Richard Koo at the Nomura Research Institute writes:
With massive private sector deleveraging continuing in the US and in many other countries in spite of historically low interest rates, this is no time for fiscal consolidation. There will be plenty of time to pay down the accumulated public debt because the next balance sheet recession of this size 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.
Similarities between house price movements in the US and in Japan 15 years ago suggest the two countries contracted a similar disease. The Japanese recession following the bubble burst in 1991 was no ordinary recession and differed with an ordinary recession in that a large portion of the private sector was minimizing debt instead of maximizing profits following the asset price bubble.
When a debt-financed bubble bursts, asset prices collapse while liabilities remain, forcing households and businesses 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.
The traditional remedy for recessions, monetary policy, doesn’t work because people with negative equity are not interested in increasing borrowing at any interest rate nor will lenders lend to for those with impaired balance sheets.
The money supply – mostly bank deposits – contracts as bank deposits are drawn down to repay debt. Injecting liquidity into the banking system doesn’t reverse the shrinkage of bank deposits when there are no borrowers and the money multiplier is zero or negative at the margin.
Bringing back inflation or inflation targeting doesn’t work because people are reducing debt in response to the fall in asset prices, not consumer prices, and so the central bank cannot produce the money supply growth needed to increase the inflation rate.
When the private sector deleverages in spite of zero interest rates, resulting deflationary spiral causes the economy to continuously lose demand equal to the sum of savings and net debt repayments until either private sector balance sheets are repaired or the private sector has become too poor to save, i.e. a depression.
Repairing balance sheets after a major bubble bursts typically takes many years—15 years in the case of Japan.
There are at least two types of recessions: those triggered by the business cycle and those triggered by private sector deleveraging or debt minimization – Economists have never considered the latter type so it has no name, so let’s call it a balance sheet recession.
Nationwide debt-financed bubbles and balance sheet recessions are rare and, untreated, result in a depression.
Many authors wrongly argue that monetary policy led to the post-1933 US recovery because they all failed to look at the asset side of banks’ balance sheets. From 1933 to 1936, only lending to the government increased, while lending to the private sector did not.
Fiscal stimulus is essential in keeping both GDP and the money supply from contracting during a balance sheet recession.
The US, UK, Spain, and Ireland (but not Greece) are all in serious balance sheet recessions because their private sectors are undergoing massive deleveraging in spite of record low interest rates. The private sectors in Japan and Germany are not borrowing, either. With borrowers disappearing and banks reluctant to lend, industrial economies are still doing poorly after nearly 3 years of record low interest rates and massive liquidity injections.
In the US, the increase in private sector savings exceeds the increase in government borrowings, which suggests that the government is not doing enough to offset private sector deleveraging.
Shunning fiscal profligacy is the right approach when the private sector is healthy and is maximizing profits, but the worst approach when a sick private sector is minimizing debt.
In a balance sheet recession, fund managers who must invest in fixed income assets without foreign exchange risk have no choice but to lend to the government, which is the last borrower standing. 10-year bond yields in the US and UK of 2 percent indicates that bond market is aware of the nature and dynamics of balance sheet recessions.
Investors continue to demand high yields to hold the debt of eurozone countries like Spain and Ireland because of a factor unique to the eurozone: fixed-income fund managers can buy government bonds issued by other eurozone countries without taking on any exchange rate risk.
Spain and Ireland are in serious balance sheet recessions, as is the entire eurozone.SpainandIrelandare unable to tap their own private savings surpluses to fight the balance sheet recessions.
Instead of borrowing and spend the money flowing in from Spain and Ireland to sustain the broader eurozone economy and help Spain and Ireland, Germany and Holland et al are focused entirely on deficit-reduction efforts to observe the 3% ceiling on budget deficits prescribed by the Maastricht Treaty.
There is a tendency within the eurozone for fund flows to go to extremes. When times are good, funds flow into booming economies thereby exacerbating the bubbles, and when the bubbles finally burst, the funds shift suddenly to the countries least affected by the boom.
One way to solve the eurozone problem of capital shifts is to prohibit member nations from selling government bonds to investors from other countries.
The Maastricht Treaty with its rigid 3 percent GDP limit on budget deficits made no provision for balance sheet recessions which did not exist when the Treaty was being negotiated.
Unfortunately, both the ECB and BOE are still pushing for additional fiscal retrenchment – only the IMF appears to have recognized the need for fiscal stimulus in countries facing balance sheet recessions.
Bernanke understands the risk of balance sheet recessions, but unfortunately he and NEC Chairman Sperling are the only two officials openly pushing for fiscal stimulus: everyone else, including Obama at times, seems to be in favor of fiscal consolidation. With the US private sector still deleveraging massively in spite of zero interest rates, nothing is potentially more dangerous for the US economy than premature fiscal consolidation.
Recent developments in the US, UK, Spain, and other western countries have proven that it is extremely difficult to maintain fiscal stimulus in a democracy during peacetime as fiscal hawks are out in numbers demanding an end to fiscal stimulus as soon as the economy shows the first signs of life. As a result of this backlash from fiscal hawks, the fiscal stimuli are being allowed to expire, despite private sector deleveraging continuing unabated at alarmingly high levels.
The pattern of on-again, off-again fiscal stimulus is why it took Japan 15 years to climb out of its own balance sheet recession, and caused the disastrous collapse of the US economy in 1937.
How the money is spent is largely irrelevant during a balance sheet recession: the important thing is that the money be spent. Unfortunately, in a democracy, political leaders end up arguing endlessly about which projects the money should be spent on, while the economy continues in a deflationary spiral. Only when it is obvious where the money should be spent, like wartime, can democracies implement and sustain the kind of fiscal stimulus needed to overcome a balance sheet recession in the shortest possible time. Recovering from a balance sheet recession takes a long time in a democracy.
The general public typically is unable to envision what might have happened in the absence of fiscal stimulus, so seeing only a large deficit and no crisis, assume the money must have been wasted on useless projects. The man or woman who prevents a crisis never becomes a hero – for a hero to emerge we must first have a crisis, as Hollywood will attest.
The long time required for the economy to pull out of a balance sheet recession means the private sector must spend many painful years paying down debt, causing debt “trauma” in which the private sector refuses to borrow money even after its balance sheet is fully repaired, which may take years if not decades to overcome. Until the private sector is both willing and able to borrow again, the economy will be operating at less than full potential and may require continued fiscal support from the government to stay afloat. After paying down debt during the Great Depression, the same aversion to borrowing kept interest rates unusually low until 1959, despite massive fiscal stimuli in the New Deal and World War II.
The experiences of post-1929 US and post-1990 Japan suggest that interest rates will remain low for a very long time even after private sector balance sheets are repaired. Governments should therefore introduce incentives for businesses to borrow, like generous investment tax credits and accelerated depreciation allowances.
Balance sheet recessions are a borrower’s phenomenon, while financial crises are a lender’s phenomenon. The economic “recovery” starting in 2009 has been largely limited to a recovery from the policy mistake of allowing Lehman to fail. The collapse of Lehman sparked a global financial crisis that weakened the economy far more severely and rapidly than what would have been suggested by balance sheet problems alone.
Unlike balance sheet recessions, in which monetary policy is largely impotent, financial crises can and must be addressed by the monetary authorities.
All the balance sheet problems that existed before Lehman failure are still in place and the continuous fall in house prices since then has exacerbated these problems. Balance sheet problems are likely to slow down the recovery or derail it altogether unless the government moves to offset the deflationary pressure coming from private sector deleveraging.
Read the full article at http://www.paecon.net/PAEReview/issue58/Koo58.pdf