By Vivek Kaul
The 10-year bond issued by the United States (US) government currently gives a return of around 1.8 percent per year. Returns on similar bonds issued by the government of the United Kingdom (UK) are at1.9 percent per year.
Nearly five years back, in July 2007, just before the start of the financial crisis, the return on US bonds was at 5.1 percent annually. The return on British bonds was at 5.5 percent. The return on German bonds back then was around 4.6 percent per year. Now it stands at 1.44 percent.
Since the start of the financial crisis, governments all over the world have been running huge fiscal deficits in order to try and create some economic growth. They have been financing these deficits through increasing borrowing.
In 2007, the deficit of the US government stood at $160 billon. This difference was met through borrowing. The accumulated debt of the US government at that point of time was $5.035 trillion. In 2012, the deficit of the US government is expected to be at $1.327 trillion, or around 8.3 times more than the deficit in 2007. The accumulated debt of the US government is also around three times more now and has crossed $14 trillion.
The situation in the United Kingdom is similar. In 2007, the fiscal deficit was at £9.7 billion. The projected deficit for 2012 is around 9.3 times more at £90 billion. Government debt as a percentage of gross domestic product (GDP) has gone up from around 37 percent to around 67 percent of GDP.
The same trend seems to be happening throughout Western Europe as well. Hence we can conclude that it is more risky to lend to the governments of the US, UK and even countries like Germany and France in Western Europe. Though, to give Germany due credit, it doesn’t run fiscal deficits as large as those of the US or UK. Its fiscal deficit in 2010 was at €100 billion, but this was cut to around €25.8billion in 2011.
Even though the riskiness of lending to these countries has gone up, investors have been demanding lower returns from the governments of these countries. Why is that?
The answer might very well lie in what happened in Japan in the late 1980s.
The Japan story: The Japanese central bank started running a low interest policy to help exports from the mid-1980s. This policy, other than helping exports, fuelled massive bubbles in both the stock market as well as the real estate market. The Nikkei 225, Japan’s premier stock market index, returned 237 percent from the start of 1985 to 29 December 1989, the day it peaked at a level of 38,916 points.
Real estate prices also shot through the roof. As Paul Krugman points out in The Return of Depression Economics: “Land, never cheap in crowded Japan, had become incredibly expensive…the land underneath the square mile of Tokyo’s Imperial Palace was worth more than the entire state of California.”
This was the mother of all bubbles.
Yasushi Mieno took over as the 26th governor of the Bank of Japan, the Japanese central bank, on 17 December 1989. Eight days later, on 25 December 1989, he shocked the market by raising interest rates. And more than that, he publicly declared that he wanted land prices to fall by 20 percent, which he later upped to 30 percent. Mieno didn’t stop and kept raising interest rates.
The stock market crashed. And by October 1990 it was down nearly 40 percent. Since then the stock market has largely been on its way down. And it currently quotes at 8,900 points, down 77 percent from the peak.
Real estate prices also fell but not at the same fast rate as the stock market. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracle: “The greatest bubble in human history” burst in 1990 with no pain at all, like falling off Everest without breaking a bone. At its peak Japan accounted for 40 percent of the property value of the planet, but instead of collapsing, the price of real estate slowly declined at a 7 percent annual rate for two decades, ultimately falling by a total of about 80 percent. There was never a major round of foreclosures or bankruptcies, as the government kept bailing out debtors, ruining its own finances.”
The GDP growth rate collapsed from 3.32 percent in 1991 to -0.14 percent in 1999. In the next 10- years, i.e. between 2000 and 2009, the GDP growth rate never went beyond 2.74 percent and was at -5.37 percent in 2009.
The balance-sheet depression: Japan has been in what economist Richard Koo calls a balance-sheet recession. What this means in simple English is that after bubbles burst, especially real estate bubbles, private sector companies as well as individuals and families who had speculated on the bubble end up with a lot of excess debt and an asset (like land or stocks) which is losing value. The excessive debt has to be repaid. Given this, individuals and companies try to save in order to repay the debt. But what is good for the individual is not always good for the overall economy.
The paradox of thrift: John Maynard Keynes, unarguably the greatest economist of the 20th century, called this the “paradox of thrift”. What Keynes said was that when it comes to thrift or saving, the economics of an individual differs from the economics of the system as a whole.
If one person saves more, saving makes tremendous sense for him. But as more and more people start doing the same thing, there is a problem. This is primarily because what is expenditure for one person is an income for someone else. Hence, when everybody spends less, businesses sees a fall in revenue. This means lower aggregate demand and hence slower or even no growth for the overall economy.
The Japanese savings rate at the time when the bubble popped was near zero. After this the Japanese started to save more and the savings rate of the Japanese private sector and households increased. It reached around 16 percent of GDP in 2000.
All this money was being used to pay off the excess debt that had been accumulated. This meant slower growth for Japan. The government, in turn, tried to pump economic growth by spending more and more money. For this it took on more debt and now the Japanese government debt to GDP ratio is around 240 percent – even worse than Greece.
Ironically, as government debt went up, the return on government debt kept coming down. As Martin Wolf of Financial Times points out in a recent column, “At the end of 1990, when its ‘bubble economy’ went pop, the Japanese government’s 10-year bond was yielding 6.7 percent…But yields on 10-year Japanese government bonds (JGBs) fell to close to 2 percent in 1997 and then, with sizeable fluctuations, to troughs of 0.8 percent in 1998, 0.4 percent in 2003 and, recently, to 0.9 percent. In short, the worse the Japanese government’s present and prospective debt position has become, the lower the interest rates on JGBs has also become” (Note: all returns per year).
The reason for this in retrospect is very straightforward. As Japanese individuals and companies were saving more they did not want to risk their savings in either the stock market, which had been continuously falling, or the real estate market, which was also falling, though at a slower rate. Hence a major part of the savings went into government bonds which they thought were safer. Given that there was great demand for bonds, the Japanese government could get away with offering lower returns on its bonds, even though over the years they became riskier.
The Japan Way: Richard Koo believes that what happened in Japan over the last 20 years is now happening in the US, UK and parts of Europe. Individuals in these countries are saving more to pay off their excess debts. An average American in the month of March 2012 saved 3.8 percent of his disposable income. Before the crisis the American savings rate had become negative.
The same stands true for Great Britain where savings of household were -3 percent at the time the crisis struck. They have since gone up to 3 percent of GDP. The corporate sector that was saving 3 percent of GDP earlier is now saving 5 percent of GDP. The same stands true for Spain, Ireland and Portugal where savings were in negative territory (i.e. the people were borrowing and spending) before the crisis struck, and are now going up. In the case of Ireland, savings have gone up from -10 percent of GDP to around 5 percent of the GDP since the crisis struck.
Hence companies and individuals across countries are saving more to pay off the excess debt they had accumulated. This, in turn, has meant that they are spending less money than they used to. This has led to slower economic growth. A large part of these savings is going into government bonds which are deemed to be safe, keeping returns low. Retail investors have taken out nearly $260 billion out of equity mutual funds in the United States since 2008, even though the stock market has doubled in the last three years. At the same time, they have invested nearly $800 billion in bond funds, which give very low returns.
ZIRP – Zero interest rate policy: The governments of these countries have cut interest rates to almost zero and are also borrowing and spending more money. That, as was the case in Japan, has resulted in some economic growth, but nowhere as much as they had expected. Even though governments want their citizens and companies to borrow and spend money in order to revive economic growth, they are in no mood to do that.
Citizens would rather pay off their existing debt than take on new debt. And the companies need to feel that the economic opportunity is good enough to invest, which it clearly isn’t. That explains to a large extent why US companies are sitting on more than $2trillion of cash.
The banks are also not willing to take on the risk of lending at such low interest rates, as was the case in Japan. What has also not helped is the case of continuously bailing out the financial sector, like was the case in Japan. Hence real estate prices in countries like Spain still need to fall by 35 percent to come back at normal levels.
Slow growth: All in all, most of the Western world is headed the Japan way, which means slow economic growth in the years to come. As Sharma writes: “Over the next decade, growth in the United States, Europe and Japan is likely to slow…owing to the large debt overhang”. This will impact exports of countries like China, South Korea, Japan, Taiwan, and India, among others. Chinese exports for the month of April 2012 grew by 4.9 percent in comparison to 8.9 percent during the same period last year. This, in turn, has pushed down imports. Imports grew at a negligible 0.33 percent against the expected 11 percent.
A slowdown in Chinese imports immediately means lower prices for commodities. As Sharma puts it, “It’s my conviction that the China-commodity connection will fall apart soon. China has been devouring raw materials at a rate way out of line with the size of its economy… Since 1990, China’s share of global demand for commodities, ranging from aluminum to zinc, has skyrocketed from the low single digits to 40, 50, 60 percent – even though China accounts for only 10 percent of total global output.”
Over a longer term slower growth in the Western World will also means slower and lower stock markets. As the old Chinese curse goes “may you live in interesting times”. The interesting times are upon us.
Vivek Kaul is a writer and can be reached at email@example.com