By Vincent Papa, CFA
In one of the concluding sessions at the fourth annual CFA Institute European Investment Conference in Paris, Richard Koo, Chief Economist at Nomura Research Institute, challenged the widely held consensus view of fiscal consolidation and austerity as being the best pathway to economic recovery. Koo argued instead that sustained fiscal stimulus is the only economic policy that can forestall the protracted and potentially irreversible economic malaise in western economies — and he called on policymakers to learn from the Japanese experience.
Koo observed that balance sheet deleveraging is today a common feature across several major western economies, as this is the only way that firms can avoid potential bankruptcy following the bursting of asset price bubbles. However, the net effect of deleveraging is the creation of dormant financial capital and shrinking aggregate income, and these effects cannot be offset by monetary policy measures. Koo’s belief that fiscal stimulus is required to minimize the scale of GDP shrinkage whenever deleveraging is occurring is primarily based upon Japan’s experience over the last two decades, but he also drew on key macroeconomic data from the United States, the UK, the eurozone, and China. Koo emphasized that as policymakers in western economies grapple with seemingly unprecedented economic times, they ought to apply their analytical “binoculars” and learn from the Japanese experience.
While many observers might consider Japanese policymakers poor economic crisis managers, there have been plenty of parallels in macroeconomic data trends during the current crisis (e.g. anemic economic growth despite reduced interest rates). In Koo’s opinion, Japan can boast of having undertaken the “best economic policy in history” through its largely sustained expansionary fiscal policy, which injected a cumulative stimulus of 460 trillion yen during the 1990 to 2005 period and forestalled a potential precipitous shrinkage in GDP. In his view, the only mistake made by Japanese policymakers was when they failed to stay the course and abandoned fiscal stimulus in the 1997 to 2001 period following the “green shoots” of economic recovery that had begun to emerge in 1996.
Koo expounded on how balance sheet deleveraging and overall debt reduction can lead to a deep recession, which cannot be offset by either liquidity injections or reduced interest rates. The impact of deleveraging on shrinking GDP is apparent when considering the economic flow, where expenditure by one economic actor equates to income for another. Therefore, reduced expenditure or saving by firms and households, without a corresponding demand for borrowing, simply results in dormant financial capital and shrinking GDP. The shrinking aggregate GDP cannot be offset by monetary policy intervention as evident when reviewing time series trend data: for example, there is a high, nine percent unemployment rate in the U.S. despite three years of near-zero interest rates.
Koo contended that if households and firms cannot borrow, the state has to borrow in order to stimulate aggregate demand. Koo pinpointed that some headroom for ongoing government borrowing tends to arise due to savers in the economy seeking safe havens in their domestic government debt. In turn, the rising aggregate demand for domestic government debt ought to keep domestic sovereign bond yields at low levels so as to support governments borrowing in their domestic capital markets.
However, Koo observed that this relationship between rising aggregate saving and a corresponding rising demand for domestic sovereign bonds does not necessarily exist in all eurozone countries. This is due to the unrestrained opportunities for cross-border investment — for example, there are no restrictions towards savers in Spain allocating their capital in German sovereign bonds, and this helps to keep German government debt yields at low levels. If balance sheet deleveraging is occurring in Spain, Spanish government debt yields will not necessarily benefit from the saving surpluses of households and firms that are resident in Spain, and this will constrain the ability of the Spanish government to borrow within Spanish domestic capital markets.
This adverse consequence within the eurozone helps to explain much of the current sovereign debt crisis. For this reason, Koo called for the prohibition of cross-border capital flows in relation to sovereign bonds within the eurozone, in order to keep sovereign yields at manageable levels and facilitate sustained domestic borrowing by European governments in cases where balance sheet deleveraging is occurring.