The middle-of-the-road option for a ‘Japan experience’

The IMF has warned that global growth will decline further unless more action is taken to stimulate growth. In the coming quarters we foresee the financial markets no longer accepting the authorities attempting to stimulate growth by means of extra fiscal stimuli (demand side policy). The room governments had to do so has been used up in the years following the credit crisis. In the meantime, in many countries public debt is approaching or has exceeded the 90% limit (in relation to GDP). Above the 90% limit, the burden of debt has an increasingly negative effect on the economy’s growth potential. Many countries in Europe and the US have also reached the point where budget deficits remain high but no longer make any positive contribution to growth. To stimulate growth, government expenditure then have to mount higher, but with the current growth decline, government revenue will already be below par so the higher deficits will not provide any direct boost for the economy.

 

In short, budget deficits continue to mount swiftly while the growth outlook is not improving or is even deteriorating, because governments are using up capital that then cannot be used by the private sector. Moreover, with the burden of debt rising, governments are less able to invest in growth-promoting measures (such as innovation and education). That increases the risk of the government no longer being able to repay its debts or needing to implement an inflation policy. Investors in long-term bonds will have to increasingly take this into account.

 

In this climate, we foresee central banks remaining extremely reluctant to implement extra monetary stimuli to promote growth:

-   An even looser (quantitative) policy also has drawbacks – see also our regular ECR Research reports.

-   Without extra fiscal stimuli, extra monetary stimuli are fairly ineffective in stimulating growth

-   Due to the combination of weak growth (prospects), and persistently high budget deficits, central banks have to be careful not to give investors the impression that the aim of loosening monetary policy is monetary financing of the budget deficit. That would be disastrous for confidence in the currency. The Bank of Japan is already making serious allowances for this in its policy.

 

Therefore, we do not expect central banks to opt for a demand-side policy. On the one hand of their own accord, as the drawbacks of extra fiscal and monetary stimuli keep growing. On the other hand, because we expect the financial markets to rebel against further loosening of fiscal policy and demanding higher interest rates, in which case public finances would quickly get out of hand.

 

However, we do not envisage the authorities opting for a supply-side policy (structural reforms and cleaning up troubled balance sheets), either. Voters in many countries do accept that something has to be done to reform the economy and the labor market as long as it is done on a limited scale. The danger is that, as soon as the negative effects of a deflationary spiral become evident (as is the case inGreeceandSpainnow), voters will demand of the authorities what they have kept promising in the past few decades: to sustain a certain level of growth.

 

We therefore feel it is most likely that pressure from the financial markets and voters will force the authorities to take a middle-of-the-road route between demand-side and supply-side policy. For fiscal and monetary policy, that means the authorities will be increasingly cautious in stimulating growth, but will fight the negative effects of the (approaching) deflationary spiral as far as possible.

 

We foresee the room the authorities have to maneuver shrinking. The more evident the negative effects of a deflationary spiral become, the greater the risk that investors will lose confidence in the government’s creditworthiness. As soon as that results in rising interest rates, the situation deteriorates further and there is little the government can do. This generates further political tensions, and probably more protectionist measures and increased pressure to implement financial repression. Financial repression is when the authorities make investment options more or less appealing according to what suits the government best.

 

As the authorities are more or less forced to take a middle-of-the-road route, the major drawbacks of demand-side and supply-side policy are avoided, but the benefits are not being enjoyed either. This is quite similar to whatJapandid in the decades after the property and credit bubbles burst in the early 1990s: postponing painful reforms and failing to restructure the banking sector in the hope that future growth will automatically solve the problems.

 

What this means for stock prices, EUR/USD and long term interest rates will be thoroughly explained in our regular ECR research reports. For a free trial, click here.