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NMA-Richard Koo 22-11-11

NMA-Richard Koo 22-11-11

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Published by: John Papadakos on Nov 23, 2011
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Richard Koo
Still no end in sight for eurocrisis
November 22, 2011
(issued in Japanese on 21 November 2011)
In the past two weeks, I visited two cities in Europe and three in the United States andspoke with people in academia, finance, government, and industry. Wherever I went, themood was far from optimistic.Although the markets briefly welcomed the change of leadership in Italy and Greece,pessimism soon returned as market participants realized the emergence of two new primeministers would not bring an end to the current crisis.Money flows into government bond markets in Japan, the US, and the UK sent yieldslower, with British gilts down to levels not seen since 1898. Investors also fled to the dollar and the yen, which resumed its climb in spite of the Japanese government’s interventionagainst it.
Eurozone residents anxious to protect themselves
My impression of the situation in Paris and Madrid was that people were extremelyconcerned about the unfolding crisis and were rushing to protect themselves against acrisis for which there is no end in sight.While the problems continue to spread, national authorities seem unable to present either a long-term scenario for a way out of the crisis (i.e., an endgame) or a sufficient short-termresponse to it.The debtor nations now find themselves in a vicious cycle in which the more they yield todemands for fiscal consolidation, the weaker their economies become. That prevents themfrom achieving their deficit-reduction targets (as a percentage of GDP), forcing additionalausterity measures that lead to further economic weakness.Generous social benefits in most eurozone countries have kept the unemployed fromflowing out onto the streets, but Spain’s unemployment rate stood at 21.5% in Jul–Sep andwas a devastating 45% for younger members of the workforce.
Two structural problems responsible for unnecessary fiscal consolidation
I have previously argued that there are two issues at the heart of this crisis. One is that theMaastricht Treaty is a defective agreement that was not designed with balance sheetrecessions in mind. The other, unique to the eurozone, is a procyclical shift of funds thathas complicated governments’ policy response to the balance sheet recession.Regarding the Maastricht Treaty, the concept of balance sheet recessions was unknown inEurope when the unified currency was adopted. That is why fiscal stimulus—which isessential during a balance sheet recession—is considered a violation of the treaty.Regarding capital flow, government bond yields ordinarily fall during a balance sheetrecession. But they have risen instead because of the specific type of capital flow occurringin the eurozone, which prevents governments from delivering the fiscal stimulus that wouldin any case have been difficult under the Maastricht Treaty.
Richard Koo is chief economist at Nomura Research Institute. This is his personal view.
Richard Koo
To receive this publication, pleasecontact your local Nomurarepresentative.
See Appendix A-1 for importantdisclosures. Analysts employedby non US affiliates are notregistered or qualified asresearch analysts with FINRA inhe US.
Nomura | JPNRichard Koo November 22, 2011 
In a typical balance sheet recession, private savings rise sharply amid a lack of loan demand, and most of the surplus savingsflow into government bonds. Investors seeking a principal guarantee and no currency risk have nowhere to go but the localgovernment bond market. Government bond yields can therefore drop to unprecedented levels, a phenomenon witnessed inJapan, the US, and the UK. These low yields make it possible for governments to carry out the fiscal stimulus that isindispensable during a balance sheet recession.In the eurozone, however, investors can buy bonds issued by other eurozone governments without taking on currency risk.Surplus private savings throughout the region have therefore been flowing into German government securities, considered thesafest of the region’s sovereign debt offerings. That leads to lower yields in Germany and higher yields in the countries that aresuffering from balance sheet recessions and are providing the savings.At a meeting of large investors in Madrid, when I asked who had shifted funds to German bonds, the answer was “everybody.”Consequently, the sharp increase in private savings in Spain, Ireland, and Portugal—all of which are in balance sheetrecessions—has been absorbed by the German bond market. The resulting rise in government bond yields in the threecountries has not only prevented them from providing the fiscal stimulus needed during a balance sheet recession, but hasactually forced them to cut their deficits, the worst possible action at such times.
German austerity efforts persist despite fund inflows from surrounding countries
Germany continues to experience fund inflows from investors in neighboring countries seeking a safe haven. If Germansborrowed and spent those funds, they would be helping to sustain the broader eurozone economy and support the economiesof countries like Spain and Portugal in particular. But the German government is intent on reducing its fiscal deficit.Nor has Germany’s private sector shown any signs of wanting to take advantage of the lower interest rates to invest. Bothbusinesses and households continue to accumulate savings or pay down debt.The end result is a shrinkage of the broader eurozone economy, with nothing on the horizon that might change that.
Eurozone policymakers fundamentally do not understand crisis
My analysis of the eurozone crisis mentioned above came as a surprise to those hearing it for the first time in Paris and Madrid.Many people in finance and industry told me afterwards that they finally grasped the problem, suggesting just how poorly theconcept of balance sheet recession is understood in the eurozone.In effect, eurozone policymakers are trying to treat a disease they know nothing about. That is why they are unable to developan effective response to the vicious cycle they face.
Next-best policy: prohibit non-residents from buying government debt
My proposal for an endgame—a way to allow the euro to function properly—is to prohibit non-residents from buying governmentdebt. Everywhere I spoke, this idea was initially met with disbelief. But after I spent a half hour discussing the proposal andanswering questions, people had changed their minds.The first objection was that my proposal goes against the spirit of greater efficiency through market integration. I responded thatwhile market expansion is likely to enhance the efficiency of private capital allocation, easier government access to funds in theintegrated market has enabled countries such as Greece to pursue profligate fiscal policies. So while businesses andhouseholds should remain free to borrow or invest money wherever they want, I see a place for restrictions on governmentfundraising activities. The first-best policy would be fiscal integration of the eurozone, but that is basically out of the question for both political and cultural reasons. I argued that my proposal would be acceptable to policymakers as a second-best policy, inpart because it would be less troublesome than the alternatives.Inasmuch as the eurozone is a manufactured currency zone, rules not necessary in an ordinary economy may be required inthe zone to ensure that it functions properly. I think allowing only citizens to buy a government’s debt is the best of the second-best options available because it is easy to understand and offers both fiscal discipline and fiscal flexibility.
No solution likely until EU and ECB better understand balance sheet recessions
I do not know how many minds I was able to change in my two-day visits to France and Spain, but one business leader inMadrid came up to me afterwards and said, “Spain should nationalize Richard Koo and have him find a solution to our problems.”Even if Spain and France understand the nature of the problem, however, I think it will be impossible for the Spanish or Frenchgovernments to leave the destructive path of fiscal consolidation unless the EU and ECB share that understanding andauthorize a new policy direction for the countries in balance sheet recession.The flight of private funds into German bonds would only accelerate if individual governments were to push ahead with fiscalstimulus without official approval from the EU or ECB. That is why a major change of course is unlikely until the broader eurozone understands that austerity programs will not solve the problem.
Nomura | JPNRichard Koo November 22, 2011 
Financial crisis deepens along with fiscal woes
Underlying the current debt crisis is a balance sheet recession, which is essentially a borrower’s problem. But the eurozone alsofaces growing problems at lenders in the form of a financial crisis.Financial institutions holding debt issued by Europe’s periphery nations are seeing their credit suffer and their ratingsdowngraded, hindering access to market funding and creating an added impetus to sell their sovereign debt.But the more they sell, the higher yields will rise, aggravating the fiscal crisis.
Now is the time for ECB to be treating symptoms
Breaking out of this vicious cycle will eventually require a fundamental shift in the EU’s understanding of the problem. But sincethat will not happen overnight, measures to address existing symptoms are also needed.On this point, people I spoke with in Spain pointed to the lack of a lender-of-last-resort (LLR) function for the ECB and arguedthat the situation would continue to deteriorate until the ECB took on this role.Although I think the two issues noted above are more responsible for the euro crisis than the absence of a lender of last resort, Iagree that using the ECB’s balance sheet as an emergency measure may be unavoidable given the severity of the crisis.
Eurozone experiencing balance sheet recession
The question then becomes how much eurozone government debt the ECB can buy without sparking inflation. The quantitativeeasing experiences of Japan, the US, and the UK suggest the answer is “very much indeed.”We first need to make sure that the broader eurozone—like Japan, the US, and the UK—does in fact face a balance sheetrecession, defined as a situation in which businesses and households seek to minimize debt in spite of exceptionally lowinterest rates. Flow-of-funds data for the eurozone make it clear that both the household sector and the corporate sector arecurrently net savers, a telltale sign of a balance sheet recession (Figure 1).
Fig. 1: Eurozone is in balance sheet recession
Financial surplus or deficit by sector 
Note: For the latest figures, 4-quarter averages ending with CY11 Q2 are used.Source: ECB, Nomura research
When the private sector as a whole is trying to minimize debt despite ultra-low interest rates, the money multiplier for the privatesector turns negative at the margin, which means the money supply will not increase no matter how much quantitative easingthe central bank engages in. And without growth in the money supply, there can be no inflation.
-8-6-4-20246000102030405060708091011(As % of nominal GDP)(CY)Corporate Sector (Non-Financial + Financial Sector)General GovernmentHouseholdsNon-EurozoneShift fromCY08 Q3 inprivate sector:4.28% of GDPCorporate: 2.81%Households: 1.47%Shift fromCY08 Q3 inpublic sector:3.99% of GDP
(Financial surplus)(Financial deficit)

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