Recovery plans need to avoid Japan’s example
Are things getting any better? Those who focus only on the direction of change compared with the last quarter or the last year will doubtless say that, yes, there has been an improvement. Western economies have turned a corner.
No longer are they shrinking. They appear, instead, to be recovering.
This recovery, however, is a very strange affair. Since the end of the Second World War, simple rules governed the economic cycle. Deep recessions were followed by strong recoveries. Shallow recessions were followed by limp recoveries.
Given the depth of the credit crunch recession, we should now be in the middle of a particularly strong recovery. But we're not. The recovery so far has been remarkably soft, despite all the interest rate cuts, the fiscal boosts and the unconventional policies. It was a non-standard recession and it's proving to be a non-standard recovery.
Put another way, the level of economic activity is far too low. Measured by past recoveries, this latest effort has delivered very little. Consumer confidence is at rock bottom. Small businesses cannot easily access credit. People the world over are talking about the dreaded ‘double-dip’.
These difficulties emphasise the importance of talking about levels rather than rates of change. Those who focus only on the latter fail to recognise that most of us have ‘absolute’ standards for economic performance. Doubtless, they would congratulate little Johnny for the doubling of his school marks even if most of us would argue that a score of two out of 10 is really not that much better than a score of one out of 10. In the 1970s and 1980s, the chances of remaining economically depressed were very low for the simple reason that each recessionary cloud was accompanied by a disinflationary silver lining. Back then, inflation was mostly too high. Each recession pushed inflation back down again and, in time, economic performance began to improve. Lower inflation was typically less volatile. Lower volatility, in turn, reduced uncertainty for businesses and households, leading to increases in spending.
Today, inflation is not too high. It is mostly too low. Admittedly, the UK is an exception, most likely a reflection of the lagged effects of sterling's collapse in 2008. For the majority of countries in the Western world, however, the bigger danger confronting policy makers is deflation, not inflation. The annual rate of US core inflation, excluding the volatile food and energy components, is down at just 0.9% and has been stuck there for five consecutive months. This wouldn't matter quite so much if interest rates weren't already down at zero and if debt levels weren't quite so high. But given they are, we're stuck in a fragile economic world. The more inflation falls, the higher zero interest rates become in real terms.
In other words, a central bank finds the setting of monetary policy increasingly difficult in a world of zero interest rates and excessively low inflation. No one in policy circles has had to come to terms with these kinds of challenges before. No one, that is, except the Japanese.
Yet it increasingly appears that Western policy makers have been slow to apply the lessons of Japan to their own economies. Even if activity is incredibly depressed and inflation worryingly low, central bankers cannot help but reach for the interest rate trigger at the first sign of recovery.
Given all this, central bankers should have indicated that there was no chance whatsoever of interest rates rising purely in response to the first signs of a cyclical pick-up in economic activity. If that pick-up is to be sustained, it's vital that interest rates remain low until there are clearer signs that activity is operating at a much higher level, that inflation is not too low and that the private sector isn't still desperately repaying debt. Otherwise, like the Japanese, we'll be stuck with a two out of 10 economy.