While his diagnosis of the balance sheet recessionary outbreak that is sweeping global economies (including China now he fears) is a useful framework for understanding ZIRP's (and monetary stimulus broadly) general inability to create a sustainable recovery, his one-size-fits-all government-borrow-and-spend to infinity (fiscal deficits during balance sheet recessions are good deficits) solution is perhaps becoming (just as he said it would) politically impossible to implement. In his latest missive, the Nomura economist does not hold back with the blame-bazooka for the mess we are in and face in 2012. Initially criticizing US and now European bankers and politicians for not recognizing the balance sheet recession, Koo takes to task the ECB and European governments (for implementing LTRO which simply papers over the cracks without solving the underlying problem of the real economy suggesting bank capital injections should be implemented immediately), then unloads on the EBA's 9% Tier 1 capital by June 2012 decision, and ends with a significant dressing-down of the ratings agencies (and their 'ignorance of economic realities'). While believing that Greece is the lone profligate nation in Europe, he concludes that Germany should spend-it-or-send-it (to the EFSF) as capital flight flows end up at Berlin's gates. Given he had the holidays to unwind, we sense a growing level of frustration in the thoughtful economist's calm demeanor as he realizes his prescription is being ignored (for better or worse) and what this means for a global economy (facing deflationary deleveraging and debt minimization).
Nomura, Richard Koo:
Pessimism ushers in 2012; outcome will depend on policy response
January 17, 2012
The year 2011, which began amid general optimism, was quickly transformed into a year of trial and tribulation by a number of natural and man-made disasters. There is no shortage of problems facing the global economy in 2012. Whether this initial economic pessimism turns to optimism will depend to a large extent on the national policy response.
Conditions in the eurozone took a sudden turn for the worse in 2011 H2, and the situation there has yet to improve in spite of ten summits in the last 12 months.
In addition, the banking crisis sparked by the eurozone’s problems has sharply curbed the risk tolerance of European financial institutions, which have traditionally been active in emerging markets. The resulting outflow of capital from these regions is starting to adversely affect economies outside the eurozone.
Apart from the problems in Europe, economic activity is decelerating in China and India, where policymakers are working to rein in inflation. Some areas of China are facing a deflation—not yet a collapse—of the real estate bubble leading to balance sheet recession-like conditions.
Economic conditions in Japan and the US are relatively stable by comparison. But the governments of both countries are moving towards fiscal consolidation at a time when the private sector is trying to clean up its own balance sheet. If the private and public sectors attempt to deleverage simultaneously at a time of zero interest rates, the risk is that the economy will fall into a deflationary spiral.
ECB’s 3-yr fund supply operation has been effective…
This report will focus on developments in the eurozone. Under the ECB’s Long Term Repo Operation (LTRO), announced by incoming president Mario Draghi last December, the Bank agreed to supply an unlimited quantity of three-year funds at an interest rate of 1%. The program reassured eurozone market participants by substantially reducing the risk of sudden financial institution failures due to liquidity problems.
The latest government bond auctions for Italy and Spain also suggest the ECB has succeeded for now in preventing the worst-case scenario of a continued rise in bond yields for both countries. This success also indicates that at least some of the funds supplied by the ECB have flowed into the government debt markets of Europe’s periphery. That, in turn, has reassured market participants, just as the Bank envisioned.
But does not offer fundamental solution to the problem
That noted, I think the LTRO is largely a means of buying time and does little to address the underlying issues.
Although the recent government bond auctions went relatively smoothly, interest rates in these countries remain fairly high, and a catalyst could send them higher yet.
More important, most of the funds supplied by the ECB remain with the Bank in the form of deposits and have not flowed into the real economy.
Mr. Draghi has argued that banks with deposits at the ECB are not necessarily the same institutions that borrowed under the LTRO. Still, the heavy buildup of funds within the ECB is a sign that Europe’s banks do not trust each other and that the broader financial system remains beset with doubts and fears.
LTRO may rescue financial system but cannot save real economy
Many European banks must also roll over substantial amounts of debentures between now and spring. These institutions have stockpiled funds borrowed from the ECB to protect against the eventuality of being unable to roll over their debt.
Italian banks’ heavy use of the LTRO is attributable at least partly to the fact that they have the largest amount of debt that must be refinanced over the next several months.
But the decision of private banks to use funds obtained from the ECB as “back-up” for refinancing their own debt means those funds are doing nothing to help overcome the recession in the real economy.
While the current situation is clearly preferable to one in which the Bank had stood by and done nothing, it appears the LTRO program will do little to spur a recovery in eurozone economies.
LTRO should be viewed in similar light as Fed’s QE1
In that sense, the LTRO can be viewed in a similar light as the Fed’s QE1. The Fed supplied large amounts of liquidity under QE1 in the wake of the Lehman Brothers collapse. The primary purpose of those funds, however, was to prevent financial institutions from failing due to an inability to access market funding.
The banks effectively used funds borrowed from the Fed to meet payment obligations. The money was not used to fund new loans.
Consequently, neither bank lending nor the money supply grew despite all the liquidity injected under QE1, and inflation and growth in the real economy remained lackluster.
The ECB’s LTRO is also designed to prevent a liquidity shortage in the banking system. It would be a mistake to assume that funds lent under the program will have a positive impact on the economy or inflation by boosting lending or the money supply.
Biggest bottleneck: EBA’s tough new capital rules
The next question is, What is preventing the funds supplied by the ECB from flowing into the real economy and improving economic conditions? Although there are a number of answers, the biggest obstacle from a policy perspective is the European Banking Authority’s tough new capital rules.
The EBA has demanded that European banks raise core Tier 1 capital to 9% of risk-weighted assets by June 2012. None of the policies unveiled in response to the crisis has been so counterproductive.
A tightening of bank capital requirements would not create major problems in an ordinary world without a financial crisis. If only a handful of banks are in trouble, asking those institutions to raise more capital would not lead to major macro-level problems because other financial institutions would be willing to supply capital to those banks or increase lending in their place. But with a financial crisis already in progress and the sector undergoing a systemic crisis, in which a majority of banks face the same problem, demanding higher capital ratios will trigger a destructive credit crunch, as I have argued previously.
This is because sources of additional capital during a systemic crisis are extremely limited, and for many institutions raising capital, if possible at all, can be very costly. Expensive capital, in turn, will only weaken these banks’ financial strength.
As a practical matter, the only way banks can satisfy the new capital requirements if raising capital is difficult is by reducing the denominator in the capital ratio: total assets. If all banks try to do that at the same time, the result will be a destructive credit crunch.
Adoption of BIS rules sparked severe Japanese credit crunch in 1997
Although Japan’s bubble burst in 1990, it was not until October 1997 that the economy experienced a serious credit contraction.
The decision by the Ministry of Finance’s Banking Bureau to unveil the details of new BIS-based capital rules on 1 October that year—a time when most Japanese banks were struggling under the weight of bad debts—triggered a destructive credit crunch.
Discussions about the new BIS standards had been ongoing for a number of years, but it was the announcement of the specifics on new rules in October 1997, when the bubble’s collapse had left Japanese banks in an extremely weakened state, that prompted a major credit contraction.
At that time, bank branch managers were ordered by their head offices to cut lending by 10% each half-year. The Japanese economy duly entered its worst-ever postwar recession, contracting for five consecutive quarters according to data at the time.
The post-October 1997 situation in Japan bears a striking resemblance to today’s Europe, where much tougher capital requirements for banks struggling in the wake of a burst housing bubble have triggered a credit crunch.
Japan was quick to respond to credit contraction
However, the Japanese government was quick to respond to the credit crunch. Just two months later, in December 1997, the government began discussing a capital injection, and by the following February an act providing for a ¥13trn facility to recapitalize the banking system had been passed into law. This was just four months after the credit contraction began.
The first round of injections, carried out in March 1998, amounted to only ¥1.8trn because the process represented uncharted territory for both the government and the program’s recipients. Still, it helped prevent conditions from worsening. A second round of capital injections in March 1999 totaling ¥7.5trn succeeded in ending the credit crunch once and for all.
In Europe, the credit contraction became a pressing issue after discussions commenced last summer on the so-called 9% rule. Yet there have been few calls for a revision of this rule or for an early government injection of capital into the banking system.
Japan had no choice but to adopt BIS rules
Similarly, few in Japan in 1997 argued in favor of modifications to the BIS capital rules. This was attributable to a belief that, at a time when banks around the world were moving to adopt the 8% rule (4% Tier 1 + 4% Tier 2 capital), allowing Japanese banks to continue operating with less capital would cast doubt on their creditworthiness, making it even more difficult for them to access market funding.
Japanese banks faced heavy scrutiny from overseas investors at the time and were forced to pay a “Japan premium” to borrow money. Some banks were completely shut out of the funding markets for a time and were forced to borrow money from nonfinancial companies within their keiretsu to meet their payment obligations.
Under such conditions, ignoring the BIS rules was simply not an option for Japan. The government managed to keep the credit crunch from getting worse in spite of the new rules by injecting public money into the banking system.
New eurozone capital rules will lead directly to credit contraction
The new international capital requirements proposed by the BIS, known as Basel III, call on banks to raise their core capital ratios to 7% by 2019. The EBA, meanwhile, has demanded another 2% on top of that while insisting that banks comply by June 2012, offering no logical basis for its position. Nor has the ongoing credit crunch in the eurozone prompted any discussion of a government recapitalization of the banking system.
Even a 7% target would have been hard for banks to meet, which is why they were given until 2019 to comply. The EBA’s demand that banks raise core capital ratios to 9% by June 2012 in the midst of a systemic crisis seems spectacularly ill-advised. I think it a miracle if Europe does not experience a full-blown credit contraction.
EU’s response has aggravated crisis
This 9% rule effectively prescribes the size of European banks’ balance sheets. This means banks will not be able to increase lending no matter how much liquidity the ECB supplies, effectively rendering any monetary accommodation by the ECB powerless to stimulate the economy.
The EBA’s 9% rule may help in preventing the next crisis, but it will do nothing to resolve the current one—in fact, it will make it much worse.
Indeed, much of the EU’s policy response to the ongoing crisis appears to be directed at preventing the next crisis and has actually aggravated the current situation. Prime examples in this regard are the EBA’s 9% rule and the German government’s insistence on fiscal austerity and the adoption of balanced budget amendments.
EBA’s 9% rule should be scrapped
The question then is, What should be done? The quickest, easiest answer is to scrap the EBA’s 9% rule and return to the internationally approved Basel III, under which banks are required to raise their core capital ratios to 7% by 2019. I think this change alone would go a long way towards restoring the effectiveness of monetary policy and easing the credit crunch precipitated by the 9% rule.
European banks forced to shrink their balance sheets to comply with the 9% rule are cutting back on lending and selling assets around the world—including the emerging economies—and that has weighed heavily on the global economy.
Because the victims of the 9% rule are not limited to the eurozone, the governments of Japan, the US, and the emerging nations should pressure the EBA to withdraw it.
If banks cannot meet lower capital targets, public funds should be injected
If lenders have difficulty meeting even the lower 7% capital requirement, the authorities should inject fresh capital into the banking system. Government capital infusions during a credit crunch caused by a shortage of capital have a leveraged effect, and the economic impact is correspondingly large.
If banks’ inability to meet a 7% capital requirement is at the heart of the credit contraction, a capital injection would support lending equal to 1/0.07 = 14.3 times the value of the government’s investment. In my view this represents a very effective use of taxpayer money.
A resumption of bank lending due to the capital injection would also boost the money supply, thereby amplifying the impact of monetary accommodation by the ECB.
The injection of government funds into a large number of banks would also ease the sense of mutual mistrust that exists among lenders. Japan’s initial ¥1.8trn injection of capital was insufficient and failed to prevent Long-Term Credit Bank of Japan and Nippon Credit Bank from going under. But it seems the ¥7.5trn infusion conducted in March 1999 did much to alleviate mutual mistrust among lenders.
In summary, I think lowering the core capital requirement from the EBA’s 9% to the BIS’s 7% and, if necessary, injecting government funds into the banks would go a long way towards resolving the financial crisis in the eurozone.
Credit downgrades stand in way of capital injections
While the EBA rule could be changed at the stroke of a pen if the authorities wanted, capital injections would require fiscal measures and would lead, however briefly, to larger fiscal deficits.
But, in my view, S&P’s reckless downgrades of eurozone sovereigns have complicated any attempts to provide fiscal stimulus.
For more than a decade I have been warning that those rating agencies which do not understand balance sheet recessions could downgrade countries in the midst of such recessions based solely on economic weakness and the size of their budget deficits and jeopardize these countries’ ability to carry out the fiscal stimulus needed during this kind of recession. The recent actions by Standard & Poor’s are a case in point.
On 13 January the agency announced it was downgrading nine eurozone countries and was lowering the ratings of four of those—Italy, Spain, Cyprus, and Portugal—by two notches. France and Austria lost their AAA ratings and are now rated AA+.
S&P downgrade reminiscent of CDO episode
This major ratings action recalls the agency’s decision three years ago to suddenly and drastically lower its ratings on a large number of AAA rated collateralized debt obligations (CDOs) containing subprime loans. It also underlines the perfunctory nature of the ratings themselves.
Making matters worse is the fact that, apart from fiscally profligate Greece, the widening fiscal deficits in most eurozone countries are attributable to the balance sheet recessions touched off by the bubble’s collapse. A government reluctance to apply fiscal stimulus under such conditions will only exacerbate matters. Eventually the resulting economic weakness can actually cause the fiscal deficit to increase despite determined government efforts to reduce it (witness Japan in 1997 and 2001).
The statement accompanying the Standard & Poor’s decision, however, indicated that no consideration had been given to such risks. It merely repeated the disturbingly orthodox view that fiscal consolidation would result in lower budget deficits, which in turn should help the economy.
Do we treat patient’s pneumonia or put him on diet?
This is akin to a doctor telling a patient suffering from pneumonia to go on a diet and get more exercise. While exercise is important, it assumes a healthy patient. If the patient is sick, he must build up his strength until he is physically capable of exercising again.
No matter how overweight a patient with pneumonia might be, the doctor’s first task is to give him the treatment he needs to fight the disease. After all, the pneumonia patient can die if treatment is delayed for too long.
Balance sheet recessions, which occur when businesses and households rush to pay down debt in spite of zero interest rates, are a kind of pneumonia. The only way to treat them is for the government to become the borrower and spender of last resort with fiscal stimulus aimed at propping up aggregate demand.
Fiscal deficits during balance sheet recessions are good deficits
All fiscal deficits are good deficits during this type of recession. Once public and private investors realize this, I suspect their decisions will no longer be influenced by the views of those rating agencies that do not understand balance sheet recessions.
Japanese investors faced an almost identical situation ten years ago. But because they understood the nature of the disease affecting Japan’s economy, they were able to ignore the downgrades by seemingly clueless western rating agencies.
The yields on JGBs therefore remained anchored at low levels even as Moody’s downgraded Japan’s credit rating to below that of Botswana. And it was domestic investors’ reasoned behavior that enabled Japan’s economy to emerge finally from the balance sheet recession.
Eurozone investors will eventually learn to ignore rating agencies
In the US, local investors responded to the S&P downgrade of the US government last summer by pushing yields even lower.
By last August, many US officials and market participants—including Fed Chairman Ben Bernanke—understood the concept of balance sheet recessions, and that helped US markets over the initial shock of the downgrade.
In Europe, however, I find few people—including the authorities—understand what a balance sheet recession is. The vast majority are unaware that such a thing even exists, and to some extent that is why the crisis continues to worsen. Since the ongoing balance sheet recession and sovereign downgrades are a first for eurozone investors, their confusion, like that of their predecessors in Japan, is understandable.
But I think it is just a matter of time before eurozone investors come to understand this concept and learn to ignore the views of rating agencies operating in ignorance of economic realities.
Funds naturally flow to government bonds when private sector is not borrowing
The private sector seeks to minimize debt during a balance sheet recession, creating an abundance of private savings. That money must be invested somewhere. With the private sector refusing to borrow, it is hardly surprising that those funds would flow into government bonds.
That is why long-term government bond yields have fallen as far as they have in Japan, the US, and the UK in spite of massive fiscal deficits. The US and the UK even run large trade deficits.
The eurozone also has a unique problem that does not affect Japan, the US, or the UK: no matter how much the Spanish or Irish private sector saves, those funds end up being invested in German government bonds, which are dominated in the same currency. I have previously argued that something must be done to address this capital flight problem that is unique to the eurozone.
But with the exception of this region-specific problem of capital flows, I think the more eurozone investors understand that they are dealing with balance sheet recessions, the more the influence of the rating agencies will diminish.
German economy shrinks, but still strong in absolute terms
The slowdown in the German economy has become increasingly pronounced. Data for 2011 Q4 show the economy contracting by 0.25%, with production activity also weaker.
In terms of the level of activity, however, the German economy remains robust despite the recent deceleration, with the unemployment rate at a 20-year low of less than 6%. That, in my view, is part of the reason why the German government has been so obstinate in its response to the ongoing crisis.
Chancellor Angela Merkel insists that Germany will continue on a path of fiscal consolidation regardless of the downturn in activity. The government is also demanding that other eurozone countries enact balanced budget amendments.
Like the EBA’s 9% rule, these actions may help prevent the next crisis, but they do absolutely nothing to address the crisis that is unfolding now. In fact, they make it worse.
What should Germany do?
Given the capital flight problem that is unique to the eurozone—i.e., the fact that southern European savings are invested in German government bonds—what should Germany do? In my view, it needs to borrow the funds flowing in from the periphery and either (1) spend the money itself or (2) channel it via the European Financial Stability Facility or a similar mechanism back into aid for the countries generating those savings. Doing so would make it possible to sustain the income cycle throughout the eurozone and prevent a weakening of the broader eurozone economy.
From a macroeconomic perspective, the first is unlikely to happen as long as the German economy remains robust. But the second is worth considering. With yields on short-term German government debt now below zero and long-term yields at historic lows, such policies would be inexpensive to implement as well. Unfortunately, the current German government appears to have no interest in playing such a role.
If nothing is done, however, the private savings flowing into Germany from Spain and Ireland will not be spent and will effectively represent a leakage to the broader eurozone income stream. In that sense, Germany’s refusal to serve as the “borrower of last resort” is accelerating the eurozone’s plunge into a deflationary spiral.
Global economy to remain under spell of housing bubble collapse
To summarize, the LTRO unveiled late last year has substantially reduced the risk of bank liquidity shortages or failures. But all the other macroeconomic issues remain, along with the problem of capital adequacy ratios. Nor have any meaningful solutions for those problems been proposed.
I therefore expect the eurozone’s problems will continue to weigh on both Japan and the global economy. It appears as though the world economy will remain under the spell of the housing bubble collapse that began in 2007 for some time yet.