To the Point - September 8, 2011: The real threat is stagnation

1. To the Point
Discussion on the economy, by the Chief Economist September 8, 2011
The real threat is stagnation
There is fear of a new recession in the western countries, spreading to emerging
markets and thus creating a new global economic crisis. Although the threat is
real, and would be serious if it materialised, as the tool box is more or less empty,
an even more likely danger to western societies is the possibility of economic
stagnation. With no or low growth for many years to come there would be great
negative effects on welfare systems. More than ever, it is thus important to
understand the challenges a stagnating Japan has faced for two decades and make
Cecilia Hermansson sure the same mistakes are not repeated.
Group Chief Economist
Economic Research Department Austerity dampens growth
+46-8-5859 7720 From a large country or regional perspective, the amount of austerity affecting
cecilia.hermansson@swedbank.se domestic demand does not look gigantic. Between 2009 and 2012, the OECD
expects the change in the structural fiscal balance (the one where fiscal policy is
adjusted by business cycle developments) in relation to GDP to be some 1.4
percentage points (pp) in the US, 2.4 pp in the euro zone, and 3.4 pp in the UK.
This is one way of measuring how large the austerity effects are on the economy,
and these effects seem relatively moderate over a three-year period.
However, if we analyse individual crisis-struck countries, such as Greece (12.7
pp), Iceland (8.9 pp), Portugal (7.3 pp), and Ireland (5.7 pp), it is clear that the
austerity imposed over these years affects domestic demand much more
profoundly. As a matter of fact, Germany is implementing an expansionary fiscal
policy during these years, albeit a mild one, thereby disguising the burden that
many of the euro zone countries are facing. PIIGS countries have less freedom to
postpone savings, as financial market investors now want compensation for
taking higher risks, thus increasing the interest rates on government bonds.
There are those who argue that austerity can be expansionary, and yes, this can be
the case if one or two countries on their own tried to lower interest rates by
cutting expenditures and raising taxes. Also, building political trust could
increase the propensity to consume and invest. However, when most of the
western countries are constraining their fiscal policies, the effects on growth will
be mainly negative; this is especially true as long as there is no political vision on
how to get the economy growing.
A lost opportunity
When the global financial crisis and the great recession started, massive stimulus
packages were implemented with the objective of creating higher demand and
getting economies “back to normal” again. However, there was no normal, and
countries with skewed household and financial sector balance sheets needed time
to deleverage. The old “milking-cow sectors” such as retail, construction and real
estate, finance, and services, became crippled as demand was lost in the process of
increasing savings and rebuilding wealth.
At the start of the crisis, stimulus packages should have already been combined
with structural reforms. For example, the housing sector in the US needed a new
credit and foreclosure system, and the labour market needed new competence as
structural unemployment rose. In Europe, the reforms of labour market and pension
systems should have come at once, and, with the stimulus provided at the same
No. 6 time, the reforms would have been easier to implement. Overall, global financial
systems needed a much faster overhaul.
2011 09 08

2. To the Point (continued)
September 8, 2011
Different policies for different types of recessions
The US is experiencing a balance sheet recession, and a lot of deleveraging is
needed before the economy can function again. It also means that the money
Graph 1: Structural fiscal balance, % of
multiplier is either zero or negative, and, despite quantitative easing (QE), the
GDP, 2009 and 2012
money supply does not really grow. A new QE package would lift share prices,
4 but probably just temporarily, since the global growth momentum is negative
2 and the debt crises in the western countries add to pessimism.
0
We now know from new data that the US economy is recovering more slowly
‐2
than expected. As households and businesses repair balance sheets, the role of
‐4 the government and fiscal policy increases. Unfortunately, there is little or no
‐6 understanding of these aspects. It makes sense to postpone fiscal consolidation
2009
‐8
2012
as long as there is also a clear mid-term plan, but, if the previous tax cuts are
‐10 terminated too early, we may have more consolidation than what is good for
‐12 the economy. In order to avoid a new recession, fiscal policy may have to be a
‐14 bit more expansionary in the short term, as monetary policy cannot do the job.
‐16
In southern Europe, the crisis has more to do with structural imbalances than
asset price bubbles. Therefore, reforms have to focus on improving the
functioning of the labour market, pension system, public administration,
competition, etc. Debt levels cannot continue to rise. Instead, fiscal
Source: OECD consolidation is needed, along with a combination of strong structural reforms.
Not that easy to create inflation ...
Graph 2: Consumer price inflation in the US
Economists discuss if it would be a good idea to create higher inflation, in order
annual growth (%) between 1913 and 2011
to expand demand and decrease debt levels faster. Yes, wage inflation would
25 maybe speed up demand, not least in the US, but how easy is it to create wage
20 inflation with high unemployment and most workers afraid of losing their jobs?
15 What about if inflation could be brought up to 6% per year over a five-year
10 period, as Kenneth Rogoff has suggested? How much lighter would the
sovereign debt burden be? Cottarelli and Vinals of the IMF (Sep. 2009) found
5
Percent
that the total reduction after five years would be only 8-9 %. Most likely,
0
nominal and perhaps also real interest rates would increase. They found that
-5 double-digit inflation rates would be needed for many years to seriously ease the
-10 debt burden, and that this would come with several other risks.
-15 So even if Rogoff urges us to think outside the box, it may be hard to get the
-20 higher inflation in the first place. Japan, as noted above, has tried for years, and
20 30 40 50 60 70 80 90 00 10
even if policies have not been right to the extent needed, it may just be that it is
Source: Reuters EcoWin
harder to achieve inflation when deleveraging is going on and unemployment is
Source: Ecowin extremely high. The other aspect is, if higher inflation actually could change
things – and for wage earners higher wage inflation would help some – in real
terms wages would still be weak. When it comes to debt reduction, it seems as if
higher growth and structural reforms would be more in line with what is needed
than the creation of double-digit inflation. Thinking outside the box may be
good, but even better is thinking – and doing – the right things.
Cecilia Hermansson
Economic Research Department
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