Why will the bubble economy collapse at some point?

Hans-Werner Sinn

In 1989, Tokyo could have bought all of Canada. That was how far the real estate boom had inflated Japan. Japanese stocks reached record prices at the same time. Everything was unreal, a mere speculative bubble that had arisen because the Japanese central bank wanted to counteract the appreciation of the yen by drastic interest rate cuts, which in turn had been caused by American tax and monetary policy.

When the Japanese bubble burst in 1990, share prices fell in half in two years, and sluggish house prices have fallen a good 60 percent to date. The decline caused great hardship among financial institutions and private investors, because while the debt remained, the equity was eaten up by the fall in asset prices. Many companies went bankrupt.

The banks delayed their bankruptcy by avoiding posting the new market values ​​of their assets on the balance sheet. As a result, they accumulated silent losses. But even the cleverest accountants couldn't put them off indefinitely. 1997 was the year of truth for Japanese banks as the financial industry was largely liberalized. Around 40 percent of them got into trouble at the time and were taken over, nationalized or liquidated by others.

Economic policy reacted to the crisis by using the medicine kit of the Keynesian and monetary macro-theory. The state went into debt on a large scale and operated deficit spending in order to increase the demand for goods and services from the private sector. The central bank kept lowering interest rates and flooded the country with money.

Only: Nothing helped. Japan has only grown by an average of 0.9 percent per year since 1990, which is slower than any other developed country except Italy, at least if you look at the group of OECD countries.

When the drugs proved to be ineffective, the Japanese reacted again and again by increasing the dose. The representatives of the Keynesian macroeconomics argued that politics was far too timid and did not dare to go all out.

The interest rate in Japan has been close to zero percent for 20 years

But an even more expansive policy than that implemented in Japan is simply not possible. The national debt ratio, which was 67 percent in 1990, is now 246 percent. And the discount rate at which the Japanese central bank lends its money has been practically zero since autumn 1995, that is to say for more than 20 years. In February of this year, the Japanese central bank even pushed it down to minus 0.1 percent.

The last desperate attempt to address the problem by increasing the dosage of the medication was the so-called Abenomics program, which began in 2013 and was named after the current Prime Minister Shinzo Abe. Essentially, it was about new, huge debt programs and the acquisition of government bonds by the central bank, as the American economist Paul Krugman had recommended the Japanese government. Initially, the program seemed to work and generate some growth. But these effects also fizzled out very quickly. Just three years after the new policy began, the Japanese economy is doing as badly as it was before.

That is the fundamental problem of macroeconomic policy, be it of a fiscal or monetary nature: the measures always only have a short-term effect. On the one hand, this is due to the fact that, although government debt draws government demand for goods and services from the future to the present, it cannot increase it over the years. Every debt has to be serviced or repaid, which will deprive the economy of as much stimulation in the future as it can get today. Because of this trivial effect alone, it is not possible to generate a lasting economic recovery. And if the citizens see through this and become suspicious, then such a revival will not even come about in the short term.

On the other hand, monetary policy only has a short-term effect because its successes largely come about through currency devaluation. Part of the large amount of new money that the central bank is pumping into the economy is pushing its way abroad and leading to additional demand for foreign currency, which appreciates foreign currencies and thus depreciates one's own currency. That is expansive because consumers tend to buy domestic products instead of the increasingly expensive imported goods and because exports, which are becoming cheaper for foreign countries, are picking up. But the central banks of the other countries usually do not stand idly by. If they enter a devaluation race with their own rate cuts, the effect can turn into its opposite.

Sure, one can also hope for stimulating effects insofar as the low interest rates make it easier to finance investments. The demand for capital goods is an important element of the domestic demand of any country because many companies do not sell to end customers but to other companies. But this is regularly countered by negative effects on consumers. In Japan in particular, where retirement provision is primarily based on funded capital, a cut in interest rates means that consumers save even more in order to still achieve the standard of living planned for old age. And if consumers do not want to buy, it is not worth investing for companies despite the low interest rates.

Why are governments around the world succumbing to this policy? This is mainly due to the short-term nature of their thinking. The next election is to be won, and for that the Keynesian and monetarist stimulants come in handy. Abenomics was basically nothing more than giving more of the stimulant that had been given to the Japanese economy for more than two decades. Abe's politics temporarily helped against the headache, but then created an even bigger hangover.

Incidentally, a major reason for the loose monetary policy is not to try to revive the economy, but to stop the fall in property prices and the prices of other assets such as long-term government bonds or stocks. It is a matter of preventing the devaluation of the owners' capital and the collapse of banks and companies. A more sarcastic way to say is that the policy of low interest rates is always meant to delay bankruptcies in order to help the politically influential owners of stocks, real estate and long-term fixed-income securities avoid the consequences of their bad investments.

But this endeavor not only means that risks are transferred from investors to taxpayers, who, through the central bank, become owners of the securities to an ever greater extent.

They are also detrimental to the economy in so far as the creative destruction of traditional corporate structures, the beneficial effects of which Joseph Schumpeter and Karl Marx had already described, is delayed. Inefficient old companies that should have been replaced by new, dynamic companies are maintained by the state injections of demand. Banks and financial institutions that, if properly valued, should have gone bankrupt are dragged along - and with them the companies to which they extend loans. This is a major reason why Japan has been laboring around for a quarter of a century without getting anywhere.

This shows the parallels to the euro area, because not only Italy, but all of southern Europe remains today in a state of lack of competitiveness, which is not broken because new money is made available again and again with which the traditional structures can be maintained . The lack of competitiveness has historical reasons. But it is largely explained by the euro itself.

After the euro had led investors to believe that investing in southern Europe was secure and caused them to be satisfied with significantly lower interest rates than before, it came about in southern Europe in the years after the Madrid summit (1995), when the timing up to It was finally decided to introduce the euro, leading to a huge inflationary credit boom. Since in the state sector - and also in building loan - financed wage increases that were no longer geared towards productivity growth, the countries became too expensive and lost their competitiveness.

That became a problem when the flow of credit from abroad suddenly dried up with the Lehman bankruptcy in 2008. The local central banks then printed the money for their economies that the foreign lenders no longer wanted to lend there, which is measured by the so-called Target balances. In a second step, politicians created huge fiscal rescue packages to avoid overloading the local printing presses. All of this helped to avoid the crash, but it was also said that the credit-financed wage increases and their consequences for prices were not corrected (Italy and Portugal) or only to a very limited extent (Greece, Spain).

That is exactly where the ongoing problem lies today. The countries of southern Europe would probably have to become 15 to 30 percent cheaper than their competitors in the euro area in order to become competitive again. In the euro, however, this presupposes a long phase of austerity policy, in which these countries are forced to lower their prices in relation to the other countries through an economic downturn. Something similar happened in Germany after joining the euro. But politics in these countries lacks strength and tolerance today. Again and again she succumbs to the temptation to provide short-term relief for the electorate through new debts, but this is exactly what prevents the urgently needed correction in relative prices.

It is understandable that under these circumstances the ECB would rather go down the path of inflating the euro zone as a whole. Then Italy & Co. will be competitive again on their own, provided they waive new debts so that their wages and prices can remain constant. But the prices in Germany have to rise all the faster.

That is easier said than done, however, because a large country as stability-oriented as Germany cannot easily be inflated. It's sluggish like a heavy tanker. The German goods prices rise only slightly, so that the competitiveness of the southern countries hardly improves. In contrast, there is inflation in German real estate prices. Since 2010 they have risen by a third in the cities and by half in the big cities.

The real estate boom is stimulating the domestic economy and helping to integrate the refugees by creating many simple jobs in construction and in the trades. However, this boom threatens to become a bubble because of the ECB's zero and negative interest rate policies, and that is dangerous because most bubbles will burst at some point. Yet it is not so far. It can take a decade and a half before bubbles burst, and Germany has only been in the first five years. But when they burst, the chaos is great. Then Germany would get into the state in which southern Europe is today. Mass unemployment, bank deaths, new excess debts and, above all, more political radicalism and the destabilization of the system could be the consequences.

Therefore it is time to set the ECB tighter legal restrictions or at least to relegate it to the existing ones and to urge the southern countries to make more of their own efforts to overcome their competitive crisis. But how and whether this can even be done in the euro is another and open topic.