October 19, 2014 2:33 pm
Eurozone stagnation is a greater threat than debt
Monetary policy can boost markets in the shortrun, but this cannot be sustained indefinitely
It would be wrong to think last week’s global market gyrations signal a return of the eurozone debt crisis. Sovereign bond spreads in the eurozone did not move by much, except in Greece.
What happened last week is something rather different. Financial markets have woken up to the possibility of a eurozone-wide economic depression with very low inflation over the next 10 to 20 years. This is what the fall in various measures of inflation expectations tells us. Investors are not worried about the solvency of a member state. That was clearly different two years ago.
But the present scenario is no less disturbing. The implications for those who live in such an economic snake pit are already visible: high unemployment; rising poverty; real and nominal wage stagnation; a debt burden that will not come down in real terms; a decline in public sector services, and in public investment. A shocking example is the decrepit state of German military hardware. Of the Luftwaffe’s 254 fighter planes, 150 cannot fly.
The eurozone’s stagnation will affect the rest of the world to different degrees. The UK might manage to escape the same fate, but the eurozone economy is big enough to pull Britain down with it.
Hardest hit will be the parts of central and eastern Europe that do not use the euro. They are caught between an imploding Russia and a stagnating Europe. It is hard to see how the oil price can recover in an environment of permanently low growth. And it is even harder to see how Russia can live with a permanently depressed oil price.
Secular stagnation – the idea that a chronic shortfall of investment might produce a long period of weak demand – also has disturbing implications for financial investors. The recent high levels of equity prices were premised on the best possible of all scenarios: that productivity growth rates would revert to historical averages, and that the level of gross domestic product would eventually catch up with the pre-crisis economic growth trajectory. Investors have now begun to realise that neither is going to happen. GDP is still only close to the levels of 2007; growth is slow.
The share of GDP accounted for by profits cannot go much higher, either. So, if productivity growth remains low, it is hard to see how equity investments can yield large real returns. Monetary policy can boost markets in the short-run, but this cannot be sustained indefinitely. In such an environment, the yields on risk free securities will be low.
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