Richard Koo On Why Europe's Austerity Will Cause Deflationary Spiral
While not new to our thoughts, Richard Koo, Nomura's Balance Sheet Recession guru, has penned a lengthy but complete treatise on why governments need to borrow and spend now or the world faces a deflationary spiral. The Real-World Economics Review posting makes it clear how his balance sheet recessionary perspective of the deleveraging and ZIRP trap we now live in means bigger and more Keynesian efforts are needed to pull ourselves out of the hole. While we agree wholeheartedly with his diagnosis of the problem, his belief in the solution...
At such times and at such times only, the government must borrow and spend the private sector’s excess savings, not only because monetary policy is impotent at such times but also because the government cannot tell the private sector not to repair its balance sheet.
...is flawed in so much as the size and scale of additional government borrowing at this time of smaller and more risk averse balance sheets leaves the governments (of currency issuers and users alike) more anxious of bond vigilantes than ever before. Furthermore, the impact of a much-bigger-than-previously-believed shadow banking system deleveraging and de-hypothecating and the historical precedents now engraved in manager's minds leaves them thinking 'fool me once...'. His discussion of the cause and cure of the deflationary abyss we now stare into is useful for completeness but his thoughts on the political difficulties of such a borrow-and-spend solution and the 'when to exit this solution phase' is noteworthy in its timing (and cyclical perspective):
There will be plenty of time to pay down the accumulated public debt because the next balance sheet recession of this magnitude is likely to be generations away, given that those who learned a bitter lesson in the present episode will not make the same mistake again. The next bubble and balance sheet recession of this magnitude will happen only after we are no longer here to remember them.
He warns that perceptions of the recovery from the Lehman shock is NOT recovery from the balance sheet recession and has an interestingly xenophobic approach to solving Europe's problems.
In case you have not heard of balance sheet recessions before:
The key difference between an ordinary recession and one that can produce a lost decade is that in the latter, a large portion of the private sector is actually minimizing debt instead of maximizing profits following the bursting of a nation-wide asset price bubble. When a debt-financed bubble bursts, asset prices collapse while liabilities remain, leaving millions of private sector balance sheets underwater. In order to regain their financial health and credit ratings, households and businesses are forced to repair their balance sheets by increasing savings or paying down debt. This act of deleveraging reduces aggregate demand and throws the economy into a very special type of recession.
which inevitably leads to:
More importantly, when the private sector deleverages in spite of zero interest rates, the economy enters a deflationary spiral because, in the absence of people borrowing and spending money, the economy continuously loses demand equal to the sum of savings and net debt repayments. This process will continue until either private sector balance sheets are repaired or the private sector has become too poor to save (i.e., the economy enters a depression).
Its important to note that at all times, in our view, a deflationary shock will be met with an increasingly more powerful currency devaluation, no matter how many Japanese economists scream, after all its never been easier just to add a few zeros.