Europe’s Japanese Decade

Europe is now officially in the liquidity trap.

Even though this gives me plenty of reason to say “See I Told You So”, I prefer to note that this is a thoroughly bad thing for businesses and households in the euro zone.

The ECB may have a positive intent with this, but the only thing it has achieved is to cement a fundamental imbalance in the euro-zone economy. That imbalance is a structural excess supply of liquidity. This is what happened in Japan in the ’90s, when what was then the world’s third largest economy got stuck in a state of economic stagnation for so long that the country basically lost an entire generation to dependency on parents and whatever social welfare they have there.

The significance of the ECB overnight rate move cannot be understated. The ECB is one of the world’s four most important central banks (together with the Bank of England, the Federal Reserve and the Bank of China). By nailing its interest rates not to the floor, but to the ceiling of the basement, the ECB has officially capitulated on the monetary policy front.

This is huge. Before we get into just how huge this is, let us listen to a couple of astute observers, whose points illuminate the practical side of the issue. First, Ambrose Evans-Pritchard from the Daily Telegraph:

The way we are going, the whole world will end up with zero interest rates or some variant of quantitative easing before long. Such is the overwhelming power of deflation in countries with burst credit bubbles. Such too is the implication of a global savings rate that has spiralled to an all-time high of 25pc of GDP, starving the world of demand.

There you go. While Evans-Pritchard is wrong about the root cause of QE (I will explain this in a moment) he nails it right on the head about aggregate demand. Lack of demand is, in turn, driven by overarching pessimism among businesses and households, a pessimism that translates into a net reduction of spending in the economy. To quote Lord Keynes (General Theory, Chapter 16):

An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, — it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.

And that is precisely what has happened in Europe. While the American economy seems to continue its sluggish recovery after a hiccup in the first quarter, the European economy is sinking even deeper into the stagnation quagmire. Neither businesses nor households want to spend. They choose to save instead, which increases liquidity levels in the banking system. Banks in turn signal excess liquidity to the ECB, which now has responded by saying “don’t come to us with your money – lend it out instead”. But so long as households and businesses remain pessimistic and prefer to save, not spend, they will not demand more loans from Europe’s financial institutions.

As I pointed out back in April, interest rates in Europe have been on the downslope for at least three years now, without generating a macroeconomic restart. There have been isolated pockets of recovery, such as in the Spanish and Portuguese exports industries, but overall the European economy remains at a standstill. The problem is not lack of liquidity – the problem is lack of confidence.

Somewhere, the ECB knows this, but they are not the ones who can restore it. Yet as Evans-Pritchard suggests, their sub-zero interest rate policy is an expression of a desperate desire to do the impossible, namely use monetary policy in a liquidity-saturated economy to restore business confidence:

The chief purpose is to drive down the euro, an attempt to pass the toxic parcel of incipient deflation to somebody else. The ECB is expected to map out future purchases of asset-back securities, “unsterilised” and intended to steer stimulus with surgical precision towards small businesses in what amounts to light QE. This is not yet the €1 trillion blitz already modelled and sitting in the ECB’s contingency drawer.

But that is the next step. And, again, the ECB’s commitment to buy treasury bonds from any troubled country, at any time, at any amount, is de facto a standing commitment to start QE at the drop of a hat.

One more point from Evans-Pritchard:

In China the new talk is “targeted monetary easing”, with the first hints of outright asset purchases. Railways bonds have been cited, and local government debt. The authorities are casting around for ways to keep the economy afloat while at the same gently deflating a property boom that has pushed total credit from $9 trillion to $25 trillion in five years.

Which, again, de facto puts all three major global currencies in the QE zone. So far only the euro has reached liquidity-trap territory, but its fate is a stark warning to other central banks to put a foot down at some point when it comes to saturating the economy with liquidity – in other words, printing money day and night.

Another Telegraph columnist, Jeremy Warner, explains:

This is truly desperate stuff. That nearly six years after the collapse of Lehman Brothers, Europe is still belatedly trying to address the twin afflictions of deflation and economic depression tells you as much about the political paralysis that grips the euro area as about the severity of the crisis.

Yes. However, I am not sure Warner knows exactly what that political paralysis consists of. Europe needs deep, far-reaching structural reforms in order to get its economy going again. The key content of those reforms must be the gradual, but eventually complete dismantling of the welfare state. This will not only eliminate the heavy tax burden on Europe’s private sector, but also open up large sectors of the economy for free-enterprise entrepreneurship. Both these effects will generate GDP growth way beyond what today’s political leaders in Europe – and, frankly, in America – can imagine.

Such reforms would also pave the way for a restoration of sanity in monetary policy. Today’s vastly excessive supply of money, both in Europe and in the United States, is related to big, structural government deficits. In a way, government has established a third funding arm for its expenditures: in addition to taxes and borrowing from the general public, Europe’s and America’s welfare states have learned to work with their central banks to create an ongoing funding opportunity for government outlays. Central banks print money, buy treasury bonds and thereby allow welfare states to survive – theoretically in perpetuity – even as they max out taxes and their credit rating with the general public.

In other words, the purpose behind money supply under a welfare state is broader and more complex than in a free-market economy. In the latter, all the central bank does is provide a base for liquidity in the economy; in the former, the central bank adds to its liquidity commitments a “funding buffer” for big government. Since big government slows down economic growth, over time the tax base cannot keep up with the growth in entitlement spending that is symptomatic for the modern welfare state. As a result, money supply grows faster to provide compensating funding. When the economy makes a serious downturn, as it did a good five years ago, this slow replacement of money supply for taxes to fund the welfare state accelerates.

Eventually, money supply becomes impotent. Unless fiscal policy picks up the slack; unless legislators make the necessary reforms; the central bank will hit the point of zero interest rate. From there, it only has two ways to go: back or down in the negative-interest basement.

The ECB chose the latter.

Welcome to the liquidity trap, Europe. Enjoy the stay, because it is going to be long. A Japanese Decade long.