Markets have high expectation
from next week’s Draghi’s ECB meeting but moreover Friday’s inflation figures
from Europe will decide or will direct next policy
Meanwhile last week’s Jackson Hole meeting helped to highlight a simple
reality: unlike other parts of the world, the eurozone remains mired in a
deflationary bust six years after the 2008 financial crisis. The only official
solutions to this bust seem to be a) to print more money and b) to expand
government debt. Meanwhile, Europe’s already high (and rising) government debt
levels and large budget deficits raise the question whether we should worry
about ‘debt thresholds’, past which increasing deficits, and hence growing
sovereign debt, no longer add to growth? Such a constraint could come from one
of at least two sources:
1) Once the debt level gets
high enough, debt service costs (even at very low rates of interest) can eat up
so much of the budget that it is impossible to spend new money on anything
else. Fortunately, most European countries are not at that point. Take
France as an example: at roughly €45bn (or 2.1% of GDP), debt servicing costs
are not out of line with its recent past.
When looking at an
over-indebted borrower the most important questions should always be ‘Who owns
the debt?’ and ‘Will the owner prove patient or fickle?’ For example, a
family in which a father lends money to his children, will, on a consolidated
basis, have no debt. Applying this analogy to Japan, it seems that Japanese
savers prefer to buy bonds rather than pay taxes (government debt is
nothing but deferred taxes). As a result, 92% of outstanding Japanese
Government Bonds are owned by the Japanese themselves. Thus, in a
pinch, Japan could choose to convert its repayable debt into perpetual bonds
yielding, say, 1%. Even better, it could transform its debt into pieces of
paper called banknotes, which are really perpetual debt yielding 0% (perhaps
this is what Japan is already doing?). Another option would be for Japan to
impose inheritance taxes of 80%, and very quickly the government debt would
melt away…
Of course, such
solutions are not consequence free. Financing governments through debt
rather than a functioning tax system tends to be debilitating for economic
growth. Over time it favors the rentier above the entrepreneur (since the only
way to find buyers for the new debt is for its yield to be higher than the
growth rate of corporate profits). As Knut Wicksell conclusively showed, this
pushes the economy into stagnation. Still, Japan has proved that such
stagnation is compatible with economic stability. But is the Japanese option
open to France?
The other alternative
to growing debt levels is the path trodden by Argentina, Russia and Greece in
recent decades. What unites these bankrupt issuers is that a majority of
their debt was owned by foreign savers. Indeed, when a country accumulates too
much debt and begins to find the roll-overs a growing challenge, it really has
just two options: the first is a total or partial default; the second is a
large currency devaluation. The second choice begs the question ‘Who
prints the currency in which the debt is labeled?’ When a central bank
controls and independently prints the currency, then a default is highly
unlikely and devaluation a near certainty (which is what is starting to occur
in Japan). If the central bank does not control the currency in which the debt
is labeled, then the only solution over time is a partial or total default,
especially if interest rates are above the nominal growth rate of the economy
(debt trap).
This brings us to Mr.
Draghi’s speech at Jackson Hole, in which the European Central Bank (ECB) head
argued for more fiscal stimulus and more structural reforms before the ECB does
more to help out Europe’s failing economies. But, at this stage, more
fiscal stimulus in countries like France and Italy would likely mean much
higher budget deficits and debt levels. Given the rollover schedule of the next
18 months, those could prove challenging for the bond market to swallow,
unless, of course, the ECB is willing to embark on the same kind of exchange
program that the BoJ has embraced in the past 18 months, namely trading 0%
interest rate bank notes for government bonds. It is a kind of Catch 22:
the ECB wants to see more reform before turning on its printing press; however,
reforms without growth are particularly tough to deliver. Incidentally,
this was the pattern in Japan for 15 years or so: the Ministry of Finance (MoF)
pointed the finger at the Bank of Japan (BoJ) for not printing enough, and the
BoJ pointed the finger at the MoF for the slow pace of reform in the Japanese
economy. Replace MoF with Bercy, and BoJ with ECB and very little has been
‘lost in translation’.
But as we know, there
are key differences between Japan and France; differences which bring us to the
following conclusions:
Investors who believe that
the ECB will always step in to prevent French spreads from blowing out should
probably conclude that France is now heading down the Japanese path: that of an
underperforming economy whose technocratic elite has a growing embedded
interest in keeping interest rates low (and thus nominal growth low), lest a
spike in rates trigger a funding crisis.
Investors who believe that
the ECB will not always step in to prevent French spreads from blowing out will
have to conclude that a potential debt restructuring lies in France’s future.
However, this restructuring is unlikely to happen until the ECB decides to let
France go. And the ECB won’t let France go until conditions in Germany (most
likely higher inflation) force the ECB’s hand. Hence, this scenario is not a
near term concern.
Very clearly, with
French Government Bonds (OAT) yields at record lows, and the euro gapping down,
the market is acknowledging these conclusions.
Nothing Mr Draghi
said in his Jackson Hole speech changed this reality.
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