The Global Economic Crisis is Severe: More than fiscal and monetary policy, corporate vitality needs to be invigorated

Chairman, RIETI

The European crisis will not be resolved easily

The government debt crisis in Europe, while being addressed, continues to reflect severity. In addition to enhanced efforts to rebuild public finances in Greece and the strong support posture demonstrated towards it by EU nations, on September 29, Germany, the largest credit-granting nation in the union, approved a function expansion proposal for the European Financial Stability Facility (EFSF), which provides fund-based support to Euro member countries experiencing fiscal and monetary instability. This action has allowed the nations of southern Europe to avoid fiscal collapse. Additionally, the unrestricted supply of euros to European financial institutions by the European Central Bank (ECB) and dollars by the Bank of Japan and the central banks of four other major nations are acting as the main forces in keeping the financial crisis that originated in Europe under control.

However, this does not mean that the situation has essentially improved. While monetary assistance provided to Greece and other countries has enabled them to avoid fiscal collapse, it does not halt the ballooning of government debt. In order to address fundamentally the issue of government debt held by the likes of Greece, adjustments need to be made by over-borrowing governments, over-lending financial institutions and investors, and even economies that have achieved growth exceeding their actual capability through fiscal deficits. In no indirect terms, this means that governments must facilitate a reduction in their debt balance, financial institutions and investors must clear off the massive amount of debt generated, and economies must make adjustments for their overreaching as a result of perpetuating low growth and deflation.

Moreover, given that no real progression has been made in the radical structural adjustment of the likes of Greece, fundamentally addressing the debt issue in Europe will take a considerable amount of time as bold adjustments will be accompanied by large-scale write-offs in government debt out of necessity, which will in turn significantly impact the Euro member countries and provide tremendous funding assistance as well as the European financial institutions which possess large sums of associated receivables. Eventually, should conflicts of interests between each nation intensify, the very foundation of the Euro bloc may be shaken.

The crisis after Lehman's fall: Still in effect

The picture of the debt issue in Europe, which will be forced to undergo a time-consuming economic structural adjustment, bears strong similarities to the crisis that the U.S. economy encountered after the collapse of Lehman Brothers. The trends exhibited by Euro bloc economies, which have inflated their fiscal deficits, accentuated imbalances, and caused Greece and other countries to fall into a government debt crisis, appear to be the same as trends demonstrated by the U.S. economy, which careened head first into the "Lehman crisis" after excessively issuing subprime loans to people with limited repayment capability and triggering the widening of an imbalance between economic and monetary spheres. Furthermore, these similarities also extend to the forced initiation of structural adjustments after the crisis came to the surface.

Although economic conditions may be sluggish, the fact that the U.S. has at least started to pick up the pieces following Lehman's fall paints it in a better light. Still, it would be fair to estimate that structural adjustments to the U.S. economy will still take several years before they reach completion. Subprime loans and other elements have also contributed to the advent of a monetary bubble that caused household debt to blow up (See Figure 1). Luckily, since 2008, the ratio of household debt to disposable income has been trending downwards. And yet, estimates show that it will still take approximately two years for trends surrounding this ratio to normalize. The same can be said for the adjustment of the home ownership ratio of households, which rose rapidly from 2000 onwards.

Figure 1: U.S. Economy Still in Adjustment Phase—Elimination of Excessive Household Debt to Take Several More YearsFigure 1: U.S. Economy Still in Adjustment Phase—Elimination of Excessive Household Debt to Take Several More Years

During the period leading up to the completion of adjustments for household debt, even greater amounts of income will be allocated towards debt repayment, causing consumption to be pushed downwards. The U.S.' economic deceleration in the immediate term can be construed as the result of economic structural adjustment in the post-Lehman era still being in the implementation phases, and to the fiscal and monetary policies that underpinned the economy hitherto running out of breath. Moreover, as long as such adjustments remain incomplete, it is difficult to anticipate that the U.S. economy will revert to its previous strength.

Limits of fiscal and monetary policy

The economies of Europe and the U.S. are not the only ones going through an adjustment phase following their recovery in the post-Lehman order. The Chinese economy is also at a state where it must make adjustments. Even after Lehman's fall, China continued its high levels of economic growth though capital expenditure centered largely on aggressive investment in infrastructure and state-owned enterprises. However, the Chinese economy's percentage of public and private sector investment relative to GDP is approaching 50%, a glaringly high level even when compared to the post-war bubble economy of Japan or the advanced growth achieved by South Korea between the late 1980s and the 1990s, both of which peaked at approximately 35%. Already at the point of producing the world's highest levels of manufacturing value-added, China has adopted the approach of aggressively investing in manufacturing industries and intensifying its production and export efforts as a means of driving economic growth. This approach, however, is gradually approaching a limit.

In China, the template of excessive manpower in agricultural villages being diverted to manufacturing industries in abundance is also in the process of shifting rapidly. Already, half of the nation's existing agricultural workers are individuals aged 40 and older who do not venture out to far, unfamiliar places to earn money, and the villages that they occupy are experiencing a dearth of help. Increasingly diminished supplies of manpower in urban areas have also pushed the rate of rent increases upward. Sustaining high levels of growth is gradually coming to mean the opening of doors to an inflationary surge.

Income per capita in China is still in the vicinity of 1975 Japan levels. Furthermore, improvements in the levels of education, vibrant infrastructure investment and capital investment indicate that there is latent growth potential in the future as well. However, economic growth model using infrastructure investment and capital investment as drivers and enabling manufacturing industries to continue to absorb jobs needs to be structured into a growth pattern centered on consumption and domestic demand.

Following the collapse of Lehman Brothers in September 2008, the bold fiscal and monetary policies of major powers and the advanced economic growth of China and other emerging countries have underpinned the growth of the world economy. However, the template of continuing to prop up economic growth through such actions as expansionary fiscal and monetary policies and currency wars while breaking down the economic-monetary balance in the process can also be labeled as a fiscal bubble, a central bank bubble, or an emerging country bubble. If the sustaining of economic growth through fiscal and monetary policy and the advanced growth of emerging countries can be labeled as "The Crisis after Lehman's Fall: Act One," then major powers can be said to be currently in the process of entering "The Crisis after Lehman's Fall: Act Two," in which they attempt to conduct full-fledged economic structural adjustments. This "Act Two" can also be viewed as the stage in which economic imbalances are rectified in preparation for a stage of stable growth by the global economy as a whole.

It goes without saying that restoring economic balance will take some time. Moreover, rectifying unsound economic imbalances may not produce new growth as a matter of course. The fact is, a hint on how to break through this kind of distressed situation can be found in the U.S. economy from 40 years earlier and the global economy following World War II.

Learning from post-war history

A look at the U.S. economy in terms of the stock market following 1971, the year that the foreign currency market made the transition to a floating exchange rate system, shows five periods in which the market rose in both significant and relatively prolonged spurts. The first period was during the Reaganomics era of the early 1980s, a phase that also saw an increase in the "twin deficits" of finance and trade. The second period was during the phase in which the appreciation of the dollar was rectified in accordance with the Plaza Accord of 1985, and Japan, Germany, and other major nations, acting as locomotives for the world economy, implemented economic stimulus measures such as monetary deregulations. The third period came after Black Monday 1987, during which worldwide monetary deregulation gave way to a real estate bubble in numerous countries. The fourth period was the IT revolution, or "dot-com bubble," that began in 1992, which saw the realization of a phase of long-term, quality growth dubbed the "new economy." Finally, the fifth period was the monetary bubble of 2000 and beyond that witnessed a glut of subprime loans and securitized instruments.

Out of these five periods, with the exception of the dot-com bubble, all were characterized by improper fiscal and monetary policies yielding high-level growth through augmenting economic imbalances, and therefore cannot be labeled as times of sound economic growth. Contrary to this, during the dot-com bubble, the explosive proliferation of PCs and the Internet resulted in the creation of new businesses and lifestyles, thereby driving prolonged, high-level economic growth. The U.S.' fiscal balance entered into the black during this phase.

The high-level economic growth of advanced nations following World War II represents an example of such growth achieved globally over the long term. After the Great Depression of 1929, major powers propped up economic conditions by taking themselves off of the gold standard and enacting expansionary fiscal and monetary policies. However, postwar inflation was responsible for laying the final blow to the worldwide recession and alleviating the fiscal collapse brought on by World War II. The newly-established, growth-promoting systems and frameworks that followed would propel the major powers into a stage of advanced economic growth.

A Call for the next Industrial Revolution

The above mentioned examples illustrate that growth models not steeped in economic imbalance were realized through large-scale industrial innovations that brought with them lifestyle transformations as well as through the introduction of new systems and frameworks at the fundamental level. Additionally, it can be deduced from historical facts that even though the rectification of economic imbalances currently being implemented in major powers is an absolute necessity, in order to bring about new, high-level growth without augmenting such imbalances, growth strategies that serve to transform radically the regulatory and economic frameworks as well as an industrial revolution that ushers in changes in lifestyles are needed.

What is interesting to note here is the relationship between productivity growth rates and real economic growth rates demonstrated by OECD countries over the last 10 years (See Figure 2). Greece, Spain, and Italy, which are caught in the vortex of Europe's debt dilemma, are all currently capable of only achieving productivity growth rates that fall below the trend line, indicating the relationship between average productivity growth rates and real growth rates in OECD countries.

Figure 2: In Greece, Economic Growth was Driven Upwards Relative to Productivity Growth RatesFigure 2: In Greece, Economic Growth was Driven Upwards Relative to Productivity Growth Rates

This phenomenon indicates that the economic growth exhibited by these countries in recent years is the result of a relative dependence on expanding the fiscal deficit and similar actions rather than on the vitality of the private sector. At the same time, however, it is evident that there is an absolute need to improve corporate vitality to facilitate future economic growth.

As it enters "The Crisis after Lehman's Fall: Act Two," the global economy reflects a situation in which the steady rectification of imbalances must be conducted, yet the stagnation of growth will persist while those efforts are in progress. However, these efforts alone do not constitute a sufficient policy response and must be accompanied by fundamental deregulation and other bold enhancement measures for corporate vitality that yield breakthroughs in growth.

Figure 2 shows clearly that radical efforts to elevate corporate vitality may potentially produce new growth models. Furthermore, revolutionary technologies that act to bring about transformations in lifestyles are abundant. Additionally, factors such as enhanced environmental awareness and growing expectations toward new energy are also setting the stage for a major transformation. Given that previous industrial revolutions have occurred 50 to 60 years apart from one another, an appropriate amount of time has passed since postwar developments in the likes of aerospace and telecommunications which yielded the last industrial revolution. This also intensifies the possibility that an industrial revolution to surpass the dot-com bubble will occur in the not-so-distant future.

The question of whether the global economy will be capable of ushering in a new, balanced phase of advanced growth early on depends not on putting additional fiscal and monetary policies into motion, but instead on nationally-implemented growth strategies that make corporate vitality the top priority.

>> Original text in Japanese

* Translated by RIETI.

November 2011 WEDGE

December 26, 2011