I tend to be bullish on Europe – partly as a corrective to the mass of commentators who too early wrote off the crisis in the Eurozone as irresolvable.
This optimism has been justified by the recent run-up in European equities, with developed European countries (Germany, Ireland, Finland…) constituting four of the five best-performing stock markets of 2013, when measured in US dollar terms.
That said, a spectre is now haunting Europe – the spectre of deflation.
The problem with deflation is that it makes the value of savings grow, which encourages people to spend less. If prices are falling, a penny saved is more than a penny earned, because, if you do not buy that TV set (for instance), not only will you have saved your penny, but the TV set will be cheaper in a few months, so you are actually getting a return on your patience.
Hence deflation encourages people to save, which reduces demand. The TV shops in response reduce the prices of TVs even further, in an effort to get you to buy. Which implies yet more deflation. A few rounds of this, and you have the dreaded “deflationary spiral”, producing not only deflation but a serious contraction in consumer spending and hence real economic activity.
Scenarios run by Oxford Economics on the potential impact of sustained deflation in the Eurozone are not pretty, suggesting the economic bloc would be pushed back into recession. In response to such concerns, Germany’s Bundesbank has recently softened its opposition to quantitative easing, suggesting that radical measures to combat the threat of deflation may be forthcoming.
This announcement has widely been treated as welcome news, but it worries me. Fighting deflation directly can have costs.
Take the instructive case of Japan, which has been in the grip of deflation (falling prices) for more than a decade. The textbook response to deflation is to cut interest rates (possibly to zero, which the Bank of Japan did – at the time, a radical measure). The next step is quantitative easing (in effect, printing money).
Japan is now printing money, in a deliberate effort to create inflation. At one time, of course, printing money was seen as bad (remember hyperinflation in Brazil?). But as a deflationary spiral has set in, there may not be much choice. The Japanese government’s objective becomes to deliberately erode the value of people’s savings, so they start to spend now.
The problem is, the mechanisms of deflation-fighting can have other effects, particularly in the short term. In Japan, interest rates set at zero gave rise to “zombie companies”, which were unable to pay their debts but continued to operate because, if interest rates are zero, then interest payments are zero (or close to it). Japan’s TV shops (and others) kept cutting prices, losing money, and refusing to go bust – adding to the deflationary pressures easy money was supposed to fight. Of course, eventually the banks should cut such companies off, but banks that had already taken large losses on property they owned were reluctant to cause more insolvencies.
A new book by David Pilling argues that Japan has overcome this problem and restructured its economy slowly over the past two decades, despite the continued presence of “easy money” (which Abenomics has just made much easier). The data are mixed. Japan’s incremental capital output ratio remains low, which suggests that a lot of investment is being wasted, possibly by companies that need to go belly up but have not. On the other hand, corporate profitability has recently recovered strongly – but only after two “lost decades” in which growth in corporate profits was, on average, negative (during the 1990s) or under 3% (in the 2000s).
The bad news for Europe is that it took Japan two decades to get to this point.
The US seems to have done better – corporate profit growth remains high, averaging about 7% per year, which is in keeping with historical averages. Despite easy money, US banks did not hesitate to cut off credit to businesses with poor prospects (no doubt partly because they were confident that juicy bailout packages would await them if they got into trouble). US companies did not hesitate to close offices or factories and fire people.
I worry about Europe though. European banks have been hit hard by the sovereign debt crisis, and if money is easy, they may choose to look the other way rather than forcing bad borrowers into bankruptcy. European governments are likely to encourage this behaviour – many of them are too indebted to afford further bank bailouts.
And Eurozone profitability statistics are worrying. In the years since the global financial crisis, companies in France, Italy, Greece, and Portugal have produced negative profitability growth, on average. To be sure, these companies have been grappling with a long and ugly negative business cycle, but cheap credit could produce some “zombies”. (Indeed it probably has, and over-production by these undead, loss-making companies is one factor driving Eurozone prices down.)
The only remedy to this is structural reform: making it easier to fire, hire, start businesses, close businesses, restructure businesses, and take businesses over. It would have been much better if the Eurozone had avoided deflation this way, rather than being forced to go down the money-printing route.
Of course, structural reform is the so-called “third arrow” of Abenomics, although for now it remains stuck in Abe’s quiver. If Europe is to avoid Japan’s troubles, it needs to be more brave.