Solving Secular Stagnation

There is now a sense of gloom that pervades the corridors of power in the developed world, six years on from the Lehman Brothers' default and the ensuing “great recession” we are still in the economic dead-zone.  In particular Europe is marred by low growth, high unemployment, falling prices and the worry is that this is the “new normal”.  Most economist are satisfied that the problem is poor aggregate demand, caused by falling investment in both the private and public sectors combined with diminishing disposable income - wages have been flat for years.  This malaise has been characterised as “Secular Stagnation” (SS), a term made famous by Larry Summers a former Head of the US Treasury department.

Larry Summers - feeling the torpor of Secular Stagnation

Ignoring the Wealth of Nations

When Adam Smith published his economic treatise in 1776 he gave the world a number of defining ideas for wealth creation and preservation.  The first was that regulations on commerce are a menace and counter-productive. Smith’s amazing insight was that a nation’s wealth is really the stream of goods and services that it creates not the gold it accumulates.  Another important idea was that a country’s future income depends upon this capital accumulation (wealth) and that the more that is invested in better productive processes, the more wealth will be created in the future. As an adjunct to this idea people must be confident that their capital will be secure. The countries that prosper are those that grow their capital, manage it well, and protect it. The final theme is of course the “pin factory” and that productive capacity rests on specialisation (the division of labour) and the accumulation of capital that this makes possible.

My thanks to the Adam Smith Institute

Abenomics on the ragged edge

Economist around the world watch Japan with baited breath, there is much at stake for the both sides of the argument, The Keynesian wing have their fingers tightly crossed hoping that Abenomics will finally  be the solution to kick starting the world third largest economy, that has been moribund for years. Others on the monetarist wing believe that it will end in tears, and it looks like the markets are voting in favour of the monetarist.

Abenomics is in fact a sort of con-trick, the Bank of Japan (BoJ) is trying to break a deflationary cycle but massive doses of Quantitative Easing (QE) alongside a huge increase in government spending on capital projects.  It is hoped that these two levers will prize economic growth out of an economy that has been going sideways for 20 years.   What everyone knows, is that the moment inflation resurfaces and growth returns, the BoJ will return to a more prudent approach.  This highly transparent strategy has now turned into a game of cat and mouse between the BoJ and the markets.  This week bond yields rose (higher interest rates expected), stock prices fell and the yen rose a little against the dollar last week.  Paul Krugman argues that higher bond yields, a weaker stock market and a stronger exchange rate are all in response to a tighter monetary policy than the one now promised (a broken promise).  The markets don’t believe the Haruhiko Kuroda the new governor at the BoJ is going to be as mad as he says he will be!  The big questions are:

1. Will the markets believe that the policy to risk all for 2% inflation is real or just a short term con-trick 

2. Will interest rates remain lower enough to see this policy through
3. Will the fourth arrow of increase sales taxes to fund the capital spend programme actually be delivered

It’s difficult to believe that the BoJ will be utterly reckless for much longer, everyone knows that Mr Kuroda is trying a form of blind man’s bluff.  The markets will take a medium term view so this promise ‘to be reckless for a little while’ doesn’t cut much ice.  

A further difficulty is that the whole plan depends on low interest rates, to force down the value of the Yen (supporting export growth) and to drive up consumer spending in Japan.  But low interest rates are going to be dependent on the level and expectation of government debt, which already unsustainably high.  If interest rates rise then the need slash capital spending would create a very swift about turn in policy and this is what the markets believe will happen – this could become one-way bet.  

In addition to the interest rate time bomb another problem is that Abenomics has weaken the Japanese banking sector, which is now sitting on Y821tn ($8tn) of government bonds (the result of government debt and QE) and the bottom is falling out of this market.  This is making it very difficult for the Banks to lend money to new and growing businesses.   

The net result of all of this is that Shinzo Abe is on a tightrope above a shark infested river.  He needs to tread a fine line between a credible reflationary policy and need for low interest rates to manage the crippling public debt.  He might just totter across the ravine and receive a hero’s welcome but my money is on him ending up in the torrent with the short sellers enjoying a tasty lunch. 

Go Abe Go - Proving Paul Krugman Correct

We watch with bated breath for the results Abenomics (the economics strategy of Shinzo Abe the Japanese premier), which is a lethal cocktail of Keynesian supply-side expenditure reckoned to be worth $75bn in this quarter alone and a massive dose of quantitative easing.  Some like Paul Krugman (the liberal conscience of economics) believe it’s the perfect cocktail of goodies to resolve the liquidity trap that the Japanese economy has been in for 15 years or more.  A liquidity trap is where private demand is too weak, so that even at a zero short-term interest rate private consumption (spending by people and private companies) falls well short of what’s required for full employment and positive growth. In these circumstances, monetary stimulus, quantitative easing (QE) is unlikely to have any effect.

Which on is Abe, Angela?

Japan is a very important economy to study and understand as they have been in this liquidity trap for 15 years and these are now the conditions that apply in the US and much of Europe, so if Abenomics works we all need to know how and why.  Krugman argues that people will continue saving even at low interest rates if they believe that central banker are genetically modified to maintain low inflation and interest rates. Krugman is pining his hopes to the idea that Bank of Japan can this time “credibly promise to be irresponsible”.

Read his blog at 

http://krugman.blogs.nytimes.com/2013/04/11/monetary-policy-in-a-liquidity-trap/

I think things are a little bit more mom and apple pie than Krugman.  Private consumption is flat and saving are increasing for two reason, firstly we have an aging population in the west and Japan that are under-funded in their pensions and they are having to stash whatever they can away to cover their endless retirement (same is true with company schemes).  This squeeze on 35-40% of the population is intensified by the terrible savings rates due to all that QE, you need double the pension pot if interest rates are half of what you expected.  Secondly working households are carrying the entire burden of austerity and have no room for manoeuvre, although mortgage rates are down real wage deflation and unemployment have hit them hard. 

So what to do, in the short term I would ignore the saving issue as monetary policy doesn’t seem to have much effect and the medium term expectation is for continued low rates of interest.  I would focus is providing relief to  the working middle class (cutting sales taxe is the most direct route) this would give them money in their pockets, which is likely to flow back into the economy quickly.  This should help prices to rise and eventually force interest rates up.  However unpopular a demand side stimulus is, it's probable to only way to escape the liquidity trap!