Richard Koo On The Three Problems With Bullish Speculation On Europe
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
- 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.
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...