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RWER issue 58: Richard Koo

December 12, 2011 Leave a comment Go to comments

The world in balance sheet recession: causes, cure, and politics 
Richard C. Koo      download pdf                   

Read and leave comments here

Categories: real-world economics review
  1. Peter Robson
    December 12, 2011 at 7:58 pm | #1
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    This is an absolutely excellent analysis, especially regarding Europe. Mr. Koo has been right about this for many, many years and should get much more air time.

  2. Very Serious Sam
    December 12, 2011 at 10:15 pm | #2
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    Interesting paper, thanks. As for solutions for the European countries with short term refinancing problems, why don’t you propose compulsory bonds?

  3. Gianfranco Clarizio
    December 12, 2011 at 11:00 pm | #3
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    The analysis, intuition, perspectives and solutions, proposed by Mr.Koo, are commendable as far as known to the academic community. Failed to financial industry workers, unbalanced speculation on contingency, or on statistical models as inconsistent fruitful to convince unsuspecting investors to sell in the panic, and buy into the complacency. But the stakes are high. Who does not know the valuable work of Mr. Koo, once derided equally irresponsibly, is the political class, the one with the “p” tiny, committed to complying with populist instincts pro-cyclical policies that only a miracle would prevent exacerbating crisis like this, rather than the effect due to a cyclical process recurring every 60-70 years. Let’s make a petition to send Mr. Koo to Bruxelles, Frankfurt, or Washigton, at our expense, now that the debate, between states and the authorities, are still “civil” as dull. That is, before it is too late, or degenerate with no way out.
    Gutta-cavat-lapidem.

  4. Ruch
    December 13, 2011 at 12:11 am | #4
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    I disagree with the premise. The private sector is unwilling to spend and borrow because there is not enough demand – including government – to warrant additional investment.

    As long as housing prices remain depressed – regardless of income/work situation – people are going to “feel poorer” and therefor keep spending in check or seek deep discounts – neither of which spurs additional demand.

    The answer is not more government – the last 4 years – the Feds have spent an additional $1.4 trillion beyond receipts – which roughly equals 10% of GDP i.e. your 1000, 900, 810 scenario. Is 2% BEFORE a real inflation rate of more than 2% really growth? Answer – NO!

    And yes, we are getting inflation – check your food receipts, gas bills and gold.

    The first thing we have to do is get rid of excess housing inventory. Since – the tax payer is ultimately responsible to pay back all the spending in the form of the Fed buying government bonds, we should benefit too.

    While uncle Ben and Obama are letting the banks recapitalize on the backs of taxpayers, we continue to see the value of our largest assets dwindle. As evidenced by the average American seeing $21,000 shaved off their net-worth in the last 3 months.

    How in the world does that help create new demand?

    The banks get to clean up their balance sheets while the average Jane/Joe sees their’s deteriorating. The equation is backwards! We need to recapitalize the average hardworking American’s balance sheet simultaneously.

    How do we do that? Easy – if the banks get free money from the taxpayer through the Fed, bailouts, stimulus… then the banks repay the taxpayer by resetting mortgage interest rates to a fixed 3% or allowing homeowners to payoff their balance for 75 cents on the dollar.

    At the same time, the the Federal government institutes a tax holiday on all the purchases of all distressed properties within a specific time-frame. Buy one of these properties and you never owe any tax on income received or capital gains for the life of ownership.

    With trillions on the sidelines, it’s a square peg/square hole solution.

    In the meantime, the FED agrees to keep the lending window open at next to zero and the government allows the banks to write-down 100% of the loses right away. Again – essentially a license to print free money.

    This solution would have a major stimulating effect. Homeowners would save millions in the form of reduced mortgage payments – not some stupid one time check or tax gimmick from the government, the banks would be flush with cash as the distressed properties are taken off of their hands, and the excess supply of real estate would dry up; which means prices would recover.

    In the end, the average american would in fact be richer and be more likely to borrow and spend. Which gets us back into the real growth cycle – not just papering holes.

    • Carol Wilcox
      December 13, 2011 at 1:18 pm | #5
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      “As long as housing prices remain depressed – regardless of income/work situation – people are going to “feel poorer” and therefor keep spending in check or seek deep discounts – neither of which spurs additional demand.” This is pretty desperate stuff – shows how distorted markets have become, especially the land market. The UK also experienced a boom/bust house price phase but we still have a (n affordable) housing shortage. Using land (which is our common wealth) as collateral is at the heart of the financial crisis. Until you address the land issue you will never sort this one out.

  5. T. Kobayashi
    December 13, 2011 at 1:24 am | #6
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    My first question is in regard to the exit strategy from fiscal spending. Japan is the most appropriate example for this question. The chart on page 23 indicates exit from Japan’s balance sheet recession in 2006, yet no progress has been made on fiscal consolidation. Instead, with debt now at 200% of GDP and the private sector still not in a net borrowing position (according to chart on page 23), when will Japan be in good enough economic shape to start its fiscal consolidation?

    Japan’s population has been decreasing for the last 3 years, 25% of their population is now over the age of 60, and they have a growing % of foreigners purchasing JGBs. Japan appears to be past the point of domestically support their government debt. If its not, the prescription in your approach would be more monetary expansion to purchase JGBs? When does a country, even one with a printing press, reach the point where they have so much debt relative to productive ability that debt write down is the only answer?

    Japan has also been probably the best description of your condition that a country be limited to buying its domestic bonds. The US and Europe do not have purchase restrictions on their debt and readily invest elsewhere, thus, in the case of Europe, they are choosing not to lend to the government. Does this factor materially inhibit these country’s ability to work their way through their balance sheet recessions – or does this imply that they instead require more monetary support of their debt markets?

  6. Ben Bornstein
    December 13, 2011 at 4:59 am | #7
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    I agree entirely with the sentiments expressed by Mr. Robson. What is truly frightening for people who are trying to plan for the future here in the US is the knowledge that the politicians and population at large cannot see the obvious truths. Instead, we have a ‘conventional wisdom’ that is backwards focused on the inflationary history of the 1960′s Great Society and the 1970′s Oil Shock. We will all need to suffer through years of GDP shrinkage until one day the Council on Economic Advisers is able to convince whoever is then President that fiscal crowding out is not a meaningful concern and that government spending of the consumer and corporate savings is the only hope, or at least a better hope than a massive military outlay (as in WWII).

  7. SJM
    December 13, 2011 at 1:34 pm | #8
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    This is an excellent article. I’d be interested in hearing more on Mr Koo’s thoughts on the role that demographics and savings behaviour plays, particularly as Japan has exactly the locked in domestic banking and savings Mr Koo suggests as a remedy for financing deficits but still has huge embedded challenges associated with the sustainability of its debt burden.

    Perhaps the point is that even if the deficits incurred have been well spent, ultimately no country on earth will ever be able to pull off a fiscal contraction of the size and scale of the one required in Japan – the economic impact of paying down a 200% of GDP deficit to a sustainable level would require that the state expropriates private savings on an unprecedented scale – that’s implausible in a developed democracy. The only way in which a deficit of this size can be reduced is via monetisation and inflation. The Japanese have explicitly sought to avoid inflation risk as it would be to the direct detriment of the domestic saver who has lent to the government for two decades at ever lower rates. These savers are a large and influential constitutency in Japanese society – they are the increasingly aged baby-boomer demographic group. Inflation would be an explicit tax on the fixed interest savings of this generation. The Japanese have thus chosen a socially cohesive and politically less contentious path that has come at the cost of twenty years of deflation.

    Isn’t this is the problem with forcing domestic domestic savers and banks to lend to bust governments in societies that have become top-heavy and old? You end up with with a large constituency of politically influential savers that are inflation averse and have lent to goverments that are balance sheet insolvent. Its not that monetary policy has become ineffective – it’s that the political and social costs of its effective use becomes intolerably large.

    • John Creighton Campbell
      December 14, 2011 at 12:03 pm | #9
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      Three points:
      1. I agree Japan should, when it safely can, move to a primary balance and then start paying off the debt. But why pay off that much of it? I would think the process should be slow unless and until another boom starts up.
      2. If inflation goes up, so would nominal and to a lesser extent interest rates, so the value of people’s savings should be maintained.
      3. What is the evidence from Japan or any other country of this big block of older savers becoming a politically influential interest group opposed to inflation? It might be true for the UK, right now in the form of opposition to low interest rates.
      (note this reply was written after my comment just below)

  8. John Creighton Campbell
    December 14, 2011 at 11:30 am | #10
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    I think this article is brilliant, and in particular the analysis of Japan is the best I have seen, as a concise, tightly argued summary of Koo’s book. I hope it is widely circulated.

    To the comment by Kobayashi: the Japanese public debt is much bigger than it should have been because premature austerity policies took the moderate level of steam out of the economy and and so lowered revenues. Just as in UK today. The answer to his question is that the government should cut its borrowing when it is clear that the private sector really wants to increase its borrowing.

    I also appreciate the on-target political analysis.

  9. Michael Farmer
    December 14, 2011 at 4:26 pm | #11
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    The analysis suggests the solution to excess private debt is excess government debt, and ongoing recycling towards some never-ending bubble economy? It seems to me the missing component is the prevention and/or short-circuit mechanism for the bubble cycle in the first place. No recourse for financial decision errors ensures a repeat performance, whether a Lehman or McMansion buyer be. Could it be that Japan has spent the last 20 years making their problems exponentially worse, with a bigger and more economically painful crisis yet to come?

  10. Claude Hillinger
    December 16, 2011 at 1:53 pm | #12
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    This is the best, most illuminating article on the current financial/debt crisis that I have seen. Thanks!

  11. hendrikrood
    December 16, 2011 at 9:40 pm | #13
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    Am I correct that you effectively advocate a kind of Capital Controls, by prohibiting (deposit) banks to own government bonds from other Eurozone countries than their own?

    Does this requirement also extend to a country’s Pension funds and Life insurance funds and private individuals (nationals)?

    We recently observed in Europe a “drive” from the Italian government and Belgian government, calling up their own citizens to buy their bonds (a voluntary act). But I think it is difficult to implement, when it will be allowed to buy shares in another country. What would it imply if I buy from the Netherlands shares in a German fund that invests in German Bunds?

  12. Ken MacNeal
    December 16, 2011 at 10:39 pm | #14
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    I am a believer in Mr. Koo’s work as it constantly predicts and explains unusual current economic events. A cursory glance at any number of long term economic charts shows that something very different is happening in this post-credit bubble world. Economists of the old persuation keep forecasting incorrectly. For example, his contention that QE II would be ineffective since few would use the added liquidity pumped into the system proved accurate when the first half of 2011 saw mediocre growth after a brief economic surge due to higher share prices gaving a wealth effect in the last quarter of 2010 immediately after the start of QE II. The weakness of the first half of 2011 was a surprise to the mainstream economists. Also another confirmation in the real world is Prem Watsa, a follower of Mr. Koo and the president of a large insurance company that reported a $1.5 billion profit on its Koo-styled investment portfolio in the third quarter of 2011 when other insurance companies were reporting large losses. I believe Mr. Watsa will emerge from the next few years as a world renowned investment personage as will Mr. Koo in economics.

    Since it will likely be impossible to enact legislation in Europe to prevent cross-border purchases of government bonds maybe a way to promote a country’s citizens to buy their own government’s bonds is to offer tax incentives. Make interest on your own bonds tax-free for instance (like municipals) or put a surcharge on foreign bonds.

  13. Lyn Eynon
    December 17, 2011 at 5:38 pm | #15
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    A useful paper but why are fiscal and monetary policies presented as alternatives rather than complementary? I agree that central bank liquidity injections will not in themselves expand private credit when individuals and businesses wish to reduce debt. But fiscal expansion needs support from such injections, without which interest rates can rise to unsustainable levels for indebted governments. The reluctance of the ECB to purchase government debt has aggravated the eurozone crisis.

    I disagree that democracy is the obstacle to sustained fiscal stimulus. On the contrary, elected governments have been removed in Italy and Greece precisely in order for unelected ‘technocrats’ to force through fiscal austerity in the face of popular resistance. The real obstacle – now as in the thirties – is financial capital which opposes policies it deems threatening to its own wealth and subverts democratic processes.

  14. Ajay
    December 19, 2011 at 1:07 pm | #16
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    Agree on the need for fiscal stimulus. However the proposition to just spend the money is a bit lazy. In times when the private sector withdraws, the governement has a wider role to play in business and should engage in structural reforms to promote competitiveness. The withdrawal of governement can come at a time when the sentiment changes in the private sector.

    I am also keen to see the governments tackle zombie banks and in particular the derivatives market. It is surprising that derivatives market which is in essence, money creation is not regulated by central banks.

  15. Mark Sinclair
    December 23, 2011 at 1:18 am | #17
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    I would be interested to hear what Mr Koo thought about the alternate track – large-scale write-offs.

    In Europe, all of the excessively indebted sovereigns default, at least to a manageable level, say 60% of GDP. That triggers a wave of bank defaults, then you can recapitalize them and begin again.

    Would they all have to leave the Euro at the same time? Maybe it’s only feasible for a few individual countries, Greece, Ireland?

    In the US you could let underwater homeowners default without penalty. You let them stay in their homes and pay market-rate rent to the bank. You force banks to mark-to-market, they default, and you recapitalize.

    Moral hazard aside, isn’t this a faster route than a lost decade?
    Didn’t Argentina recover relatively quickly?

  16. R Schefer
    December 28, 2011 at 11:31 pm | #18
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    The idea that a country limited to buying its domestic bonds guarantees low rates probably deserves more discussion and analysis

  17. Patrick Snyder
    December 29, 2011 at 12:47 am | #19
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    Great paper. A minor detail: Koo writes “…the fact that 10-year bond yields in the U.S. and U.K. today are only around 2 percent—unthinkably low given fiscal deficits of nearly ten percent of GDP—indicates that bond market participants are aware of the nature and dynamics of balance sheet recessions.” I disagree. Economists tend to believe that business people think like economists, but they don’t. They base their actions on their own balance sheets, what’s happening in their own companies, and business conditions around them – a short, local view.

  18. Tim
    December 29, 2011 at 9:36 am | #20
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    Mr. Koo

    First of all thank you for an excellent analysis. However, I am puzzled by your suggestion for the Euro zone and Spain in particular.

    You suggest that only the citizens of a country may invest in its own government debt, but even under this rule, what is to stop the Spaniards from simply exchanging their Euro’s and investing in Dollars instead.

    A common euro bond would solve this issue, but of course then on the other hand increase the moral hazards issue

    Another approach altogether would be to impose capital controls, this would effectively break the current strangle hold the the financial markets have on the governments of Europe.

  19. R Schefer
    December 29, 2011 at 4:13 pm | #21
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    One example underlying my comment “The idea that a country limited to buying its domestic bonds guarantees low rates probably deserves more discussion and analysis” on Dec.28, is Brazil. Real rates for sovereign bonds in local currency are, and have been for some a long time, above 6-7%, bringing the total interest bill to 5.7% of GDP.

  20. Ronald Calitri
    December 29, 2011 at 4:26 pm | #22
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    Great Paper! I’d trend towards Krugman’s (NYT blog) comment about the complete ineffectiveness of monetary policy. There is a semantic issue. I wish we would all stop using the word “trap” with respect to liquidity. There is a dam, or perhaps a contracting sieve, or some kind of cash reservoir. Money is not an animal, liquidity never dries.

  21. E.L. Beck
    January 1, 2012 at 12:02 am | #23
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    Many parallels to a paper on Japan from 2004:

    http://www.scribd.com/doc/29494256/A-Roadmap-to-Follow

    Enjoyed the analysis.

  22. D.Reed
    January 3, 2012 at 10:26 pm | #24
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    Very interesting article and compelling especially in the first part of the paper. I can certainly agree that where deleveraging in the private sector outweighs increased borrowing in the public sector, because of a balance sheet recession, then the result may well be sub-par / negative growth.

    The question must however be asked whether this option of supercharging government spending to get the economy back into a growth cycle again is a viable option open to governments in their present position. Were one in Australia’s shoes with just 20% debt to GDP or Norway’s (with a net positive fiscal position) then this clearly makes sense. However the story of last year was one of private debt investors increasingly questioning the credit worthiness of various European governments, and this probably wasn’t solely as a result of banks and investors having the ability to avoid currency risk.

    Arguably when a country reaches this position then the option of increasing government spending to boost the economy back to growth is no longer available. Countries that have their own currencies can of course just print money for governments to spend once they reach this point, but as countless examples show (Weimar Republic and Zimbabwe to name just two), the ultimate endpoint to this process is likely to be inflationary.

    Japan has been fortunate in that its private sector savings have fully financed its additional government spending over the past 20 years and it has had a structural current account surplus which means it is not beholden to international debt investors either. This has enabled government bond yields to remain low. The long term picture however looks anything but sound with debt levels only achieving ever greater heights, and an increasingly smaller part of the population being of working age with each passing year. This cannot continue indefinitely.

    For countries such as the UK and the US, one might argue that the spending option remains available at current debt levels, but this is not at all clear cut. (I would not for the UK). Both nations face adverse demographic shifts in the next couple of decades whilst the emerging world becomes increasingly competitive in industries which used to be the preserve of advanced economies only. It is hopeful to assume forcing leverage to increase anew from these record levels will solve our problems.

    If we take the other extreme demonstrated by Latvia in 2009, facing a massive deficit they took radical action on cutting government spending very sharply to bring it back into line and suffered a very sharp recession (-18% in that year). However this is now behind them and they are growing again nicely having re-balanced their public sector. In the long term this may prove to be a far less expensive an option for them as a nation.

    • Ken MacNeal
      January 5, 2012 at 4:09 am | #25
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      Thanks for this thoughtful post. This is the crux of the current situation. The Japanese solution to their balance sheet recession may not be available to others because of differing demographic and cultural factors. Outside of Japan, the mobility of international capital and “bond vigilanties” may as you say make the option of increasing a particular government’s spending to boost growth “no longer available”. Mr. Koo’s logic versus political reality is also a challenge. Does that mean highly levered economies are in for some unavoidable level of Latvian reset over a shorter or medium term period as balance sheet recessions play out?

    • Talvez….
      January 8, 2012 at 7:01 pm | #26
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      «Arguably when a country reaches this position then the option of increasing government spending to boost the economy back to growth is no longer available. Countries that have their own currencies can of course just print money for governments to spend once they reach this point, but as countless examples show (Weimar Republic and Zimbabwe to name just two), the ultimate endpoint to this process is likely to be inflationary.»
      I have read an article the other were it was noted that the Uk was passed Weimar’s levels of financing by currency creation. Now I could not confirm this, but the analysis of US and ECB data tells us clearly that growth in monetary aggregates does not lead, per se, to inflation.

  23. M. Oteski
    January 9, 2012 at 3:28 pm | #27
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    The idea of avoiding balance sheet recession by limiting bonds market to domestic one is interesting. However, the paper omits to take into account a negative balance of capital flow in most of EU countries due to imbalance of export/import sheet. This exhausts economies of the capital on the long term . As ECB does not make quantitative easing policy nor the weakening of the currency this can only lead into recession, as well.

  24. Renaud
    January 30, 2012 at 2:29 am | #28
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    Excellent analysis by Koo. For further testing of his framework, see the analysis of the sequencing of private and public deleveraging in Sweden and Finland after their 1980s bubbles by the McKinsey Global Institute. (MGI January 2012 report on “Debt and Deleveraging: Uneven Progress”. This MGI report has data on 10 high income countries plus the four BRIC economies.)

    http://www.mckinsey.com/insights/mgi.aspx

    P.S. MGI does not mention Koo’s work that appeared as a book in 2009.

  25. DF
    February 5, 2012 at 3:17 pm | #29
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    I do not know much about Japan but have they managed to invest to good effect over the last 20 years or has much of it been wasteful. I presume that the quality of investment is important, which might suggest that the government is not best placed to direct this.

  26. AN
    February 10, 2012 at 12:23 pm | #30
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    Excellent paper.

  27. lbattisti80
    February 12, 2012 at 12:25 pm | #31
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    Hello to everyone.

    I have a question to pose: what’s the difference between your “balance sheet recession” and the analysis made by fisher on deleveraging during ’30?

    thank you.

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