Three of the seven key developments for 2015 are already shaping investment strategy
Eurozone policy mix remains incomplete
The European Central Bank had already signalled its intentions and did not disappoint investors when, on 21 January, it announced a plan to acquire sovereign debt to a minimum of €60bn monthly up to September 2016.To understand what this level of quantitative easing can do to boost the eurozone economy, and also its limits, the exceptional nature of the current US economic cycle and much of Europe needs to be recognised.
All macroeconomic theory is based on the assumption that the private sector, households and businesses seek to maximise profits at all times. It follows that, when the central bank eases
credit conditions by lowering interest rates, private sector credit demand should increase. This monetary transmission mechanism works most of the time, except in rare instances such as the United States in the early 1930s, Sweden in 1992, or Japan in the mid-1990s.
In such cases, when households or businesses have accumulated excessive debt, usually associated with a bubble in financial assets or real estate, the private sector ceases to maximise profits and enters into debt-minimisation mode. At such times, lenders cease to provide credit, and falling asset prices cause a substantial loss of wealth. This rare phenomenon is called a balance-sheet recession. In such conditions, households and businesses raise their savings rate significantly to rebuild their wealth. The result is a structural deficit in domestic demand in the country or region concerned, and monetary policy is no longer transmitted through the usual channels.
These deleveraging cycles are extremely deflationary, especially if the policy mix implemented by the authorities – both political and economic – is unsuitable for these exceptional conditions. To avoid a disorderly liquidation of accumulated excess debt leading to a deflationary spiral, monetary and fiscal policy needs to be coordinated. In particular, any attempt to reduce the government deficit to an equilibrium position will be doomed to failure to the extent that the private sector is in still savings recovery mode, unless it can generate a large external surplus as Sweden did in the 1990s. This scenario is obviously not true for individual euro countries, which can (no longer) devalue their currency, nor for the whole region, whose GDP is much too high relative to the rest of the world to expect the necessary external surplus.
In this context, the ECB’s quantitative easing will certainly generate a portfolio rebalancing effect through an increase in asset prices, particularly of financial assets, and a decrease in the value of the euro. Investors have anticipated these changes in recent months. However, in the absence of a tax component in the policy mix, Berlin’s insistence on austerity rules out self-sustained economic recovery in the eurozone over the medium term. It is crucial that tax policy should seek to change the mix of spending by states, by reducing transfers to households and redirecting these amounts to investment programmes. To go into debt to invest rather than spend should be the principle. At the same time, the structural reforms that the German government insists on, including the relaxation of labour laws, are essential. In other words, reforms and indiscriminate austerity should not be conflated.
For now, the decline of the euro and the collapse of the oil price will give some relief to the eurozone economy. In the longer term, as long as households and businesses are rebuilding savings and in the absence of an ambitious fiscal programme, the economy will remain sluggish and interest rates will remain low for a long time until… private-sector credit demand gets going. This last measure, as well as the relative performance of eurozone banking stocks, are instant barometers of progress in the reflation efforts of the Old Continent.