The key chart

Introduction

In my previous post, “Policy reboot 2020?” I suggested that, “progress towards dealing with the debt overhang in Europe remains gradual and incomplete”. This prompted two follow-up questions:

• How do I monitor this progress within the Macro Perspectives framework?
• Why does it matter?

In this post, I present eight graphs that are key to monitoring this progress:

1. Private sector debt ratios (PSDRs)
2. Costs of borrowing
3. Lending spreads versus policy rates
4. Growth in broad money (M3)
5. Growth in private sector credit
6. Money supply vs demand for credit dynamic
7. Inflation
8. Private sector net financial balances

Summary and implications

The eight graphs confirm that the EA is still dealing with the legacy of a debt overhang. Private sector debt levels are still too high, money, credit and business cycles are significantly weaker than in past cycles and inflation remains well below target.

In spite of this, the collective fiscal policy of EA nations is (1) about as tight as any period in the past twenty years and (2) is so at a time when the private sector is running persistent net financial surpluses (largely above 3% GDP since the GFC).

An important lesson from Japan’s experience of a balance sheet recession is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. These savings (at a time of zero rates) are responsible for weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary (Koo, R. 2019).

Ironically, the EA is positioned better to ease fiscal policy than the UK (where both the private and public sector are running simultaneous financial deficits) but we are more likely to see fiscal stimulus in the latter (March 2020) than in the former.

It’s time for a policy reboot in the EA for 2020 and beyond.

Eight key charts

Key chart 1: Private sector debt ratios

The first chart illustrates twenty-year trends in private sector debt ratios (PSDR) – private sector debt as a percentage of GDP – for the UK, EA and US. The three vertical, dotted lines mark the point of peak PSDR for each economy. This is the standard starting point for analysing debt overhangs.

Private sector deleveraging began much later and has been more gradual in the EA than in both the US and the UK. The PSDR in the EA is now the highest among these three economies.

• The US PSDR peaked first at 170% GDP in 3Q08, fell to a post-GFC low of 147% GDP in 3Q15 (co-incidentally the point when the EA PSDR peaked) and is currently 150% GDP
• The UK PSDR peaked one quarter later (4Q08) at 194% GDP, fell to 160% GDP in 2Q15 and is currently 163%
• The EA PSDR continued to rise after the GFC before peaking at 172% in 2Q15 and declining slightly to 166% currently

For reference, but not shown here, household (HH) and corporate (NFC) debt ratios (the two sub-sets behind these totals) differ across the three economies. In the EA, the NFC PSDR is 108% (above the BIS’ maximum threshold of 90%) but the HH PSDR is only 58%. In the UK and US these splits are 79%:84% (see “Poised to disappoint”) and 75%:75% respectively. In other words, the risks lie in different places in each economy.

Key chart 2: Cost of borrowing

The second chart illustrates the ECB’s composite measures for HH and NFC cost of borrowing (in nominal terms). The cost of borrowing typically falls in periods of debt overhang, reflecting weak demand for credit.

Weak credit demand is reflected in the cost of borrowing for EA HHs and NFCs falling sharply.

• HH and NFC costs of borrowing both peaked in 3Q08 at 5.6% and 6.0% respectively
• The HH cost of borrowing hit a new low in December 2019 of 1.41%
• The NFC cost of borrowing hit a low of 1.52% in August 2019 and is currently 1.55%

For reference, costs of borrowing in real terms (shown here) remain low at 0.11% for HH and 0.25% for NFCs but above their October 2018 lows of -0.49% and -0.65% respectively.

Key chart 3: Spreads vs policy rates

The third chart illustrates the spread between composite borrowing rates and the ECB’s main refinancing rate (MRR). These spreads typically narrow during periods of debt overhang.

Spreads between borrowing costs and the ECB’s main policy rate are at, or slightly above, post-GFC lows.

• HH spreads have declined from 2.97% in May 2009 to a new post-GFC low of 1.41%
• NFC spreads have declined from 2.76% in May 2014 to 1.55% currently, slightly above their post-GFC low of 1.55%

Key chart 4: Growth in broad money (M3)

The fourth chart illustrates the twenty-year trend in the growth of broad money (M3). Broad money reflects the interaction between the banking sector and the money-holding/real sector.

Growth rates in broad money have been stable since ECB easing in 2014 but subdued in comparison with previous cycles.

• In December 2019, M3 grew by 5.0% YoY
• Narrow money (M1) contributed growth of 5.3% which was offset by negative growth in short term marketable securities

For reference, the share of M1 within M3 has risen from 42% in December 2008 to a new high of 68%, despite the fact that HH overnight deposit rates are -1.25% in real terms.

Key chart 5: Private sector loan growth

The fifth chart illustrates YoY growth in private sector credit, the main counterpart to M3.

Private sector credit is growing at the fastest rate in the current cycle but also remains subdued in relation to past cycles and highly concentrated geographically (Germany and France).

• Private sector credit grew 3.7% YoY in December 2019 (3m MVA) above the average growth rate of 3.5%
• Germany and France together contributed 2.8% of the 3.7% growth in HH credit and 2.6% of the 3.2% growth in NFC credit in 2019

Key chart 6: Money supply vs credit demand

The sixth chart – one of my favourite charts – illustrates the gap between the supply of money (M3) and the demand for credit by the private sector. In typical cycles, monetary aggregates and their counterparts move together. Money supply indicates how much money is available for use by the private sector. Private sector credit indicates how much the private sector is borrowing.

The gap between the growth in the supply of money and the demand for credit indicates on-going deficiency in credit demand in the EA.

• Since 4Q11, broad money and private sector credit trends have diverged with gaps peaking in 3Q12 and 1Q15
• The gap narrowed up to September 2018 but has widened out again recently

Key chart 7: Inflation

The seventh chart ilustrates the twenty-year trend in inflation (HICP) plotted against the ECB’s current inflation target. Again, inflation rates tend to much lower in periods of debt overhang.

Inflation remained below the ECB’s target throughout 2019 and finished the year at 1.3%

• Inflation ended 2019 at 1.3%, below the ECB’s target of 2%

Key chart 8: Private sector financial balance

The eighth, and final chart, illustrates trends in the private sector’s net financial surplus. In this analysis, 4Q sums are compared with GDP.

Finally, the private sector (in aggregate) is running a financial surplus in spite of negative/very low policy rates – a very strong indication that the economy is still suffering from a debt overhang

• In aggregate, the EA private sector is running a net financial surplus equivalent to 3.1% of GDP (3Q19) at a time when deposit rates are negative (average -0.9% during 3Q19)

Why does this matter?

…Fiscal rules should be designed to favor counter-cyclical fiscal policies. Nevertheless, despite various amendments to strengthen the counter-cyclical features of the [EA] rules, the outcomes have been mainly pro-cyclical.

IMF, Fiscal rules in the euro area and lessons from other monetary unions, 2019

The EA is still dealing with the legacy of a debt overhang. Private sector debt levels are still too high, money, credit and business cycles are significantly weaker than in past cycles and inflation remains well below target.

In spite of all of this, the nations of the EA are collectively running a fiscal policy that is about as tight as at any period in the past twenty years. They are also doing this at a time when the private sector is running persistent net financial surpluses. Clearly, these developments fail a basic “common sense test”.

Its worth noting that fiscal policy rules in the EA, including the Stability and Growth Pact, were created without reference to the private saving and for an economic environment that no longer exists (eg, positive rates, high inflation, government mismanagement etc.).

Leaving aside, the weak track record of adherence to these rules by member states, the obvious question is whether these rules remain relevant and whether the current policy mix is appropriate?

An important lesson from the experience of Japan’s balance sheet recession is that the deflationary gap in economies facing debt overhangs is equal to the amount of private unborrowed savings. Balance sheet recession theorists, such as Richard Koo, argue that these, “unborrowed savings (at a time of zero interest rates) are responsible for the weakness in the economy, and it is because the economy is so weak that fiscal stimulus is necessary”.

Relating the same argument to inflation targets, when inflation and inflation expectations are below target and rates are zero or negative, fiscal policy should lead with an expansionary stance and monetary policy should cooperate by focusing on guaranteeing low interest rates for as long as needed.

Ironically, the EU is positioned better to relax fiscal policy than the UK (where both the private and public sector are running simultaneous deficits) but we are more likely to see fiscal easing in the latter (March 20202 budget) before the former.

In short, it is time for a policy reboot in the EA for 2020 and beyond.

Please note that the summary comments above are extracts from more detailed analysis that is available separately.