Many have asked me if I believe in austerity measures or the Keynsian approach of spending out of recession. I have stated, time and again, that the question is loaded - hence the answer can never be sufficient. When you are trying to go from your home to the market across town in a crowded urban environment, you cannot make the trip successfully by deciding ahead of time that you are just going to make left turns (austerity? Austrian?) or right turns (stimulus? Keynsian?). You come to an intersection and you make the turn that's necessary to get you where you want to go. It might sound overly simplistic and common, but I'll be damned if common sense is one of the most uncommon things I've come across over the last 7 years or so!
On that note, there does appear to be a misunderstanding on how government finances work as compared to finances in the private sector. The government is not a for profit player that competes directly with those in the private sector, but is instead a universal support network that benefits from the success of the private sector. Hence, the government must work in the best interests of the private sector in order to thrive. This sometimes entails taking the other side of the trade to ensure that a trade can take place. One pundit who has done a good job of explaining this through pretty charts that explain the peculiar situation that we are now in (a balance sheet recession), is Dr. Richard Koo of Nomura Securities. See the FT.com article abstract:
In 2008, Barack Obama told the US people the nation’s economic crisis would take a long time to overcome. In 2012, many of those voters are losing patience, because they have not been told why this recession has lasted so long or why his policies were the correct response. Here is the missing explanation – based on not only the US experience, but also that of Japan and Europe.
Today, the US private sector is saving a staggering 8 per cent of gross domestic product – at zero interest rates, when households and businesses would ordinarily be borrowing and spending money. But the US is not alone: in Ireland and Japan, the private sector is saving 9 per cent of GDP; in Spain it is saving 7 per cent of GDP; and in the UK, 5 per cent. Interest rates are at record lows in all these countries.
For those who may not get the gravity of this statement, it makes no sense to save money with a negative risk/reward proposition, unless of course the saver does not see it that way. One must save if savings are in deficit, and the risk to invest funds is considered greater than the benefit of having said funds in the first place. We are still attempting to wade through the bursting of a massive bubble, and we are playing defensive - not offensive. In other words, are Americans seeking return OF capital over return on said capital? We are over-leveraged, and to effectively delever you cannot borrow more money or take the risk of aggressive investments. This is so even if investment capital is being offered at zero interest rates. Mr. Koo illustrates the consequences of such behavior eloquently...
However, if someone is saving money or paying down debt, someone else must be borrowing and spending that money to keep the economy going. In a normal world, it is the role of interest rates to ensure all saved funds are borrowed and spent, with interest rates rising when there are too many borrowers and falling when there are too few.
But when the private sector as a whole is saving money or paying down debt at zero interest rates, the banks cannot lend the repaid debt or newly deposited savings because interest rates cannot go any lower. This means that, if left unattended, the economy will continuously lose aggregate demand equivalent to the unborrowed savings. In other words, even though repairing balance sheets is the right and responsible thing to do, if everyone tries to do it at the same time a deflationary spiral will result. It was such a deflationary spiral that cost the US 46 per cent of its GDP from 1929 to 1933.
Those with a debt overhang will not increase their borrowing at any interest rate; nor will there be many lenders, when the lenders themselves have financial problems. This shift from maximising profit to minimising debt explains why near-zero interest rates in the US and EU since 2008 and in Japan since 1995 have failed to produce the expected recoveries in these economies.
For some reason, the Fed doesn't seem to get what Mr. Koo and BoomBustBloggers do!
With monetary policy largely ineffective and the private sector forced to repair its balance sheet, the only way to avoid a deflationary spiral is for the government to borrow and spend the unborrowed savings in the private sector.
Wait a minute! The EU states are definitely borrowing, but they are not redploying the capital back into the private sector, they are simply bailing out banks! In addition, the banks are not deploying the capital into the private sector, they are simply sitting on it, just as Mr. Koo stated they would in the article excerpt above! So, after trillions of borrowing, there's no surprise why there's just relatively pennies making it into the private sector. What Mr. Koo and many who follow Keynsian economic theories seem to forget to include, is that upon borrowing the money to plunge into the private sector, you have to have a plan for paying said monies back. When you borrow said monies and simply waste them (ex. perpetual dead bank bailouts) you create a truly structural problem. Simply ask Greece, or see How Greece Killed Its Own Banks! and then move on to...
As The Year Comes An End The Ability Of Greece To Kick The Can Mirrors The Chances Of A Man With No Feet
Despite extensive, self-defeating, harsh and punitive austerity measures that have combined with a lack of true economic stimulus, Greece has (to date) failed to achieve Primary Balance. For the non-economists in the audience, primary balance is the elimination of a primary deficit, yet the absence of a primary surplus, ex. the midpoint between deficit and surplus before taking into consideration interest payments.
The primary balance looks at the structural issues a country may have.
Government expenditures have outstripped revenues ever since 2007 and have gotten worse nearly every year since, despite 3 bailouts a restructuring, austerity and a default!
On to Mr. Koo's diatribe...
Recovery from this type of recession takes time because the flow of current savings must be used to reduce the stock of debt overhang, necessarily a long process when everyone is doing it at the same time. Since one person’s debt is another person’s asset, there is no quick fix: shifting the problem from one part of society to another will solve nothing.
The challenge now is to maintain fiscal stimuli until private sector deleveraging is completed. Any premature attempt to withdraw that stimulus will result in a deflationary implosion – as in the US in 1937, Japan in 1997, and Spain and the UK most recently.
Japan’s attempt in 1997 to reduce its deficit by 3 per cent of GDP – the same size as the “fiscal cliff” now facing the US – led to a horrendous 3 per cent drop in GDP and a 68 per cent increase in the deficit. At that time, Japan’s private sector was saving 6 per cent of GDP at near zero interest rates, just like the US private sector today. It took Japan 10 years to climb out of the hole.
Average citizens find it hard to understand why the government should not balance its budget when households and businesses must all do so. It is risky for politicians to explain but, until they make it clear that the economy will implode if everybody is saving and nobody is borrowing, public support for the necessary fiscal stimulus is likely to weaken, as seen during the past four years of the Obama administration.
The US economy is already losing forward momentum as the 2009 fiscal stimulus is allowed to expire. There is no time to waste: the government must take up the private sector’s unborrowed savings, to keep the economy from imploding and to provide income for businesses and households so they can repair their balance sheets. Fiscal consolidation should come only once the private sector has repaired its finances and returned to profit-maximising mode.
I have ventured along these lines several times in the past. Here is the subscription research that I feel is best poised to take advantage of the guaranteed mistakes to be made ahead, simply click your industry/sector for the most recent research (note, non-subscribers will only be able to view free reports, you may click here to subscribe)...
- Consumer Discretionary
- Banks & Financial Services
- Insurers, Insurance & Risk Management
- Real Estate
As for whether Mr. Koo is correct in the application of severe austerity when one should be trying to prime the pump....
Cyprus said on Wednesday it expected talks to start with lenders on badly needed aid next week, as ratings agency Standard & Poor's pushed it deeper into junk territory, implying domestic political expediency lay behind a delay in clinching a deal. One of the smallest nations in the euro zone, Cyprus sought European Union (EU) and International Monetary Fund (IMF) aid in June after its two largest banks suffered huge losses due to a write-down of Greek debt.
Well, our Contagion Model showed clear paths of the knock on effects of Greek infection, and we haven't even gotten started with the economic pathogen party yet!
Although it seems as if Tyler is being a smart ass, he couldn't be farther from the truth. Reference my piece Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse! concerning the accuracy of the IMF's baseline scenarios...
And back to the ZH post:
....Breakdown of IMF deleveraging forecasts for the three scenarios, of which the realistic one is highlighted:
- Under weak policies, the withdrawal of foreign investors accelerates to twice the pace seen since 2009. Periphery spreads widen by about one standard deviation above the baseline.