Few doubt that what happened in 2008 (like what happened in the 1930s or in Japan in the 1990s) is best described as a balance sheet recession, in which households (and financial institutions) took on too much debt, over-leveraged, and then had to de-leverage in order to repair their balance sheets.
This process involves reduced spending, which entails serious risks for the economy. The question is how to respond to such a situation. Here ZeroHedge and Richard Koo sharply part ways. We're solidly behind Koo on this.
We wrote a much more extensive piece on ZeroHedge's questionable macro-economics earlier, so we will be brief here. He's at it again this morning attacking Koo (emphases Durden's):
Now, the Nomura economist, whose obstinacy in his views at times makes even such distinguished voodoonomic shamans as Paul Krugman seem like docile little lambs, is convinced that "these same agencies are once again attempting to interfere with governments that are trying to do the right thing in response to the economic crisis (ie, the balance sheet recession) triggered in part by these agencies’ actions. In spite of the fact that fiscal stimulus is the only effective measure during such a recession, the rating agencies are making it more difficult for governments to spend money by implicitly threatening downgrades." Yeah ok, the right thing is to fight debt with more debt. And more debt with morer debt. And so on. We wonder if that is the case, why doesn't Dictator Bernank just tell his Jeethner lackey to print $100 trillion tomorrow? After all that is the NEF's target for debt in 2020. That way we should grow world GDP by about 100% overnight, and save ourselves ten years of deleveraging misery. But stop there? Why not print $1 quadrillion, $1 quintillion, $1 decillion... After all debt is wealth remember? Because try as hard as we can, we just can't spot any faults with this argument which derives straight from Mister Koo's supposedly irrefutable logic.
However, Koo's irrefutable logic is actually surprisingly simple
- Households ran up too much debt (in Japan, it was mostly companies, but the difference isn't that important).
- In order to repair their damaged balance sheets, they sell assets (hence the fall in house prices) and spend less.
- To keep the economy from spiraling downward on that cut in spending, somebody somewhere needs to spend more.
It really is surprisingly simple. Without more public spending, the economy would be in great danger of a debt-deflationary downward spiral, consisting of the following negative feedback loops:
- Reduced spending reduces production, which increases unemployment and reduces spending even more.
- Reduced spending in an already depressed economy risks lowers prices, which increases the real value of debt, which reduces spending even more (a mechanism first identified by Irving Fisher).
- Increased real value of debt forces people to sell more asset, depressing asset prices and balance sheets even further, entailing further reductions in spending.
You know, stuff that happened in the 1930s and in Japan in the 1990s.
Koo has it right; increased public spending is the only answer to this:
- Government can borrow at much lower rates than the private sector.
- Public investment in infrastructure and education, apart from a short-term demand injection, also bring long-term benefits to the supply side of the economy. If spend wisely the economic returns are much greater than the short-term borrowing cost.
- Monetary policy is mostly powerless (or at least, much less effective) during a balance sheet recession.
What about all that public debt? Well, we might also stress that Keynesians argue that during boom times, government should run surplusses, so that they can actually afford to boost the economy with public investment during a crisis.