What’s on Nouriel’s Mind_ A Balance Sheet Recession Calls for Monetized Fiscal Deficits, Not...

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April 3, 2012

What’s on Nouriel’s Mind: A Balance‐Sheet

Recession Calls for Monetized Fiscal Deficits, Not

Fiscal Austerity By Nouriel Roubini

It has been argued recently by economist Richard Koo that the eurozone (EZ) should follow the example

of Japan’s response to balance‐sheet recession. While there is a misperception that policy mistakes

caused the stagnation that Japan faced for over a decade, Koo argues that if Japan had not undertaken

massive fiscal stimulus monetized by the central bank, the recession following the bust of its equity

market and real estate bubble would have led to a 1930s‐style depression.

The argument is that when the private sector is rapidly deleveraging after a private‐sector‐driven

spending and credit boom and asset bubble lead to a credit bust and asset deflation, the best policy

response is large fiscal deficits financed by debt monetization. Without large and persistent fiscal deficits,

the increased savings, reduced consumption and capital spending, and debt reduction of the private

sector will usher in a recession or even a depression because of the overall lack of aggregate demand;

monetization is necessary to finance the surge in public deficits and debt at low interest rates. These

policy prescriptions are relevant for the periphery of the EZ as well as other countries that recently have

experienced balance‐sheet crises (the U.S., the UK, Iceland, Dubai, etc.).

Unlike Japan in the 1990s and the U.S. in the aftermath of the global financial crisis, the EZ seems bound

to repeat the fundamental mistakes of the Great Depression: lack of fiscal stimulus and outright fiscal

contraction; insufficient monetary easing and resulting buildup of banking and fiscal strain; and

maintenance of a rigid monetary union that did not allow significant nominal and real depreciation to

restore external competitiveness, external balance and economic growth.

How to Jump‐Start an Economy Facing a Private‐Sector Balance‐Sheet Crisis

At the Ambrosetti Forum that took place at Italy’s Villa d’Este this past weekend, I chaired a session on the “global

debt crisis” and how to resolve it. A fascinating debate emerged after Koo, one of the leading contemporary

experts on Minsky‐style balance‐sheet recession, made a presentation based on a paper1 on the lessons the EZ

could learn from the Japanese boom, bust and stagnation of the last two decades. His main message: When the

private sector is rapidly deleveraging after a credit boom and asset bubble lead to a credit bust and asset deflation,

the best policy response is large fiscal deficits financed by debt monetization. Without large and persistent fiscal

deficits, the reduced spending (both on consumption and fixed investment), increased savings and debt reduction

of the private sector (households, corporations, banks and financial institutions) will usher in a recession or even a

depression because of the overall lack of aggregate demand. Monetization is necessary to finance the surge in

public deficits and debt at low interest rates, and is not inflationary because in a balance‐sheet recession banks

hoard the extra base money created by the government in the form of excess reserves. Thus, velocity collapses as

1 Richard Koo, “The Eurozone Crisis: Causes, Remedy and Misperceptions,” March 2012.

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base money (M0) swells while M1, M2, M3 and credit contract—heavily indebted borrowers don’t want to borrow

even at zero rates, and banks are unwilling to lend to them.

Koo’s policy prescriptions contrasted sharply with those of the two Europeans on the panel—both from the core of

the EZ—who argued that the solutions to the EZ problems were implementing fiscal austerity and avoiding

monetization of public debt.

This debate on the appropriate policy response to a balance‐sheet recession is relevant not only for the EZ

(specifically for Ireland, Spain and Portugal); economies such as the U.S., the UK, Iceland and Dubai also have

experienced recessions along the lines of what Japan went through in the last two decades. Consistent with Koo’s

argument, these economies have experienced massive deleveraging of their private sectors: In Spain the private

sector has increased its financial savings (the gap between private savings and investment) by 18% of GDP since

2008; in Ireland, 29%; in Portugal, 8%. In the U.S., the increase in savings was 9%, while in the UK it was 7%. Sharp

increases in private savings and/or collapses in fixed investment also occurred in Iceland and Dubai following the

bust of their real estate bubbles.

Japan Learns a Lesson; the World Takes Note

By comparison, in Japan the change in the savings‐investment balance of the private sector was 22% of GDP

between the peak of the boom and the bust. While there is a misperception that policy mistakes caused the

stagnation that Japan faced for over a decade, Koo argues convincingly that if Japan had not undertaken massive

fiscal stimulus monetized by the central bank, the recession following the bust of its equity market and real estate

bubble would have led to a 1930s‐style depression. Indeed, in Japan nominal GDP never fell below the precrisis

level, and real GDP rose by 16% between 1990 and 2011 in spite of persistent deflation; whereas during the Great

Depression, many countries saw real GDP shrink by 30‐40% amid massive deflation and the collapse of nominal

GDP. If anything, Japan’s problem was not that it eased monetary and fiscal policy too much; rather that the easing

didn’t occur until the mid‐1990s instead of right after the bust, and it was erroneously withdrawn in 1997, 2001

and 2005, prompting renewed economic contractions.

The lesson the world learned from Japan returned to the fore in the global financial crisis of 2008‐09. After the

collapse of Lehman Brothers, the U.S. and global economy were contracting at a faster rate than between 1929

and 1931, based on data on consumption, investment, industrial production, employment, exports and imports.

This Great Recession indeed could have ended up a second Great Depression. What prevented this was the

massive monetary and fiscal stimulus that occurred in the U.S. and the rest of the world, both advanced economies

and emerging markets, starting in earnest in the spring of 2009.

The trigger for the global monetary easing was the U.S. Fed decision to introduce a whopping US$1.8 trillion first

round of quantitative easing (QE) after policy rates had been pushed down to 0% and the economy had entered a

liquidity trap; on the fiscal side, the G20 summit in London in the spring of 2009 led to a coordinated stimulus in

both advanced economies and emerging markets. It is thus no wonder that shortly thereafter the free‐fall in risky

assets—starting with global equity—stopped and stock markets recovered, while the U.S. and global recession

bottomed out by that summer. As households, corporations and banks were rapidly deleveraging, the surge in

fiscal deficits and debt prevented the recession from turning into a deflationary depression.

The sources of this surge in public deficits and debt were threefold:

1) An increase in deficits as automatic stabilizers kicked in;

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2) Proactive Keynesian stimulus, with increases in government spending and transfer payments and reductions in

taxes, to both directly and indirectly stimulate aggregate demand;

3) And ring‐fencing, guarantees and bailouts of banks, financial institutions, indebted households and corporations

that shifted private debts onto public balance sheets.

The U.S. Chooses Stimulus; Europe, Austerity

While the initial response to the crisis was coordinated and consistent across countries, subsequently the response

became extremely fragmented and divergent, with acrimonious debates between Americans and Europeans on

the right policy path. The U.S. embarked on additional monetary and fiscal stimulus, with QE2 and Operation Twist

(possibly soon to be followed by QE3), as well as two rounds of fiscal stimulus in late 2010 and again in late 2011‐

early 2012, amounting to another US$1.4 trillion in extended tax cuts and transfer payments for 2011 and 2012

(income, capital gains, dividend and payroll taxes and unemployment benefits).

The EZ took the opposite path. Starting with pressure on Greece in 2010, the EZ dogma became the need for fiscal

austerity in both the periphery countries in trouble (Greece, Portugal, Ireland, Spain and Italy) and those in the

core, a bias now formalized with the new fiscal compact. On the monetary side, the ECB did an initial, token

attempt at QE (€60 billion of covered bond purchases, spare change compared to the US$1.8 trillion of the Fed’s

QE1).

Other advanced economies’ responses fell somewhere in between. A first round of QE occurred in both the UK and

Japan (both larger than in the EZ but smaller than in the U.S.), but then the Bank of England (BoE) and the Bank of

Japan (BoJ) went on hold in 2010 as the Fed started QE2 to the tune of US$600 billion. The BoE felt hobbled by the

temporary rise in headline inflation driven by the depreciation of the pound, the bump in commodity prices and

the increase in indirect taxes; while the BoJ was blocked by the widespread belief that Japanese deflation was

driven by structural factors (the excess supply of goods given the lack of restructuring), not a lack of aggregate

demand, which undermined the argument for pursuing more aggressive monetary easing or embracing an inflation

target.

Worse, the ECB went in reverse in 2011 by raising its policy rate—which had not been reduced during the global

financial crisis to the near‐zero levels of the U.S., UK and Japan—from 1% to 1.5%, leading to a sharp appreciation

of the euro and a worsening of the liquidity and debt problems of EZ banks and sovereigns. The double whammy of

front‐loaded fiscal austerity and monetary tightening tipped the EZ into a double‐dip recession by late 2011, with

massive strain on banks, private‐sector borrowers and sovereigns in the EZ periphery. By the end of 2011, all of the

EZ periphery was back in a severe recession after a barely perceptible recovery, and even the core had returned to

a mild recession.

In the UK, the Cameron government that came to power in 2010 decided to front‐load the fiscal austerity at a time

when the BoE was on hold given the rise in headline inflation. The combination of fiscal tightening and lack of

further monetary stimulus tipped the UK into a near recession by H2 2011, forcing the BoE into a second round of

QE by early 2012 in spite of an inflation rate still above the BoE target. Even the front‐loaded fiscal austerity of the

Cameron‐Osborne team had to be nudged back to prevent further fiscal drag.

Other central banks also moved toward a second round of QE between 2011 and 2012. The BoJ and the Swiss

National Bank (SNB) first introduced FX intervention policies to prevent their currencies from appreciating too

much, and the BoJ introduced QE2 and a formal inflation target in early 2012. The Japanese earthquake and

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tsunami also led to another round of reconstruction‐led fiscal stimulus that pulled Japan out of the double dip that

it experienced in 2011 following these tragic natural disasters.

By the time the ECB had reversed its policy rate hike—returning the rate to 1% in November 2011 and engaging in

two large quasi‐QE operations (3y long‐term refinancing operations or LTROs that increased EZ base money by

over €1 trillion)—the damage to the real economy was done, and the LTROs could only patch over the wound to

banks’ liquidity and to sovereign spreads.

Divergent Policies, Disparate Outcomes

The varying outcomes for the countries that suffered from balance‐sheet recessions reinforce Koo’s argument in

favor of persistent fiscal stimulus and monetization. The U.S. most closely followed Koo’s remedy—in an economy

with a large external deficit, unlike Japan—and by 2012, with repeated rounds of fiscal stimulus and QE its growth

rate was at worst 2% and possibly closer to 2.5%. Amid the ongoing deleveraging that follows a balance‐sheet

recession, the U.S. experienced a subpar, anemic recovery and below‐trend growth, but by 2012 inflation was low,

10y Treasury yields were at 2% and strains in the banking and household sectors were reduced. At the other

extreme was the periphery of the EZ, which sank into a deep recession that risked becoming a depression in

Greece and Spain, with yields on Greek, Portuguese, Irish, Italian and Spanish bonds spiking (and three countries

surviving on international bailouts). Finally, the ECB’s belated decision to implement disguised QE via the 3y LTROs

partially and temporarily narrowed the spreads on Italian and Spanish debt.

Between the U.S. and the EZ was the UK, where austerity tipped the economy into a near recession but an

independent monetary authority partially committed to monetized deficits (as opposed to the ECB’s hawkishness)

kept long‐term government bond yields close to U.S. levels. Similar to the UK case, Japan’s eventual QE and fiscal

stimulus after external and domestic shocks ensured a fragile and tentative economic recovery rather than a deep

double‐dip recession when the earthquake struck.

The ECB and Germany would reply to Koo by arguing that the crisis of the EZ periphery was caused by that region’s

fiscal laxity—not a private‐sector balance‐sheet boom and bust—and by a lack of structural reform that led to a

loss of competitiveness. But this interpretation is only partially valid. While Greece’s troubles were obviously

caused by reckless fiscal policy before the crisis, Ireland and Spain (like the U.S., the UK and Iceland) experienced

typical balance‐sheet recessions caused by a boom and bust in the private sector; the resulting rise in public debt

and deficits was the result of efforts to dampen the effects on growth of the private deleveraging that followed the

housing bust. The case of Portugal is less clear: The country had relatively loose fiscal policy—not as reckless as

that of Greece—but it also had significant private‐sector imbalances (an excess of investment compared with

savings of the corporate sector and financial system). In Italy, the fiscal deficit was modest before the crisis (while

the public debt was high as a legacy of large deficits in previous decades), and the private sector didn’t have

significant financial imbalances.

Aggressive monetization would have been the right policy for the EZ to prevent sovereign spreads from blowing up

when fiscal expansion was needed to counter a balance‐sheet recession and/or to finance already large public

deficits and debt. Significant fiscal stimulus also would have made sense for Spain and Ireland, while the fiscal

austerity in Greece and Portugal should have been less front‐loaded. Italy should have used proactive fiscal

stimulus in 2009 rather than relying only on automatic stabilizers, and its fiscal austerity should have been less

front‐loaded as well. Germany and the core of the EZ also should have implemented more substantial and

persistent fiscal stimulus rather than front‐loading their fiscal austerity.

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Still, the recessionary deleveraging of the EZ periphery was bound to be more severe than that of Japan. Unlike

Japan, which was running a large current account surplus and did not suffer from a lack of external

competitiveness, the EZ experienced real appreciation, a rise in unit labor costs and large current account deficits

that investors were unwilling to finance once the sudden stoppage of capital—and outright capital flight—

occurred. Since domestic demand was falling because of deleveraging (in Spain, Ireland and Portugal) while public

spending was contracting in countries that required fiscal discipline to restore growth and avoid severe recession

(and, at best, only modestly expanding in countries undertaking fiscal stimulus), net exports had to improve. The

best way to achieve the necessary real depreciation would have been a nominal depreciation of the euro together

with higher inflation in the core of the EZ relative to the periphery. These could have been achieved through

aggressive monetary easing and deficit monetization as well as relatively large fiscal stimulus in the core of the EZ.

Instead, the core and the ECB imposed an asymmetric, deflationary and recessionary adjustment on the periphery,

attempting to bring forth real depreciation with structural reforms and deflation (internal devaluation).

The trouble with these options is that structural reforms take too long to increase productivity growth and to thus

reduce unit labor costs (and can be recessionary in the short run as the intersectoral resource reallocation of labor

and capital takes time). Plus, deflation is always associated with deepening recession and causing a heavier real

burden of already high private and public debt as prices and wages fall. These risks were realized in the EZ

periphery.

Like the EZ periphery—and unlike Japan, which was running a current account surplus and was a net foreign

creditor—other economies with private‐sector balance‐sheet crises, such as the U.S., the U.K. and Iceland, were

also running large current account deficits and had currencies that were overvalued in real terms before the

bubbles went bust. Thus, a policy of monetized fiscal deficits is necessary to restore competitiveness and external

balance and return to potential growth as domestic private demand is constrained by the deleveraging process. Of

course, the fiscal stimulus, by increasing public dissaving, slows down the process of achieving external balance but

that emphasizes the need for additional nominal and real currency depreciation to enhance competitiveness that

will accelerate external balance.

The main obstacle to external adjustment for deleveraging countries with large current account deficits is that in

order for them to spend less, save more and undergo nominal and real depreciation, countries with undervalued

currencies, large current account surpluses, high savings and excess income over spending need to save less, spend

more and allow their currencies to appreciate. Given the current global imbalances, China and other emerging

economies with undervalued currencies and large current account surpluses need to allow their currencies to

appreciate, save less and increase domestic consumption and spending. In the EZ, Germany and the core need to

save less and spend more domestically (including via fiscal stimulus) and allow—on top of a weakening of the

external value of the euro—intra‐EZ real appreciation via a higher inflation rate in the core relative to the

periphery. So far, China, other emerging economies, Germany and the core of the EZ are resisting currency

movements, reduction in savings and increase in spending that would allow current account deficit reduction

among economies within the EZ and elsewhere, including the U.S., that are running large external deficits.

The Road to Depression

Unlike Japan in the 1990s and the U.S. following the global financial crisis of 2008‐09, the EZ seems bound to

repeat the fundamental mistakes of the Great Depression: lack of fiscal stimulus and outright fiscal contraction;

insufficient monetary easing and resulting buildup of banking and fiscal strain; and maintenance of a rigid

monetary union that did not allow significant nominal and real depreciation to restore external competitiveness,

external balance and economic growth. The ECB is now starting to remedy its mistakes, but the damage to the

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sovereign spreads of the EZ periphery has already been done and the recent spread compression in Italy and Spain

(not in Portugal and Greece) following the 3y LTROs may prove temporary as the EZ recession deepens, driven by

many factors:

1) The ongoing fiscal austerity that is even more front‐loaded now that binding rules have been imposed by the

fiscal compact;

2) A too‐strong euro given the lack of aggressive monetary easing and other policy action;

3) The credit crunch that the EZ periphery is experiencing in spite of bank liquidity, as banks deleverage like the

rest of the private sector and sell assets, as they have been forced to front‐load the increase in their required

capital ratios to 9% rather than receiving forbearance;

4) Rising oil prices that are further undermining EZ growth;

5) And a lack of fiscal stimulus—instead, actual fiscal austerity—in the core of the EZ to compensate for the

deleveraging of the periphery.

Already, after over a €1 trillion increase in base money following the two 3y LTROs, the spreads on Spanish debt

are rising. Imposing draconian fiscal austerity, with a 3% of GDP primary adjustment in 2012 alone, on an economy

where the private sector is undergoing drastic deleveraging while a real estate bust is still underway is a recipe for

a deepening recession. Once the recession worsens, as it did in 2011, the primary deficit will overshoot its target

and force another round of fiscal austerity that—as in Greece—will turn the recession into a depression. With

unemployment in Greece and Spain already above 20% (above 40% among young people) and still sharply rising,

both countries are on a path to economic depression. Portugal, hobbled by a long‐term lack of competitiveness, is

not far behind; a likely second bailout for Portugal will only briefly postpone a Greek‐style coercive restructuring of

its public debt. If the Spanish recession becomes deeper, as is likely, yields will rise to the point where the country

loses market access and requires a large IMF/EZ bailout package. Italy has made progress on the fiscal and

structural fronts, but the necessary policies are recessionary; that is why even the Monti government is rightly

starting to talk about the need for EZ‐wide policies to restore growth in the periphery. These policies need to

include more aggressive easing by the ECB, weakening of the euro, fiscal stimulus in the core and less front‐loaded

fiscal austerity in the periphery, together with a much larger international firewall to prevent liquidity problems

from turning into insolvency.

Restoring external competitiveness, external balance and economic growth is critical for periphery countries to

remain viable members of the EZ. If the euro doesn’t fall sharply toward parity with the U.S. dollar, and if structural

reforms take too long to restore competitiveness while deflation turns recession into near depression, the only

viable option for a distressed EZ country to restore growth and competitiveness eventually will become giving up

the euro, exiting the monetary union and returning to a national currency. The ECB has postponed a loss of market

access for Italy and Spain, prevented for now a debt restructuring in Portugal and Ireland and avoided an early exit

of Greece from the EZ. But liquidity only buys time; it doesn’t resolve the fundamental problems of private and

public insolvency and lack of growth and competitiveness. As Koo warned at the Ambrosetti Forum, to avoid a

repeat of the Great Depression and achieve milder stagnation like that experienced by Japan, the EZ periphery

requires a different set of macroeconomic policies.

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After the Private‐Sector Balance‐Sheet Repair

The argument that a balance‐sheet recession requires a monetized fiscal stimulus does not imply that such a policy

should be followed without any limit and that relevant structural reforms including real and financial restructuring

should not occur. Eventually, once the private‐sector balance‐sheet healing has occurred, the fiscal stimulus needs

to be phased out. Once the economy returns to potential growth, the excess liquidity in the financial system needs

to be mopped up and sterilized. But, as I have argued recently, the optimal path of fiscal consolidation is back‐

loaded rather than front‐loaded: short‐run stimulus with a credible plan to reduce spending and raise taxes over

the medium term, once the deleveraging and private‐sector balance‐sheet repair has occurred. In a recent

presentation at a Brookings Institution panel, Brad DeLong and Larry Summers also show that a monetized fiscal

stimulus is the appropriate policy response to a balance‐sheet recession and subsequent deleveraging in

economies that are in a liquidity trap. Of course, if the crisis was caused in the first place by a lack of fiscal

discipline (as in Greece) an appropriate fiscal austerity plan—that is not excessively front‐loaded—and an orderly

debt restructuring cannot be postponed; rather they need to be part of the strategy to solve the crisis.

Finally, relevant structural reforms including real and financial restructuring should occur at the right pace. Initially,

some forbearance for banks and financial institutions and appropriate provision of backstops, ring‐fencing and

liquidity are necessary to prevent a systemic meltdown of the financial system. But over time, keeping zombie

banks, financial institutions, corporations and households on permanent emergency liquidity support prevents the

real and financial restructuring that is necessary to clean their balance sheets when forbearance, time and liquidity

alone are insufficient to do so. Indeed, when problems pertain to solvency rather than liquidity alone, the real and

financial restructuring (including orderly debt restructuring and recapitalization of undercapitalized institutions)

should not be postponed for too long.

In fact, one of the mistakes Japan made was waiting too long to restructure zombie banks and corporations: They

were not recapitalized until the late 1990s, almost a decade after the asset bubble bust in 1990. Similarly, unlike

the U.S., the EZ has postponed for too long the financial restructuring and recapitalization of banks and financial

institutions, and putting the losses of the financial system on the government balance sheet—as in Ireland—risks

leading to the insolvency of the government. The government balance sheet can take some of the private‐sector

losses when it is strong enough; otherwise, the insolvency of the private sector is transferred to the public sector.

Private‐sector balance‐sheet repair should not come at the cost of the solvency of the public‐sector balance sheet.

Thus, the resolution of private‐sector balance‐sheet crises is a complex problem. In the short term, it requires large

and persistent monetized fiscal deficits and backstopping of illiquid but solvent private agents. Over the medium to

long term, however—once the balance‐sheet repair is well underway—it requires back‐loaded fiscal consolidation

(more front‐loaded if large fiscal deficits were one of the original causes of the crisis), mopping up excess liquidity,

restructuring the debts of governments, banks, households and corporations that face solvency—not just

liquidity—issues and appropriate structural reforms to increase productivity and long‐term economic growth.

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