We mused over the likely QE exit scenarios a couple of days ago, arguing that there is one, relatively obscure monetary policy tool that the Fed could use to contain a credit explosion as a result of the excess bank reserves overhang.
That would go some way in allaying the fears of those who seem to think that the massive expansion of the Fed balance sheet sooner or later is going to result in accelerating inflation, which will be difficult to control. However, accelerating inflation isn't the only, or even most likely (in our view) scenario.
In our view, the most serious risk is that the economy simply won't achieve escape velocity, which will make it very difficult for the Fed to taper, let alone stop or unwind QE. This is the Japanese lost decade scenario.
Lessons from Japan
Japan, which suffered a financial crisis three times the relative size of the 2008 American crisis, has hobbled along for two decades on just enough fiscal stimulus to keep the economy from plunging into the abyss whilst the private sector (and banks) were deleveraging, but not enough to keep deflation from getting a grip on Japan.
Deflation is a particularly nasty problem when an economy is dealing with a large debt overhang, as it increases the debt in real value, making the problem that much more intractable, and risking a Fisherian debt-deflationary downwards spiral. Japan has made a host of policy mistakes:
- Monetary policy was way too slow to react to the initial implosion of the bubble
- Banks shoved their massive amount of bad loans under the carpet and policy makers stood by for over a decade
- The public works policies were just enough to keep Japan from falling into a depression, but not enough to keep it out of deflation
- There was a period at which the BoJ (the Bank of Japan) tried unconventional monetary policy (QE) in the early 2000s, but this was only a half hearted approach
You have to understand that the Japanese bubble, and subsequent financial slump was three times the relative size compared to the U.S. in 2008 (or 1929), and that banks are way more important for allocating capital in the Japanese economy compared to the importance of American banks. Hence, the policy to not aggressively restructure bad loans was especially damaging in terms of real economic effects.
In short, Japan's policy reaction left much to be desired, but it wasn't such a disaster as to cause any major depression. In fact, despite the widely used term 'lost decades,' Japan's economic performance has been on par with those of the U.S. and the EU on a per capita basis.
There is one thing that should provide a very important lesson, and that is not to let these processes fester. Immediate and decisive, even drastic action is warranted in the aftermath of the implosion of an asset bubble. There are numerous reasons for that:
- To prevent a Fisherian debt-deflationary spiral in which falling prices and/or incomes increase real debt burdens
- To avoid the creation of 'zombie' banks which are a drag on credit creation for business, and hence of growth
- To avoid a collapse in demand which tends to feed on itself (lower employment and stagnant or falling wages leads to a fall in demand, which induces companies to lower investment, wages and employment even more)
- To avoid the onset of hysteresis, that is, letting demand destruction eat away the quality and quantity of the future productive capacity, by lowering investment and the destruction of human capital.
Whilst having done better than the U.S. (or many other countries, for that matter) in the 1930s, Japan could have done much better. Policy makers in government and banks dithered for years. Banks have finally cleared up their bad loan overhang, and only now is Japan tackling the rest of the problems via a rather risky bet called Abeconomics, but it's their only ticket out.
The next question is, how is the U.S. doing? Before answering that question, we first have to explain a little about the effectiveness of different policy instruments under the rather specific post-bubble economic conditions that plagued Japan, but also the US.
When an asset bubble bursts, it destroys balance sheets, as it slashes asset values, but leaves debts alive. In Japan, the values of land, real estate, and stocks declined by 80-90% of their peak (1989-91) values, an epic destruction of wealth.
The U.S. 2008 wealth destruction wasn't nearly as big, nevertheless, $9+ trillion was wiped off household balance sheets through the housing crash. The effect of such wealth destruction is that the affected parties (mostly firms in Japan, mostly households in the US) try to repair their balance sheets, by increased savings, hence reduced spending.
Unfortunately, that triggers a collective action problem. As many save more and spend less at the same time, businesses see demand for their output diminish, cut wages, employment and investment, which only worsens the situation. Massive and immediate policy intervention is warranted, but how? Here are some of the options:
- Bank recapitalization. While not popular, it's absolutely essential to keep the financial system from imploding, and to keep credit channels open.
- Expansionary monetary policy. Slashing interest rates, flooding the banks with reserves, to stimulate interest sensitive spending.
- Fiscal stimulus. Embarking on public investment, cutting taxes, and the like to compensate for the private sector deleveraging.
We would argue that dealing with bank balance sheets is absolutely essential (hello eurozone!), as so much of the bubble was based on credit, banks are likely to be stuffed with non-performing loans. The longer you let these fester, the worse it becomes.
Monetary policy, the tool of choice for softening garden variety business cycles, simply isn't very effective under these circumstances. It's not hard to understand why. The main transmission mechanism is via credit creation. However, the private sector is deleveraging, that is, it is paying off debt, rather than take on new debt, no matter what the interest rates.
And collateral values have just been greatly reduced, and bank balance sheets have also taken a big hit, so the credit channel isn't likely to work very well. Businesses sitting on large amounts of cash face tepid demand, so they're not inclined to embark on a credit binge either.
We then have 'unconventional' monetary policy like QE. The Fed buys long government bonds (and other assets, like mortgage backed securities) in the hope of lowering bond yields that could spur interest rate sensitive spending (mainly housing).
However, all academic evidence (summarized here) we've seen is that it only has a small effect on long-term interest rates and, more importantly, the effect of these interest rate changes are likely to be small themselves under the present condition, for reasons just explained (private sector deleveraging).
So, a first tentative conclusion is that QE delivers very little 'bang' for huge amounts of 'bucks.' There are likely to be other transmission mechanisms though. QE money can, for instance via the repo market, end up in the financial markets, so it might create a bit of a wealth effect.
This effect isn't for everyone (to put it mildly) and it seems to have fallen more on emerging markets anyway. We can't possibly see this as an effective way to stimulate demand in the economy either.
That leaves fiscal policy. This can create demand directly, through public expenditures, or indirectly, through tax cuts. What you have to understand is that the same reason that monetary policy is very ineffective, fiscal policy is rather effective under the circumstance of a deleveraging private sector.
In fact, the IMF had to admit last year that fiscal policy is way more effective (up to three times) than what they previously thought, an insight that now also seems to have reached the European Commission, where austerity has done considerable damage, according to a new report.
Public spending can be financed with record low interest rates instead, as the private sector deleveraging increases the supply of savings. Let U.S. provide the following analogy. When demand sags at Japanese companies, they put their workforce in 'maintenance, training and repair' mode.
That is, rather than firing them (which is expensive, considering the firm specific training they received), it lets them do training, maintenance and repair when times are lean. Public spending during private sector deleveraging crisis could be viewed in the same way.
There is something of a $3.4 trillion backlog in maintenance and investment in infrastructure. What better time to make a significant dent in this whilst there are so many unemployed construction workers from the burst of the construction boom, whilst the economy is screaming for more activity, savings are plenty and interest rates are at record low?
It's by far the most efficient way to close the output gap (the difference between actual and potential output) during private sector deleveraging. Something of that you can gauge from the figure below:
Tax cuts are not likely to be as efficient because a deleveraging private sector is likely to save a good deal of these, especially if these are deemed temporary emergency measures.
Is the U.S. making the same mistakes?
Well, no, the reaction to the financial collapse was much better than that in 1929 and the Japanese reaction in the early 1990s, and credit to both the Bush and Obama governments, and the Fed:
- There were immediate emergency measures to keep the financial system operative
- There was a strong emphasis on forcing banks to recapitalize themselves after exposing them with a rigorous stress test
- There was a massive and near instant loosening of monetary policy
- There was the stimulus bill, around $800B roughly half tax cuts and half spending increases
All this was, grosso modo, necessary, although some claimed that the stimulus bill was way too small in relation to the output gap. These policy measures managed to turn around growth, trade, and markets, which had been falling as fast, if not faster compared to the 1930s
[Growth compared to the 1930s]
However, a backlash developed as financial institutions deemed responsible for the crisis got bailed out, public deficits and debts started to career upwards, and whilst Wall Street recovered and went back to business, Main Street didn't.
One of the victims of that backlash was the 2009 stimulus bill. However, academic research shows that it more or less performed as expected. This was very unfortunate, as disillusionment over the recovery and alarm about big deficits and growing debt turned fiscal policy from expansionary to contractionary.
It is rather unique in the aftermath of an economic crisis that public expenditures and employment actually declined.
This meant that the task of closing the output gap fell completely on monetary policy, which not only had to compensate for private sector deleveraging, but now also for fiscal austerity. We've already argued that monetary policy isn't very effective under these circumstances but austerity made the task harder.
Japan kept alive through fiscal stimulus (and is only now embarking on massive QE), the U.S. made an opposite mistake, it embarked on fiscal retrenchment way too soon. Even the IMF, which routinely calls for public spending cuts during economic crisis argued that U.S. fiscal policy retrenchment was "excessively rapid and ill-designed."
And we might very well get a next round of this as a result of some kind of 'grand bargain' to avoid another shutdown or even debt default. If kept up for much longer, the gap between potential and actual output might be closed in the most destructive way possible, by a reduction in potential output.
This hysteresis effect, as it's called, is being brought about as demand remains insufficient and excess capacity pertains, giving companies little incentive to invest and expand production capacity, which then grows much slower than if demand would be close to full capacity and more older, less productive facilities are kept alive.
In such a scenario, many long-term unemployed, unable to find a job, will simply disengage from the labor market (this is already happening), leading to a destruction of human capital (and lives) and further worsening potential output.
We already see this in the figures, and it's rather worrying. The labor force participation rate has declined alarmingly, productivity growth is down and capital formation is tepid. These developments diminish future production capacity.
For those that will retort that we have to cut spending now and fast to contain future debt levels we have to stress that such a slow-growth/hysteresis scenario can also have terrible consequences for debt dynamics. If you doubt this, ask the Greek, Portuguese, Irish, Spanish, etc. We prefer to get public debt under control via vigorous economic growth and mild inflation, rather than anemic growth and capacity destruction.
In Japan, the biggest culprit has been insufficient monetary policy reaction and slow policy reaction overall. This is different from the U.S. situation, where in the aftermath of the financial crisis monetary policy was quick on its feet and fiscal policy embarked on a considerable effort as well.
But since that first good policy reaction that staved off a depression, it has been fiscal policy that has been wanting, due to political constraints and panic about the exploding deficits and debts. All the heavy lifting is now forced on monetary policy, but it's monetary policy that isn't very effective under these circumstances.
And the longer this situation continues, the more the destructive hysteresis forces eat into future production capacity. It may very well be that under this scenario the Fed will find itself unable to diminish, let alone stop or reverse, its asset buying program, especially if we get another round of budget/debt ceiling games and/or another round of austerity.
And the longer this scenario lasts, the greater the possibility that the U.S. will slide into a "lost decades" Japanese scenario, despite its entrepreneurial and demographical advantages. It doesn't have to be this way...