The GFC began five years ago.

Debt-deflation recessions take much longer to recover from than more “normal” recessions, as evidenced not just by the Great Depression of the 1930s, but by numerous examples from individual countries since then.  Japan since 1990 is a perfect example.  It has had zero nominal (i.e. before adjusting for inflation) GDP growth since then.

What do we mean by a “debt-deflation” recession/depression?  This is an economic downturn caused by too much debt.  Usually, it’s private debt, rather than public, though this time, private debt became public debt when the banks were bailed out by national governments.  It’s a question of how much debt there is relative to income or GDP.   Once the overoptimism of the boom period ends, the debt has to be repaid.  And that’s where the problem arises. There are three ways to respond to this situation.

The debt can be repaid.  But this takes a decade or more, and anyway to repay debt you must spend less, whether you are an individual or a government. Thus the personal savings ratio must rise and/or governments have to run surpluses.  This reduces spending.  Everybody’s spending is someone else’s income. So incomes fall.  This causes spending to fall again.  And so on.  Obviously, at least initially, this worsens the debt to GDP ratio or at least makes its decline much slower.  It can take years of growth and debt repayment before the debt/GDP ratio declines to a safe level.  A very long-drawn-out and painful process.

Or, you can inflate your way out of trouble. Instead of repaying debt, the government can try to alleviate the burden by letting inflation rise, which (as long as interest rates don’t also rise) reduces the burden.  Nominal GDP (that is, GDP including price inflation) rises fast, while debt stagnates, and the debt/GDP ratio falls.  Alas, the inflation genie, once released from its magic bottle, is very tricky to capture again.

Or debtors (in this cycle governments, since the banks have been saved with mammoth injections of public money) can default.   But banks are big holders of government bonds.  So a default can plunge the banking system back into crisis.   And defaulting governments find it hard to borrow again.  So the budget still has to be balanced by raising taxes and cutting spending, leading to an economic downturn.  This option is as painful as the first one, unless your debt is owed to foreigners.  Even then, it still hurts (ask Argentina!)

Each of these options is unattractive, just differently unattractive. What have the major economies done?

The US has flooded the system with liquidity, which is the textbook response to a debt-deflation.  The Fed has bought trillions of dollars of government debt and paid for it by writing a cheque on itself.  This process is called quantitative easing or QE for short.  Over the last 5 years this process has cut long term government bond yields to one or two percent per annum or less (negative in the case of index-linked bonds).  The Fed has said that it won’t stop QE until the unemployment rate is below 6.5%, more or less irrespective of what inflation is doing.

Europe at first did everything wrong.  It sharply and repeatedly tightened fiscal policy, in an attempt to repay debt.  As everybody except the European elites expected, this materially worsened the downturn.  At the same time the ECB (European Central Bank) did the opposite of the Fed, and tightened monetary policy.  Real money supply actually fell!  Over the last year or so, monetary policy has reversed direction and the ECB has embraced QE as well as buying government bonds of stressed countries on market [see our previous post].  And even the Germans have decided that everybody has endured enough fiscal austerity and are no longer insisting on further fiscal tightening for Greece and Spain.

Japan is the most interesting case.  For nearly a quarter of a century it has stagnated.  The Bank of Japan (BOJ) waited too long after the crisis began to cut interest rates aggressively and restimulate the economy.  By the time it did, inflation was negative (prices have been falling in Japan on and off for 22 years: the CPI, the WPI, house prices, share prices) and zero interest rates were in fact still too high in nominal terms (after allowing for falling prices). A classic debt deflation.  Falling prices, stagnant incomes and nominal debt.  This made it impossible to cut the debt to GDP ratio, and in fact Japan’s government debt now exceeds 230% of GDP!  The BOJ has stubbornly refused to counter deflation by using QE.  But last weekend, the elections brought to power a government on a platform of targeting 2% (positive) inflation and 3% nominal GDP growth.  This government won such a large majority that it can overturn any upper house veto of its legislation.  It has made it plain that it will amend the act governing the BOJ if the BOJ doesn’t change its targets and start QE. All this suggests that Japan (the world’s third largest economy) will at last embrace QE and start growing again.

Meanwhile, though Chinese growth has slowed from 10% to a more sedate 7.5%, this growth rate is typical of the middle-income economy it has become, and because China is so much larger now in the world economy, 7.5% growth now adds as much to world GDP as 10% growth 5 years ago.

So, five years after the GFC began, the world economy is finally starting to return to normal.  No boom, but no bust either.  And the falling risk profile of world economies and financial markets will help support Australian shares to generate modest but sustained returns over the next year.  Of course, there will come a time when QE has to stop and monetary policy has to tighten.  This will adversely affect markets, both bonds and shares.  But our judgement is that that is a good 18 months or more in the future.