The Japanification of Europe

Thinking about Japanification

Two FT articles and a discussion at Real Vision precipitated this post. On Monday, I had a conference call with a few markets-oriented colleagues at Real Vision, where I am an editor and program presenter. And one topic that came up in the face of the about-face by the world’s central banks was “Japanification”. And by that, we meant the lowering of growth and interest rates, with the two potentially feeding on each other.

The basic idea is that Japan’s low rate policy regime isn’t actually stimulus at all. Instead, zero and negative rates cause the yield curve to flatten, making banks, who lend long and borrow short, less profitable and more fragile. In an economy where troubled loans are high and capital is tied up, this could restrict future capital supply.

Deutsche Bank

Ironically, it was the research of Deutsche Bank, the weakened German bank, that sparked this post. Here’s an excerpt of the FT article reporting on it:

Negative eurozone interest rates and the ECB’s regulatory demands were today identified as the culprits for banking woes in a research note by none other than Deutsche Bank.

I would put this somewhat differently. I would say that zero level or negative base rates over a protracted period signal to the market that – because rates have remained low – rates will stay low for the foreseeable future. And as a result, the yield curve flattens over time.

And that’s because, yields of monetarily sovereign government bonds are mostly a reflection of expected future base rates with a term premium tacked on. And in the euro area, Germany is considered a de facto ‘monetarily sovereign’ issuer with an implicit full backstop from the ECB, given its policy of ‘fiscal rectitude’. Japan is the model here, with the yield curve as flat as a pancake and 10-year JGB interest rates trading below zero. The same is also true in Switzerland now.

So, far from helping the economy, rates kept low for a protracted period reinforce low growth.

Martin Wolf

The second FT article goes further in the direction I would go. Martin Wolf says “monetary policy has run its course“. Here’s his thesis:

The credibility of the “secular stagnation” thesis and our unhappy experience with the impact of monetary policy prove that we have come to rely far too heavily on central banks. But they cannot manage secular stagnation successfully. If anything, they make the problem worse, in the long run. We need other instruments. Fiscal policy is the place to start.

I agree with that statement. I think we have relied too much on monetary policy to do the heavy lifting of policy responses. But while I would agree with that, Japan shows you that just adding fiscal policy to the mix won’t do.

First, a lot of the increase in public sector debt will simply be a socialization of losses. It’s the public sector effectively transferring what should be private sector losses or writedowns onto the public balance sheet.

For example, think of Sears, the moribund retail chain that Eddie Lampert. How well would Sears do with the added boost of fiscal stimulus? Is that boost sustainable across business cycles without additional stimulus? I would say no. In Japan, a lot of the stimulus has been geared toward keeping the lights on at existing large, incumbent businesses. That creates a whole slew of zombie companies whose loans are rolled over by their banks, keeping them on life support, and tying up bank capital in the process. That’s where I was headed with the Sears example.

Japanification in practice

So, it’s not just about stimulus. It’s about, for lack of a better word, capitalism. I’m thinking of this in the Schumpeter creative destruction sense here. What we want is an economy that can sustain itself over the longer-term without zero rates and without large government deficits. Part of that is about getting to full employment and increasing purchasing power. But, part of it is allowing the likes of Deutsche Bank to fail if need be.

But we all know that’s never going to happen. What will happen is that a slow growth economy will hit the skids. And politicians and central banks will desperate to do something. A lot of that something will involve transferring private losses onto public balance sheets. And the result will be a lower productivity, lower growth economy made even more febrile by zero rates and a flat yield curve.

This is the future that awaits Europe. And the US will follow soon afterwards.