered the current episode with non-financial private sector debt ratios that were close to those of Japan two decades ago, and well above the thresholds that have been shown empirically to retard economic growth. Not surprisingly, the slump in property prices, alongside a severe decline in equity values, prompted a sharp drop in the private sector’s demand for credit, as both the household and corporate sectors attempted to rehabilitate their weakened balance sheets.
Just like Japan, private sector deleveraging continues in spite of historically low interest rates, as subdued growth in disposable income means prospective borrowers are in no hurry to add to their already difficult-to-manage debt burdens, while capital-constrained banks are reluctant to lend to all but the highest-quality debtors.
Further, the Japanese experience demonstrates that the continued suppression of long-term interest rates via quantitative easing, risks undermining the availability of credit even further, as the potential rewards from incremental lending fail to compensate for the risks attached.
Troublingly, years of private sector deleveraging in Japan did not prevent the combined government and non-financial private sector debt ratio from moving higher, as the improvement in corporate and household balance sheets was more than offset by the steady deterioration in public finances.
The same phenomenon has been apparent throughout the advanced economies of the Western world in recent years, as declining tax revenues, increasing unemployment benefits, not to mention sizable bank recapitalisation costs, caused fiscal deficits to skyrocket during the recession, and the subsequent recovery has not been sufficiently robust to stabilise public debt ratios.
Aggregate debt ratios remain close to or at record levels throughout the Western world, and as in Japan, the right-sizing of balance sheets is set to become even more difficult, due to an unfavourable demographic picture that is certain to lower potential growth. The task could prove even more onerous should elevated unemployment rates and subdued investment in the capital stock, result in lower productivity.
Stock prices have staged an impressive rally on the belief that monetary stimulus will produce a self-sustaining economic recovery any day now, but round after round of unconventional programmes suggests the Western world is edging ever closer to Japanese-style stagnation. Investors should take note.
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