August 15th, 2011
in Op Ed
by Guest Authors Marc Lavoie and Mario Seccareccia, both of whom are full professors of economics at the University of Ottawa. This was first posted at The Progressive Economic Forum
Over the last twenty years, the Japanese economy underwent a long period of economic stagnation that some economists have characterized as a protracted “balance-sheet recession”. The period has been dubbed by some as the era of the two “lost decades” in Japan. However, there are now ominous signs that seem to presage a widening of this contagion to the world economy, or at least to the industrialized Western countries. This long recession in Japan was preceded by the breaking of the bubbles in both the stock and the real estate markets, whose sharp decline in prices pressured Japanese households to de-leverage, which, in turn, led to terrible negative consequences on overall spending.
Follow up:For over a decade, the central bank of Japan pursued a monetary policy of zero interest rates in an effort to kick-start private spending, but this was to no avail. The Japanese fiscal authorities pursued generally a mildly expansionary fiscal policy, but only to back track on too many occasions, in a futile attempt to implement fiscal austerity and reducing budget deficits and debt.
The United States is facing a similar situation with the all too familiar behavioural reaction on the part of the policy authorities. We are now probably witnessing the bursting of a third bubble in ten years in the stock market. The real estate market which began to collapse in 2006 still remains in a state of disarray. Both US banking institutions and American households remain overly indebted, while non-financial business enterprises prefer to keep their profits highly liquid rather than risk investing in new machines and equipment. Much like in Japan, the only avenue left to sustain growth in the economy is through greater public spending. However, as we have seen with the political wrangling over the debt ceiling, the Obama administration has largely been held hostage by fanatics of the Tea Party movement and other advocates of balanced budgets à outrance, including some within the Democratic Party itself. Tragically, these political leaders do not understand the full macroeconomic and financial implications of their strong opposition to budget deficits in this “balance-sheet recession”, in which every sector is seeking to de-leverage itself on the backs of some other sector in a dangerous financial game of musical chairs. The dramatic volatility and sharp decline in stock market prices recently is not caused by some irrational fears that the US government will default on its debt payments which everyone knows it will not and cannot. Rather, behind all the smoke screen about the public debt, private investors now understand that the American and European economies, which have historically been the motors of growth in the world economy, are now headed straight towards another serious recession, with their governments being politically or institutionally incapacitated to implement pro-growth policies in the short to medium term.
The downgrading by Standard and Poor’s of US government debt on August 6, 2011, from AAA to AA+, will have absolutely no impact on long–term yields, such as yields on 10 year US governments bonds which had actually fallen to 2.20% at the beginning of this week. In the case of Japan, which Standard and Poor’s had downgraded to AA- on January 27, 2011, the yield on 10 year Japanese bonds was 1.05% on August 9, despite the fact that Japan’s public debt to GDP ratio was over 200%, about double the US ratio! At the same time, notwithstanding the lower debt ratios in some of the European countries, these yields on 10 year bonds in Greece, Portugal and Ireland, varied between 10 and 15%, and they were between 3.1 and 5.2% for Italy, Spain, Belgium and France. In the case of Canada, these same yields were at 2.41%. What difference is there between Canada, the United States and Japan on the one hand, and the European countries within the Eurozone on the other?
The difference is that Canada, the United States and Japan are sovereign states and issuers of their own currency, while the countries of the Eurozone are not, because of the existence of a single supranational currency. Hence, those three countries (with their own sovereign currencies) cannot possibly default on their payments, regardless of the opinion of the analysts of Standard and Poor’s, unless their governments recklessly choose not to want to meet their obligations because of some opportunistic political motives. These three countries issue their own currencies, their foreign exchange rates are not fixed, and they face no institutional constraint with regards to the central bank purchases of government securities. In other words, if you hold a government security that you would like to cash, the respective governments of these three countries would be able draw a cheque on their accounts at their respective central banks, and could then reissue and sell new bonds, directly or indirectly, via their central banks without any other consequence.
The situation of the countries of the Eurozone is quite different. The European Central Bank (ECB) cannot accommodate any national government within the Eurozone. The ECB can only refinance banking institutions. It cannot make any cash advances to their national governments, nor can it directly purchase any newly-issued bonds. Indeed, the ECB would historically not even engage in purchases of national government securities in their secondary markets — a self-imposed constraint which it abandoned on May 10, 2010 when it was confronted with the startling fact that Greek and Irish debt had become unsustainable. When the Portuguese, Spanish and Italian bonds began to succumb to speculative attacks this year, the ECB abandoned once again its long-standing principle of not intervening in the secondary bond market. With the excuse of better achieving its objective of Euro-wide price stability, on August 7, 2011, the ECB began once again to purchase government securities in the secondary markets, and was able to prevent a sharp rise of long-term interest rates in Spain and Italy with a certain degree of success. However, the stabilisation measures of the ECB are conditional: its governor, Jean-Claude Trichet, requires of the Italian and Spanish governments to implement drastic austerity measures that will plunge these already precarious economies into recession. If the Greek scenario of a vicious cycle is also played out in these two countries, the European Financial Stability Facility (EFSF) initially set up to help bail out smaller countries such as Greece, Ireland and Portugal, will have to be replenished and it will inevitably increase the speculative attacks against France, which, together with Germany, will be forced to finance the largest share of the new funding. And if France also collapses as a result of these speculative attacks, then even Germany that most analysts see as the stalwart or unfailing pillar of the Eurozone would itself be at risk of default. However, even before reaching such a situation, European banks, which are the principal holders of European “sovereign” debt, would themselves have become insolvent. It is perhaps this fear that would explain why the prices of bank stocks have been declining over the last several months, much as during the 2008 debacle.
During the 2008 financial crisis, governments had committed themselves to pursue contra-cyclical fiscal stimulus packages to secure growth via deficit spending. However, over a year later, in Toronto the G20 leaders decided to revert back to the well worn policy of fiscal austerity in support of sound finance that our finance minister, Jim Flaherty never ceases to remind us and seems to wear as a badge of honour. The mistakes of Japan over the last two decades and the errors committed during the Great Depression of the 1930s are being repeated once again on a colossal scale. Politicians internationally and bureaucrats of the ECB continue to believe that public sector deficits cause inflation and low private sector spending, even though Japan has shown that, despite large deficits and an enormous growth in the money supply, it has remained in a state of practically zero inflation for two decades. Regardless of their effects on public debt ratios, national governments must return to expansionary fiscal policy, which would be the only source of growth in the world economy today. Without it, we would have achieved what most policy makers least want, which is the “Japanisation” of the world economy.