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.