Richard Koo

EQ U I T Y R E S E A RC H

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European talks on balance sheet recessions

April 24, 2012

In the four weeks since my last report I had the opportunity to engage in fruitful exchanges with officials, investors and even ordinary people in Italy and Germany that included seminars at three central banks.

While I was away, a relatively weak payrolls report and a raft of other anemic data put a damper on the spirits of bulls in the US. As in the eurozone, the bears appear to have the upper hand once again.

The emergent pessimism led investors to buy bonds, sending the 10-year Treasury yield back below 2% from over 2.3% and pushing the yield on 10-year German government debt to historical lows below 1.7% at one point.

In Japan, the slide in the yen that began in early February came to a halt, and the yield on the 10-year JGB fell back below 1.0% after climbing to near 1.1% as investors returned to the JGB market.

Bulls had gotten ahead of themselves The rallies in government bonds in Japan, the US, and Europe came as market participants realized that previous optimism had been overdone and that conditions in the real economy were not as strong as had been thought.

While it has been repeatedly stressed, for example, that the US economy had embarked on a recovery, it turned out that the recovery was not particularly robust.

A careful reading of the Fed’s Beige Book survey of regional economic conditions, for example, makes it clear that the lack of momentum is attributable to a credit crunch and a continued slump in the housing and real estate markets.

Central bank supply of funds will help address financial crises but cannot resolve problems at borrowers In the eurozone, the ECB’s two three-year funding operations—called long-term refinancing operations (LTROs)—encouraged the optimists by giving a shot in the arm to government bond markets in Spain and Italy.

But I have argued repeatedly that while monetary accommodation by the ECB is an effective response to financial crises, which are driven by problems at lenders, it is powerless to address balance sheet recessions, which involve problems at borrowers.

A survey of lender-side issues shows that in the latter half of 2011 the eurozone faced a textbook financial crisis: many banks experienced the same problem at the same time and lost trust in each other. That lack of trust ultimately led to a state of affairs in which banks refused to deal directly with each other and insisted instead on going through the ECB.

The natural duty of a central bank facing such a crisis is to prevent a breakdown in the payments system by supplying ample liquidity. That is what the BOJ did when Sanyo Securities defaulted on the uncollateralized call market in 1997 and what the Fed did in the wake of the 2008 failure of Lehman Brothers, and those actions enabled both countries to pull through their respective crises.

Richard Koo is chief economist at Nomura Research Institute. This is his personal view.

Richard Koo r-koo@nri.co.jp

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See Appendix A-1 for important disclosures and the status of non-US analysts.

Japanese version published on April 23, 2012

Nomura | JPN Richard Koo April 24, 2012

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Draghi ECB averted financial system collapse with LTROs In the eurozone, the crisis steadily worsened under former ECB president Jean-Claude Trichet because he did not act boldly when banks were growing increasingly distrustful of each other.

Mr. Trichet’s successor at the ECB, Mario Draghi however, shut down the risk of financial system collapse due to bank funding problems by unveiling the LTRO program. A happy by-product of the refinancing operations was that investors returned to government bond markets in Italy and Spain.

But while the LTROs prevented distrust among banks from triggering a collapse of the financial system, they did nothing to address the balance sheet recession in the real economy.

Similar actions at the BOJ since 1997 or the post-Lehman Fed and BOE also failed to prevent balance sheet recessions.

And in the eurozone, ECB monetary policy—already largely ineffective—was further undermined by the European Banking Authority’s tough new capital requirements for the region’s banks. This requirement, which forced the banks to reduce lending, essentially eliminated the possibility that ECB policies might boost the real economy.

Eurozone economists overestimated impact of LTROs At first, the vast majority of market participants and policymakers appeared unable to distinguish between a financial crisis, which is a lender issue, and a balance sheet recession, which is a borrower issue. As a result, they overestimated the impact of the LTROs and assumed the ECB’s actions would solve the eurozone’s economic problems.

A senior financial official I spoke with two months ago emphasized that the worst was over and went so far as to say that “there is no problem that €1trn cannot solve.”

Another senior official said that with the ECB undertaking bold action and the Fiscal Compact in place to ensure fiscal consolidation, the only remaining task for the eurozone was to carry out structural reforms to support economic growth.

Behind these statements lie the hopeful assumption that the austerity policies implemented by eurozone authorities were the right medicine and that additional support from monetary policy and structural reforms would be sufficient to spark a eurozone recovery.

Three problems with bullish speculation on eurozone But there are three problems with this view. First, the experiences of Japan, the US, and the UK show that monetary accommodation cannot stimulate the real economy when the private sector is seeking to minimize debt in spite of ultra-low interest rates during a balance sheet recession.

Second, fiscal stimulus is the only tool a government has for maintaining aggregate demand when monetary policy has lost its effectiveness. Yet Germany and other countries of the eurozone are actively pursuing fiscal retrenchment.

Third, eurozone members hope that structural reforms will lead to growth, but the examples of Japan and the US show that such policies will not have a positive impact on growth for at least five to ten years.

Supply-side reforms of 1980s did not bear fruit until Clinton administration in 1990s The supply-side reforms enacted by President Reagan in 1980 and the six major reforms implemented by the Hashimoto administration in Japan in 1997 serve as a useful reference regarding the third point.

President Reagan presented the supply-side reforms at the time as a macroeconomic policy that would stimulate the economy almost immediately. He wheeled out the Laffer Curve, which describes the relationship between tax rates and tax revenues, and explained that if you give people $50, they will spend it and the economy will improve right away.

But it was only 15 years later, during the Clinton administration, that President Reagan’s supply-side reforms began to lift the economy. Economic performance was less than expected throughout 12 years of Republican presidents, and despite major successes on the diplomatic front, including an end to the Cold War, President George Bush Sr. was ultimately defeated by Clinton’s simple slogan, “It’s the economy, stupid!”

This suggests that supply-side reforms did not have the originally expected impact for the 12 years of the Reagan and Bush (Senior) administrations.

In was only during the eight years of the Clinton administration that the reforms began to have a positive effect, with new start-ups in IT and other sectors driving the economy and pushing the US fiscal balance into surplus after long years of deficits.

Hashimoto believed structural reforms would offset hit from austerity plans The Hashimoto administration of Japan made the same mistake in 1997. The administration understood that fiscal retrenchment would hurt the economy in the short term but believed the adverse impact would be offset by its six key structural reforms.

The government went so far as to publish estimates of how many jobs would be created by its reforms.

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A number of people who had experienced the Reagan years in the US first-hand—including myself and then-Treasury Secretary Lawrence Summers—objected strongly to the government’s argument that structural reforms could serve as a substitute for fiscal (i.e., macroeconomic) policy, but we were ignored.

In the end, the government’s policies led to five consecutive quarters of negative economic growth and falling tax revenues. Japan’s fiscal deficit not only did not decline but actually increased by 68%.

The experiences of Japan and the US should make it clear that structural reforms cannot replace macroeconomic policy, but unfortunately few in the eurozone today are sounding that warning.

Support for structural reforms in eurozone has led to neglect of macroeconomic policy In fact, the policy debate in the eurozone—much like that during the Koizumi administration in Japan—has come to focus almost entirely on structural reforms, which after all appear attractive on paper. But the price of that obsession with structural reforms was the neglect of macroeconomic policy.

The Koizumi administration completely ignored the fact that Japan was in a balance sheet recession and pushed ahead with structural reforms, insisting that there could be no economic recovery without them. But the economy failed to improve, and ultimately the only thing that grew was, in the words of one newspaper, the salaries of directors at the newly privatized Japan Highway Public Corporation.

Unfortunately, I see a real danger that European policymakers will remain ignorant of Europe’s balance sheet recession and continue to administer the wrong treatment for this economic ailment.

Many in the US and UK, have pointed out the dangers of a balance sheet recession and the risks inherent in premature fiscal consolidation, including Fed Chairman Ben Bernanke and Fed Vice Chair Janet Yellen in the US and the Financial Times’ Martin Wolf in the UK. Unfortunately, few influential figures in the eurozone have expressed similar views.

Taking the debate to Italy and Germany My recent trip to Europe began with a conference held on the shores of Lake Como in northern Italy. There I had the opportunity to debate these issues with Jürgen Stark, former Bundesbank Vice President and a leader of German economic opinion.

The panel also included a senior European Financial Stability Facility (EFSF) official and Stephen Roach, previously chief economist at Morgan Stanley and now a professor at Yale University. New York University professor Nouriel Roubini served as moderator.

The Italian business executives making up some 80% of the audience welcomed my balance sheet recession theory thanks to some powerful backup from Professor Roach, one of the very few economists to issue an early warning about the US housing bubble.

Many of the seminar participants said afterwards they found my arguments to be more persuasive than those of Dr. Stark.

European interest in balance sheet recessions is growing While Dr. Stark probably would not agree with that assessment, I was received at my next seminar—at the Bank of Italy—as “the man who stood up against Jürgen Stark.” The number of seminar participants greatly exceeded organizers’ expectations even though the event was held just before the Easter holiday.

Early the next week, I conducted seminars at the ECB and Bundesbank in Frankfurt, and once again the number of participants was far greater than initially expected despite the fact that everyone was returning from a holiday.

Both chairs and presentation materials were in short supply as a result. Similar scenes unfolded at seminars held by Nomura offices for investors in Frankfurt and Milan.

The response to these events is an indication that even in the eurozone there is growing public and private sector interest in the concept of balance sheet recessions. I suspect a growing number of people are beginning to worry that Europe could end up in deep trouble if it continues along its current path.

Seeking fiscal stimulus in overheated German economy is unrealistic Participants at the seminars appear to agree with my argument that the key issue was not how to make Germany use the money that had flowed into its financial system but rather how to keep Spain’s savings within its borders so that the Spanish government can use those savings to bolster its economy.

This is in response to Paul Krugman and others who have argued that encouraging Germany to spend more money would get money flowing through the eurozone economy again. However, I think their argument is unrealistic if we take into account current conditions in the German economy.

German unemployment rates are at 20-year lows, and the nation’s industrial output briefly exceeded its pre-Lehman peak. With inflation now the primary concern for an overheated German economy, a proposal that the country borrow and spend more is unlikely to be well received.

Nomura | JPN Richard Koo April 24, 2012

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Eurozone needs to prohibit governments from issuing debt to non-citizens I have frequently argued that if we hope to enable Spain and other countries facing balance sheet recessions to carry out fiscal stimulus, we need to prevent the private savings surplus in these countries from fleeing to Germany. To that end, I proposed a rule that would prevent non-citizens from buying a government’s bonds.

This rule could also ease fears every time an election is held in the eurozone. Today, every election in the eurozone stokes fears because the new administration may not observe agreements made by its predecessors. If government debt were sold only to citizens, however, fiscal policy would become an entirely internal issue of individual countries, and the fate of the broader eurozone would not hang in the balance every time an election was held.

Many obstacles would have to be overcome to establish a rule like this. That said, I think the fact that it is easier to understand than the alternatives is a key reason for the interest people have shown in it.

Balance sheet recession theory also attracted support in Germany I was actually very nervous about conducting the seminars at the Bundesbank and ECB in Frankfurt. My balance sheet recession theory emphasizes the importance of fiscal stimulus, which tends to be shunned in German economic thought.

But surprisingly—and perhaps because many of those in attendance were younger members of research departments—few participants attacked my theory head-on. The only objections concerned some of my historical interpretations and on the actual implementation of the solutions I was proposing.

Comments and criticism received at seminars For example, I argued that Germany had been in a balance sheet recession for at least five or six years following the collapse of the IT bubble in 2000. It was noted in response that Germany’s post-reunification housing bubble, which was centered in East Germany and subsequently collapsed in 1995–96, had far greater ramifications than the IT bubble.

It was also pointed out that while flow-of-funds data would suggest that German companies have focused on accumulating financial assets since 2000 while neglecting investment, in fact this occurred not because of balance sheet problems but because these firms invested heavily in eastern European companies which showed up as an increase in holdings of the shares of those eastern European companies.

Their accumulation of financial assets, therefore represents direct investments in eastern Europe—German companies are not just accumulating liquid assets like their counterparts in Japan and the US.

These comments were extremely helpful since they could only have come from local officials compiling the data. Apart from these points, however, there were few major objections to the argument that much of the eurozone is now experiencing the same kind of balance sheet recession seen in Japan, the US, and the UK.

“Market will not allow fiscal stimulus” A more frequently heard objection concerned the implementation of the policies I was proposing. Even if fiscal stimulus was needed to address a balance sheet recession, it was argued, the government would have no alternative but to continue along the path of fiscal consolidation if the market would not cooperate.

While this argument seems reasonable enough at first blush, I said it should not be assumed that the market will not “allow” a given policy before actually trying it. Until now the EU authorities have continually insisted that the problems in periphery countries are fiscal crises and that the only solution for them is fiscal consolidation.

If the only measure of policy success is progress in fiscal consolidation, it is easy to come to the conclusion that delays in fiscal retrenchment have undermined market confidence in periphery countries. But the situation would be very different indeed if the prescription recommended by both the public and private sectors turned out to be wrong.

Authorities have never admitted they were wrong Spain, for example, is in the midst of a severe balance sheet recession, yet is being forced by the EU to undertake fiscal consolidation, resulting in a vicious and destructive cycle. Conditions will only deteriorate if Spanish investors worried about the outlook for their economy send more funds overseas.

I suspect the majority of market participants would change their minds if the authorities shifted their stance by explaining (1) that a new economic “pathogen” had been discovered, (2) that a careful study had shown that the existing method of treatment was incorrect, (3) that the authorities would first do everything in their power to stop the vicious cycle, and (4) that fiscal consolidation would be undertaken only after balance sheets within the private sector had improved.

If the market participants agree with the new diagnosis, that would enable authorities to take the next policy step. Unfortunately, they have yet to admit that their diagnosis of the current crisis might be mistaken.

Market will not change its stance without an explanation from the authorities It is difficult to envision the market changing its stance and adopting a policy-assessment yardstick other than fiscal consolidation without an admission by the authorities that their diagnosis had been incorrect.

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In that sense, I think it is extremely irresponsible to say that a different approach is impossible because “the market would not allow it” when no attempt has been made to explain why such an approach is necessary.

It would be one thing if the market refused to accept such a policy shift despite the authorities’ best efforts to justify it. But for the authorities to blame the market for their inability to administer the correct treatment without mentioning even once that their diagnosis was mistaken is little more than an attempt to pass the buck.

“German people will not allow fiscal stimulus” The argument that the market will not allow fiscal stimulus is often accompanied by the argument that the German people will not tolerate it. Why, they say, would Germans who cannot receive a pension until they turn 67 agree to rescue countries where people become eligible for benefits before they turn 60?

The Germans are also still paying the “solidarity surcharge” introduced at reunification to help fund the rebuilding of East Germany. The argument is that asking them to pay for the rescue of neighboring countries on top of that would simply be out of the question.

The common thread running through these arguments is that they all involve emotions and sentiment, and a rational discussion of the issues naturally becomes more difficult when emotions are involved.

Explaining balance sheet recession theory to ordinary Germans In light of the above, I undertook an experiment on my recent trip. I presented the theory of balance sheet recessions directly to ordinary Germans to see how they would respond.

The seeds of the experiment were planted a month before I left during a telephone interview with a German newspaper. The paper in question was planning to hold a major forum in Berlin on the same weekend that my final conference was scheduled.

Given the newspaper’s emphasis on ecology, the forum was held on a Saturday afternoon on the non-technical theme of “Living a good life.” Subjects discussed ranged from gardening to philosophical issues, with only one slot set aside for the economy.

But I agreed to participate out of a desire to try the experiment. Before the seminar, however, the organizers apologized in advance, saying that I should not feel bad if few attended. Interestingly, a famous German author was conducting a seminar during the same time slot as mine.

Germans will understand need for fiscal stimulus if issue is properly explained When I arrived at the venue the crowds were overwhelming; a large group of people were actually upset because fire regulations had prevented them from entering the hall.

I spent an hour and a half explaining to several hundred ordinary Germans that most of the eurozone was in the midst of a balance sheet recession and that these countries desperately needed fiscal stimulus. My talk was extremely well received even though I was an unknown Asian economist speaking in English (there was an interpreter present).

Many people thanked me for letting them know that there was a different way of looking at the crisis in Europe based on balance sheet recession theory. Most of the questions from the audience were quite to the point, and while some seemed more like advertisements for environmental issues, in general I felt the audience had understood the message I came to deliver.

To be honest, neither I nor the organizers had any idea how the seminar would turn out. I was actually concerned about the possibility of being shouted down, but nothing of the sort happened.

The experiment proved that even ordinary Germans are capable of understanding the theory of balance sheet recessions—an economic concept not found in any university textbook—if only it is explained properly.

Based on this experience, I find the argument that fiscal stimulus is impossible “because the German people would not tolerate it” completely unconvincing. Even the Germans will understand the need for fiscal stimulus during a balance sheet recession if presented with a proper explanation.

Was Fiscal Compact designed to facilitate rescues? A senior official of the eurozone financial authorities who had read my book said the new Fiscal Compact is a major development that will facilitate rescues of distressed countries.

From the standpoint of balance sheet recession theory, the Fiscal Compact is the height of stupidity because it forces countries to keep their structural fiscal deficits under 0.5% of GDP. But he was making a slightly different argument.

Effectively he was saying that, under the new agreement, all countries will pursue fiscal consolidation under the same rules. If conditions in a given economy do not improve, that will be a sign that the problem lies in something other than the fiscal situation, making it easier to negotiate a rescue.

Without the Compact, he argued, it is difficult to assess what countries are trying to achieve since there is no common yardstick. The existence of such a yardstick will make it easier to arrange a rescue.

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I think this may be one way of building a consensus among nations. But rather than moving on to the rescue only after fiscal consolidation has proved itself a failure, I think the approach of bringing together a team of experts from the outset, assessing whether a country is in a balance sheet recession, and then moving on to the next step would result in far smaller economic losses.

The official’s comments were probably based on the assumption that the theory of balance sheet recessions has yet to gain general acceptance, but if German Chancellor Angela Merkel and other eurozone leaders were able to properly explain the nature of the current economic problems to their people, there would be no need to prove the current policy a failure before moving on to the next approach.

OECD begins warning about premature fiscal consolidation OECD Secretary-General Angel Gurria also participated in the Berlin economic conference. As a head of an international organization, he followed the United Nations Conference on Trade and Development (UNCTAD) in issuing a strong warning against moving too fast on fiscal retrenchment.

For the head of the OECD—traditionally a stronghold of economic orthodoxy—to warn against premature austerity represents a major shift and signals that policymakers in at least some countries are starting to worry about the fate of the eurozone given its current and exclusive focus on fiscal consolidation.

A senior British official who took part in the conference expressed similar concerns despite being quite skeptical of balance sheet recession theory until last year, suggesting that change may be afoot in the UK as well.

Has insistence on structural reforms made problems worse? Some believe that senior German officials understand that rescues will ultimately be needed but feel that unless EU authorities take advantage of the crisis to whip the less competitive periphery nations into shape, they will only face a bigger problem down the road. Hence they are delaying rescue efforts as long as possible while the periphery nations undertake structural reforms.

According to this view, eurozone authorities should take this opportunity to force periphery nations to enhance their future competitiveness by, for example, delaying pension eligibility until the standard German age of 67.

While there is something to be said for this argument, if true, it means that Germany’s insistence on structural reforms has postponed a solution and allowed a problem that was initially limited to the small nation of Greece to develop into a major crisis threatening the entire eurozone.

This is a direct result of the authorities’ attempt to use a single tool (rescue) to resolve two fundamentally separate problems—the debt crisis and the need for structural reforms in periphery nations—that should have been addressed with separate policy responses.

Central bank purchases of government debt during balance sheet recession should be last resort Professor Roubini published an article about my theory of balance sheet recessions soon after the Lake Como conference in which he argued that in a country facing this kind of recession the central bank should buy the government’s debt.

Such purchases are out of question under ordinary circumstances because they can trigger hyperinflation. But when businesses and households are paying down debt in spite of nearly zero interest rates, the money multiplier is negative at the margin and no amount of bond purchases by the central bank will lead to inflation.

Still, I think such purchases should be a last resort. And instead of agreeing to automatically underwrite new debt issues, the central bank should only buy bonds under the condition that it can sell them whenever necessary.

The reason is that in a country like Japan, where there is a surfeit of private savings in spite of zero interest rates, the only investment available to private-sector financial institutions is government debt. Purchases of that debt by the central bank would lead to additional flattening of the yield curve, squeezing bank margins even further.

With 10-year government bonds yielding around 2% in the US and the UK and substantially less than that in Germany and Japan, financial institutions already face severe difficulties, and I see no reason why the central banks of these countries should be buying government bonds at such high prices.

That said, the central bank should buy up government bonds boldly to repel any attack on the market by speculators and should be prepared to do so at any time.

Central bank should always be able to sell bonds it buys Automatic underwriting of government debt issues by the central bank creates worries that it will be unable to mop up all the resulting liquidity when private demand for funds finally recovers. Such concerns can trigger a collapse of confidence in the currency and even hyperinflation.

Purchases of government debt by the central bank should therefore be made under the condition that the bank can sell the bonds at any time. As long as that condition is assured, I see little danger of such purchases causing major problems during a balance sheet recession.

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