Richard Koo On The Three Problems With Bullish Speculation On Europe

Tyler Durden's picture

The balance sheet recession diagnosis of many of the world's developed nations remains among the clearest explanation linking the failure of textbook   monetary policy to the dismal multipliers, transmission mechanism breakages, and sad reality of a recovery-less recovery. Whether you agree with Richard Koo's traditional but massive Keynesian fiscal stimulus medicinal choice is a different matter but the Nomura economist delineates the three problems (two macroeconomic and one capital flow) exacerbating the eurozone crisis and notes that "bulls have gotten ahead of themselves". Noting that the central bank supply of funds may help address financial crises but cannot resolve problems at borrowers, and that authorities have never admitted they were wrong, Koo stresses the three key reasons that bullish speculation on eurozone is premature - monetary accommodation's ineffectiveness when the private sector is deleveraging, active fiscal retrenchment by the core when fiscal stimulus is the only plus for aggregate demand, and Japanese and US lagged-examples of that dash any short-term hope that structural reforms will lead to growth. Even his solution to the European debacle - one of financial repression limiting the sale of government bonds to each nation's own citizens - while retroactively limiting a nation's largesse seems to only lead to the inevitable Japanification we have discussed at length. In the meantime, Koo appears far less sanguine than the markets about the prospects for anything but further demise in Europe (and the US).

Two Opposing Macroeconomic Problems

The current crisis in the eurozone consists essentially of two macroeconomic problems and one capital flow problem. The first macro problem is profligate government spending, as exemplified by Greece. In such cases austerity is required: the government must cut spending and raise taxes to regain its financial health and credibility.


The second macro problem is massive private sector deleveraging in spite of record low interest rates observed in countries such as Spain, Ireland and Portugal following the bursting of their real estate bubbles. The private sectors in these countries are minimizing debt instead of maximizing profits to repair balance sheets plunged underwater when asset prices collapsed but liabilities remained. But when the private sector as a whole is saving money even with near-zero interest rates, the saved funds will leak from the income stream and trigger the kind of deflationary spiral now known as a balance sheet recession. Left unattended, these economies will follow the path of the US during the Great Depression, when GDP shrank 46 percent in just four years because everyone was paying down debt and there were no borrowers.


Monetary policy is largely ineffective in this type of recession because those whose balance sheets are underwater are not interested in increasing their borrowings at any interest rate.



The first macro problem demands fiscal austerity, but the second requires fiscal stimulus. Any solution to the eurozone crisis must address both of these challenges.

Destabilizing Capital Flows Unique to Eurozone

The capital flow problem in the eurozone is not only highly pro-cyclical and destabilizing, but also unique to the eurozone. The existence of these flows made the region’s asset bubbles and balance sheet recessions far worse than elsewhere.


This difference in the behavior between US, German, and Japanese bond markets relative to Spanish, Italian, and Portuguese bond markets stems from the fact that fund managers in non-eurozone countries face one constraint that their counterparts in the eurozone do not. When presented with a deleveraging private sector, fund managers in non-eurozone countries can place their money only in their own government’s bonds if constraints prevent them from taking on more currency risk or principle risk. Consequently, a large portion of excess private savings must be invested in JGBs in Japan, Gilts in the UK, and Treasuries in the US.


In contrast, eurozone fund managers who are not allowed to take on more principle risk or currency risk are not required to buy their own country’s bonds: they can also buy bonds issued by other eurozone governments because they all share the same currency. Thus, fund managers at French and German banks were busily moving funds into Spanish and Greek bonds a number of years ago in search of higher yields, and Spanish and Portuguese fund managers are now buying German and Dutch government bonds for added safety, all without incurring foreign exchange risk.


The former capital flow aggravated real estate bubbles in many peripheral countries prior to 2008, while the latter flow triggered a sovereign debt crisis in the same countries after 2008.

Three problems with bullish speculation on eurozone

  1. 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.
  2. 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.
  3. 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.


We are sure that Draghi, Barosso, and their colleagues are all too aware of all of this and that pressing ahead with more of the same will inevitably change the direction of the Euro-zone - just like it has in Japan (sarc.) but maybe the following will help the Elite see the way forward...

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fightthepower's picture

Fuck you Bernanke!

Britonomist's picture

There is no such thing as 'Keyensian monetary policy', Keyensians regard monetary policy as ineffective, hence the side with Koo on the need for fiscal stimulus.

narnia's picture

That's not true at all.  No serious Keyensian wants price discovery in government borrowing rates.

If the objective is to keep the ridiculous death star working as long as possible, Koo may be right, until confidence is lost.

theTribster's picture

Everything will fail at once, the whole system will freeze up in one day! We'll be trading packages of cigarettes for taxi rides, all fiat money will be useless and nobody will want it. The Euro will elad the way, as hard as it is to believe they are actually dumber (smarter?) then we are, I think they see it as a race. Bernanke can still win but he needs to loosen up the fingers to execute the infamous Ctrl-P until the printer queue is full of requests and we run our of paper and ink...

He'll show 'em, my hero MR. bernanke the saviour of all things monetary...

Vince Clortho's picture

Bless you and bless the Bearded Wonder.

B-Bank wore out his fingers years ago.  Now he just jams his elbow down on the print button.

And I understand that is starting to wear out too.

dinastar2's picture

Here comes the real clash for the European Union and for the Euro currency: François Hollande  ( the next France President ) has staed that he will renegotiate the European Stability pact ( fiscal restraint , reaching a a maximum of 3% of deficit on the government budget ) with Angela Merkel to include several pro-growth policies.And Merkel has stated today she will not budge one centimeter on the stability pact.So the future of the Euro is shaky and some serious analysts are advising for the next stage : an exit of France-Italy-Spain to create a South-Euro and tpo leave Germany choking its economy with its old Euro which will be renamed Euro-Mark and will be reevalutaed of at least 15%.

The analyst point out that in the current state we are seeing a mercantilist Germany export all over the world  and reaping the profits of tits low wages discipline and fiscal restraint , but this german success comes at the expenses of the deeply indebted southern nations which do not support any longer the austerity at home and the commercial failure in the export market.

So I would be not bullish at all on the Euro for the coming 6 months because we are entering the real clash.

CPL's picture

Sort of, Germany is pulling it's own enormous anchor of debt as well...

TBT or not TBT's picture

And its terrible demographics, it knows all to well, will not support the load.  

On top of that a lot of the money it gained by exporting is just paper..a lot of debt it owns thanks to lending to its irresponsible customers.   It's great to have a brillant manufacturing sector, but that only goes so far.   Your trading partners have to have some means of paying up eventually, and that, they cannot and will not do.  

The political establishment in Germany is just kicking the can down the road until this all breaks apart due to some external events.  They do this only so they won't be blamed, so they can keep in power, or at least not be remembered badly.

Jack Sheet's picture

It's probably best not to place credence in what Ollande and Murkel are spouting.

Rainman's picture

April investor equity redemptions the most in 17 years of record keeping. The commoners must have blown off Larry Fink's " 100% equities " advice.

SAT 800's picture

The Euro is a very interesting subject, or study in human behaviour. There's an ancient Persian saying, "You don't have any problems? Buy a goat."  If you know anything about goats, you will understand this immediately. This is basically what the Europeans did, since they didn't have enough problems, and things were working along pretty good, they bought a goat; the Euro. Now they have plenty of problems; but why is it no one can just say the obvious, "hey let's get rid of this goat"; things weren't that bad when we didn't have it. Human Ego, I suppose; but it's really too bad.

Vince Clortho's picture

The 3 biggest problems I see are:

1.  Bulls

2.  Speculation

3.  Europe

l1b3rty's picture

The reason to be bullish on Europe is that their entire economic system is a political experiment desired by the powers that be.


Tom Green Swedish's picture

You can write all this crap about Europe you want but it all boils down to one thing going back to WW2.


The United States didn't care what Germany was doing until Hitler "goofed" and declared war on the United States.  Plenty of people contributed to the Germany war effort in USA. Germans make up the largest single ethic division in the USA.  The USA fortunately had the most to gain with the detrioration of Europe, and they did gain the most, which was clearly the plan for entering the war. The USA will once again gain the most from the collapse of Europe.


This is just a realization of Germany trying to taking over Europe once again this time without weapons.  This time the other countries have no way of fighting back, in fact they didn't even see it coming. Now its too late. Every article I read all I see is Germany taking control and Germany not really caring what the other countries want and their desire to impose their will onto them. The culture and seperations are still the same as in WW2.  Germany will lose money in the process but it will be without the loss of life, and they will once again grow based on the shortfalls of the rest of Europe. It appears they are not to pleased with this but it has been the way they have been operating for the last 100 years.


It appears from past history the Germans will drag this thing out just like they continued WW2, even though defeat was imminent. As I see it we are just 2 years into a 6 or 10 year problem.  It would be too hard to speculate on what the outcome will be so I think nobody wants to get involved.

StychoKiller's picture

Hmm, sorry, but yer conspiracy theory is just NOT nutty enough! :>D