The peripheral eurozone’s problems, stemming from a monetary union, can be informed by post-Asian financial crisis Hong Kong. Again, Greenwood was at the cutting edge as, in 1983 as editor of Asian Monetary Monitor, he proposed the currency board scheme to stabilise the Hong Kong dollar – which is still in operation – and has been a member of the Committee on Currency Board Operations of the Hong Kong Monetary Authority since 1998.
Greenwood says the dominant theme holding back Western economies’ recoveries is deleveraging, or the need to repair the balance sheets of the household sector. Consumers, of course, are unable to raise capital. The ability to sell assets is limited: some may be able to sell a second home or a luxury car but across the post-bubble economy selling assets cannot meaningfully pay down debt. The third and only other way is for households to cut consumption, increase saving and pay down debt year-by-year.
“That is why the aftermath of the bubble will be with us for a prolonged period of time. It was households and financial institutions that became overleveraged – and recently the governments as well. With household leverage at the centre of things it is going to take a long time for these balance sheets to be repaired.”
Inflation and deflation
One may suspect that the option of Western economies inflating away their debts would be an attractive option for central banks. However, “in practice that is more difficult than many may think.” Greenwood has looked at over 30 cases of boom and bust since the Second World War and found high inflation has seldom been part of the solution. He notes that central banks are legally obliged to target low inflation and, more importantly, inflation would be difficult to generate.
“In a modern economy, money is created through banks making loans not central banks printing bank notes. The fact is that households and financial institutions are trying to repair balance sheets, which essentially means repaying debt, not borrowing.”
Greenwood says that this is compounded by risk averse banks raising capital and improving the strength of their balance sheets rather than increasing credit. He notes that since the bubble burst in Japan in 1989/90, Japanese bank balance sheets have hardly grown (except for the accumulation of government debt), contributing to deflation. “It is a very good example of how balance sheet repair prevents the inflation that most people assume is automatic.”
On the plus side, there are identifiable policy errors that can be avoided: Japan took too long to write off bad debts and was unwilling to allow the yen to depreciate. The US and UK especially have allowed their currencies to fall and been quick to deal with bad debts in the financial system, but that does little for the indebted consumer.
“The UK household sector is among the most indebted of all major economies and will take longer to recover. Unless the government arranges for debt forgiveness, it is difficult to see how this situation could be transformed.” Greenwood also notes that recent inflation has not helped as wage inflation has been lower than consumer price inflation, eroding personal incomes.
Government policy throughout the West is dominated by closing budget deficits so there is little scope to stimulate growth and create jobs. Ultimately all taxes are paid by individuals as companies will pass it on to customers, creditors or shareholders. Corporate balance sheets are in good shape but management remains cautious due to a lack of faith in demand.
“Ultimately the economy depends on what happens in the household sector, the end demand. While households are in a bind, it is difficult to see how corporations are going to single-handedly stimulate growth. Corporations will be reluctant to invest and hire until consumers show a response.”
Bank of England data reveals that rates are low because credit demand is weak. “Most people think that low interest rates are equated with easy credit. Wrong. On this occasion it is because demand for credit has collapsed.” Western governments have grown excessively large and the UK is the outstanding case. In the UK, under the last government the fraction of expenditure of GDP went from 36% to 46% before the recession occurred. With the recession it has gone above 50%.
“Government expenditure is notoriously inefficient. The UK had the biggest increase in the OECD in the last decade and this has done huge damage to the economy, eroding the private sector and reducing the tax base. It was fine and dandy while the bubble was going on but as soon as those conditions changed, the dream has turned into a nightmare.”
That said, the independence of the pound, outside the euro, has been of huge benefit. The large depreciation of the pound, independence of monetary policy and the government’s credible plan to close the budget deficit before 2015/16 has maintained its credibility.
The blame game
People have variously pinpointed the regulators, central banks or bankers for blame. But Greenwood says that “everybody was involved in this mass illusion”. Borrowers were happy because credit was cheap. Banks were easily able to borrow in the interbank markets and securitised instruments provided them with new revenue streams.
Greenwood says that the regulators were “captured” by the banks, succeeding in persuading them that off balance sheet entities did not need to comply with Basel II risk weighting provisions: “It was a game where the regulators were completely duped.” “I attach particular blame to the central banks and the regulators. Central banks were negligent in not preventing the rapid rate of growth in credit.”
He notes that credit derived from commercial paper, repo activities and asset backed securities grew by up to 30% per annum but regulators at the time were unconcerned. Federal Open Market Committee (FOMC) transcripts from 2006 (they are published with a five year lag) have “not a single reference to the quantity of credit,” says Greenwood. “It’s all a discussion of interest rates and interest rate spreads – which is the Bernanke view of the world.”
Asian lessons for the eurozone
Greenwood says that the German diagnosis of the eurozone’s ills is misguidedly based on its successful post-unification policies. The reconstruction of East Germany left its economy uncompetitive – and this was remedied through labour market reform and deleveraging. The implication is that it is time for peripheral European countries to accept the same medicine.
“But the reality is that debt is not restricted to government debt. Under the euro, southern European households could borrow at German interest rates – the result was their debt ratios increased dramatically. You have got to control credit.” He argues that in a boom in a monetary union money floods into those economies with the lowest labour costs. This flow has pushed up prices across the board and rendered peripheral economies uncompetitive.
He estimates these economies need devaluations in the order of 30%. Greenwood notes that IMF crisis packages for emerging markets over the last couple of decades consisted of three elements. While euro countries have been provided with short term funding and have structural reform programmes, they do not have access to the devaluation needed to kick-start growth and enable debt repayment.
“Europe is trying to achieve the adjustment without giving the countries the immediate opportunity to grow.” Greenwood has spent a significant portion of his career in Asia and draws parallels for the eurozone with the Asian currency crisis, where countries from Taiwan to Indonesia devalued their currencies by between one and two thirds. Most interestingly for eurozone countries, Hong Kong remained pegged to the US dollar and successfully negotiated its way out of the crisis.
To regain competitiveness, Hong Kong endured prices and wages falling consecutively between 1998 and 2004 – so could this be a way out for the eurozone? “Hong Kong is a very flexible and relatively high growth economy so the adjustment could be achieved. It is highly questionable whether southern European countries’ political and social systems could tolerate a long period of adjustment – and it will probably take longer than in Hong Kong.”
The issue for embattled eurozone countries is whether the current approach of chipping away at the problem with debt write-downs and cheap ECB money will deliver sustainable growth. “I doubt it. There are fundamental differences in very basic things such as productivity.” He says maintaining a 17-member eurozone will require further bailouts. “My view is that the eurozone as currently structured is not viable. It would be better, quicker, cheaper and more sensible to reduce the number of participants sooner rather than later.”