No Growth, No Inflation, No Problem

Central banks around the world have been doing everything they can to "boost" their respective economies. They did so by keeping interest rates exceptionally low and "printing money" to purchase financial assets in order to boost asset prices and avoid asset deflation and goods deflation. At the eve of a US election, it is time to take a step back and ponder the next step and the big picture.

Here is the situation for the most industrialized nations:

1. Low unemployment in the USA, Germany, Japan, Australia, and the UK.
2. High unemployment in France, Spain, and Italy.
3. High government debt-to-GDP ratios in the larger economies, especially for Japan, the USA, Italy, France, Spain, and Canada.
4. Aging populations and low employment ratios (relative to pre-2008 levels) for most countries.
5. Zero inflation.

Generally speaking, there is no big crisis in terms of high unemployment in most major economies, but there is sluggish growth and relatively high government debt. For most people, as long as unemployment is low and they can keep their purchasing power (no major tax increases and no major inflation issues), everything is OK. We currently kind of have this combo in many countries: low unemployment and stagnant purchasing power... All in a low growth and low inflation context. What's next?

First, monetary stimulus has a price: if you keep interest rates "artificially low" for extended periods, you eventually get asset price bubbles that pop, which bring "interest rates" back to normal (higher) levels... Yes that's correct: when bubbles pop, asset prices fall, which make expected returns increase, because if you buy low, your expected profit is higher than if you had purchased the same asset at a higher price. This is essentially a rise in "interest rates" even if it not presented that way.

You think central banks control interest rates, but that is an illusion: the central bank controls short term rates in the money market, but it does NOT control returns in stocks, long term bonds, housing, and many others. Yes, it does influence "the yield curve" by communicating the expected path of the policy rate and by buying various assets with QE policies, but at one point, returns respond to reality by pricing assets, land, real estate, and most other assets appropriately, based on actual economic fundamentals - good ol' supply and demand.

Central banks want to avoid deflation to avoid the dreaded "debt-deflation" dynamics and falling nominal tax income for the government, but it seems many central banks have trouble respecting their own 2% inflation mandate and are creating "inflation" in asset markets without inflation in goods and services other than land and housing. Japan is the pioneer in this new world, and what do we have in Japan? Sky-high government debt, stagnation, and... low unemployment...

In the long run, economic "growth" comes from people working and how efficient their work process is, aka "productivity." We collectively produce stuff that others want (hopefully). If we are more to produce and/or we produce more per worker, GDP increases and jobs are created in the process. The real game changers are the major innovations that change our lives: fire, the wheel, electricity, washers and dryers, computers and telecoms, medecine, planes, trains, and automobiles (such a classic movie!), and so many others.

Now the issue for most industrialized countries is demographics: a falling working age (15-64) to total population ratio going forward. This means it will be normal to have lower job creation without labor market issues... But low job creation and stagnation create problems for financial markets and public finances. This may not be sexy for politics, but it requires a reshifting of public finance management and our expectations on growth. We can't "bet" on future growth by eternally boosting growth with short run macro policies while the underlying fundamentals are ignored: demographics, employment ratios, innovation, and productivity.

If reflation works one day...
Central banks are aiming to increase inflation. For now it is a fail, but if they continue, they may just get the inflation they want, and when that comes, interest rates will rise... and what then of the massive debt service of high government debt-to-GDP for those with the worst positions, namely Japan, Italy, the USA, Spain, France, Canada, and the UK? Zero percent interest on a big debt is manageable, but 1% on a huge debt becomes a hefty amount in public finances. Expect higher taxes down the road my friends...

The main trick of macro stabilization is to boost the economy in downturns and get the debt-to-GDP ratio back down to Earth in periods of growth. The issue now is that with the demographic backdrop and normal productivity growth, it will be hard to get that balanced budget governments need in times of growth, and we will have high debt loads to deal with... Unless taxes increase or major cuts in government programs are the next big thing... Both are not fun, I know.

What countries can do now
Stop with the monetary asset price inflation policies and other short run boosting and focus on the hard questions that are "structural" and vastly more important:

1. How to we decrease unemployment permanently?
2. How can we increase the proportion of people working?
3. How can we create incentives for companies to innovate and produce?

Look at Japan. This country has been beating around the bush for essentially 20 years, building up a mountain of government debt that is almost unreal and literally impossible to pay back due to demographics alone. They have essentially eliminated the options for future generations in a spaghetti policy mix that has little logic or coherence. But at least they have no unemployment problems. What next? More of the same... Avoiding structural reforms, "boosting" the economy with half-hearted attempts, and lots of monetary intervention... The only way to get rid of an impossible-to-pay debt load is either explicit default (I tell you I won't pay you) or implicit default: you print a lot of money, which creates inflation, and the amounts due are indeed "paid back"... but they are worthless in terms of purchasing power. For Japan, barring explicit or implicit default, expect more of the same, but perhaps now they accept that printing is not a sustainable policy in the long run?

For others, either they will ponder outside-the-box policies that actually attack the causes of sluggish growth at the root or we will see more of the same, with gradually increasing government debts and a shrinking of macro policy options if another downturn comes our way. Either stimulate and get the job done OR get a grip on your fiscal balance... but by GOD, don't mess up the fiscal balance little-by-little, while at the same time going essentially nowhere. You can be for or against fiscal stimulus, but it seems clear to me that IF you decide to do it, the rule should be "when in doubt, overstimulate"... Because you are better to be stuck with the "problem" of an overheating economy rather than eternal stagnation. No? Of course we could debate over the micro efficiency of government spending in such "stimulus programs", and I am indeed sensitive to this problem, but that is not what I want to debate here.

Judging on the intergalactic emptiness of the political debate in many countries (special note for the USA) and total ignorance of the true motors of prosperity and growth in mainstream politicians, my guess is we will simply get more of no-change and empty-yet-entertaining debates... God help us all, we seem unable to think outside the box... Hey! Cheer up: US politics is now better than the best sitcoms!

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