In-between the lines
- Three lessons from Japan
- Who's afraid of inflation?
- ECB more likely to cut than to raise rates
Financial markets have not calmed since the announcement of the €750 billion European sovereign guaranty package. To the opposite, market conditions have further deteriorated, spreading from Greek bond spreads to all risky assets. Commodity prices have also fallen sharply and even bank liquidity indicators are shifting from green to yellow (see LIBOR-OIS spread). At the center of market concerns is the crisis in Europe, but Chinese stimulus withdrawal and US financial sector reform are not helping.
Markets are pricing an increased risk of a doubledip recession in Europe and perhaps beyond. Is this likely? Perhaps, but the cyclical rebound seems too strong, especially in the emerging markets and the US, and Europe's troubled sovereigns as well as the financial sector are for now protected by the official safety net. The real risk is not recession but a prolonged slump.
To better understand the dimensions and implications of Europe's adjustment ahead, both markets and policymakers should study Japan's experience more closely. The comparison is not perfect, but Japan's experience carries three basic lessons:
- First, Europe's looming fiscal and structural adjustment will not be over within a few years, but take at least a generation. Japan has now been bogged down for nearly twenty years and is still not out of the woods. This means subpar growth and no inflation. In Japan, trend growth slipped from 4% to 1% and inflation dropped from 2% to zero. In Europe, growth and inflation averaged both 2% before the crisis and may each drop to 1% or less.
- Second, policymakers should attack the problems head on and swiftly. Japan's problems were undoubtedly made worse and prolonged by the government's long inaction. The swift response to the financial crisis shows that policymakers have learned something from Japan. Unfortunately, they didn't read the full story. A key lesson from Japan is that refusing to take the inevitable haircuts paralyses the whole system and makes the adjustment longer and more costly. By guaranteeing the debt of Greece and potentially other bankrupt governments, European policymakers are repeating the same mistake. Moreover, cleaning up the fiscal act is not all. As in Japan, Europe faces deeper structural problems that it needs to address, particularly the poor competitive shape of the South.
- Third, the pending fiscal consolidation, whether done swiftly or dragged out, will become a huge drag on growth, threatening the political viability of the whole adjustment. The only tool left to offset the fiscal drag is monetary policy. In Japan, policymakers took too long to understand the need for accommodative monetary policy. In fact, they tightened prematurely before moving to the zerointerest- rate policy and quantitative easing. Whether the ECB will learn from Japan's experience remains to be seen.
To use a military analogy, this is not a short battle against speculators, but a onetotwo decadelong war against fiscal prolificacy and structural inertia. Indeed, cynics may welcome a recession, if it would force European policymakers to take more decisive action.
Worry about taxes and not inflation
The buildup of large government debt has fueled inflationary concerns, especially in Germany. The ECB announcement that it is buying government debt did not help ease fears. Although long ago, memories of hyperinflation post WWI, which was created by the monetization of government debt, are still alive in Germany. But exactly because this memory is still so present, the adjustment is likely to take a different path, namely through higher taxes and not inflation.
What drove the German hyperinflation post WWI was the legal obligation of the Reichsbank to exchange on demand government debt into bank notes. This gave the government an incentive to increase debt and not save and forced the Reichsbank to print ever more money (after a few years, the Reichsbank held almost all government debt - see chart).
The ECB, in contrast, is under no obligation to buy government debt. The decision to do so has been voluntary to ease market tensions. Moreover, the operation is temporary and sterilized through reverse repos to withdraw liquidity from the market. Most likely, the ECB will not fail the test and prove that its antiinflation stance and independence have not been compromised. Still, some reputational damage has been done, made worse by the poor positioning of ECB policy in the public.
So, if inflation is unlikely to do the trick and growth certainly neither, Euro governments will be forced to save. This may get dragged out, but the process has clearly started in the South, where governments have little choice. Germany and much of the North are in better shape, but have to consolidate their fiscal balances as well. Ideally, this should be done through spending cuts and the removal of tax privileges. Political reality, however, looks different. Thus, tax increases are set to come (see also German fiscal adjustment: cold turkey versus piecemeal, Silvia Quandt Research GmbH, 20. May 2010).
ECB to lean against fiscal drag
Going back to the Japanese experience, fiscal consolidation will be long and depress both growth and inflation. Indeed, falling into a deflationary spiral is the main risk. Good economic judgment and not political pressure will compel the ECB to lean against the fiscal drag. As the Japanese case has demonstrated, however, this requires a change in mindset, which may take some time, especially as it may require a new policy approach.
Against this background, the next ECB rate move is more likely to be a rate cut than a rate hike. With effective interest rates already close to zero, cutting official rates further will be more symbolic for the direction of monetary policy than have real impact. Real easing would mean quantitative easing, which the ECB in contrast to the Fed and the BoE has so far avoided. Indeed, this may mean buying more government debt. But if Japan is a guide, this will probably not lead to inflation. Whether and how much quantitative easing will be necessary remains open, but the ECB would do well not to rule it out in advance.