Monday, 12 September 2016

Richard Koo, please mind the gap: the Eurozone is not Japan

Richard Koo is well known for his balance sheet recession analytical framework (here a link for one of his most recent and detailed presentations: Richard Koo at May 2016's Acatis Conference in Frankfurt).

His analysis points to the fact that once a debt fuelled asset bubble bursts, leaving the private sector in a highly indebted and over-leveraged position (with many individuals and corporates in negative equity territory), monetary policy becomes ineffective. Following the implementation of a highly expansionary monetary policy, private households and corporates will take advantage of very low interest rates to repay down their debt burden faster. Not to consume more. Not even to maintain their consumption at pre-asset bubble burst's levels. The private sector unavoidably retrenches.

In such an environment, the only way to avoid an economic depression is to combine an expansionary monetary policy with an expansionary fiscal policy: the government has to step in, run large deficits and increase public spending. This is what the Japanese government has been doing following the burst of the country's real estate and stock market bubbles in 1989. Once the private sector has completed its deleveraging process, and monetary policy becomes effective again, the government can then revert to a normal fiscal policy and the central bank normalise monetary policy.


So far, so good. Richard Koo's analysis is insightful and his recommended expansionary fiscal policy sensible. For Japan.

But does it really make sense to apply the expansionary fiscal policy strategy to the Eurozone over the coming years as he proposes? At first sight, it does. After all, the Eurozone, on aggregate, suffers from the "Japanese disease": an over-leveraged, over-extended private sector in parts of the periphery that needs to de-leverage; national governments that need to step in and spend more to offset the private sector's retrenchment. However, once you look at things into more detail the picture changes. And you realise that Richard Koo's Eurozone analysis overlooks a few things. Namely:

1. And this is fundamentally true for any balance sheet recession scenario (Japan included) - if you have a private sector balance sheet whose left side is suddenly smaller than the liabilities on the right side (as a result of the burst of a debt fuelled asset bubble), you have two ways to correct the problem of negative equity. One is by inflating the left side via an ultra-expansionary monetary policy while slowly reducing the liabilities on the right side - this is part of Richard Koo's proposed strategy. But contrary to what Richard Koo argues it is not the only feasible strategy available. There is another option: to radically and swiftly shrink the liabilities on the right side via debt restructuring and haircuts. This will lead to massive impairments in the banking sector and arguably the financial sector cannot be let implode. But that doesn't imply bail-outs and debt transfers from private investors to the taxpayer. All what is needed are bail-ins. Bank shareholders and debt-holders, who freely decided to invest in bank shares and bonds, bear the pain as would investors in any other private firm in a similar situation. There will be massive turmoil in financial markets while this process is ongoing but once it is finished financial markets' will recover quickly. And with private debt restructured and a swift de-leveraging process having occurred, monetary policy will be effective again. No need for ZIRP, no need for QE. No potentially dangerous financial, economic and political distortions as a result of an ultra-expansionary, unconventional and highly experimental monetary policy. Ok, I know, the Eurozone has descended way into unconventional monetary policy territory by now. But just making the point that there are alternatives to the path followed by ECB & Co. And endorsed by Richard Koo.

2. Japan is a fiscal union with a current account surplus. The latter means that it is not dependent from external financing - Japan's private sector savings are directly or indirectly (via pension funds or private bank purchases) financing the country's large public deficits. The Eurozone is a multi-sovereign state entity. Not a fiscal union. The EU's peripheral countries, which according to Richard Koo should implement an expansionary fiscal policy, have just about reached a balanced current account after many decades running current account deficits. An expansionary fiscal policy would unavoidably generate current account deficits again. Meaning: widening fiscal deficits in the periphery would have to be financed by international investors. How many would be ready to do it? And for how long? With fiscal and current account deficits ballooning again, a sovereign credit rating downgrade to non-investment grade and a sudden-stop in international financing would likely occur sooner rather than later. An expansionary fiscal policy strategy in the periphery is not really a sustainable option;

3. The Eurozone is structurally an economic unbalanced entity, with the core running historically current account surpluses and large parts of the periphery current account deficits. The adjustment process that the peripheral countries pursued over the past seven years to balance their current accounts was an uneven one: only 1/3 of the current account adjustment is explained by an increase in the countries' exports; 2/3 is due to a fall in imports - the reflection of economies operating way under full capacity and with high levels of unemployment. Having large parts of the periphery mired in a state of semi-economic depression is not a sustainable option either - the Eurozone would fall apart. So, what to do? The peripheral countries (think Spain, Portugal, Greece) need to return to high economic growth. But it has to be an export-led growth. Not one led by increased public spending. On the other hand, the Eurozone's core countries are awash in savings and in need of attractive investment opportunities to deploy them (think German pension funds). This makes it easy to create a win-win situation for both sides.

How? Simple: the peripheral countries need to attract massive amounts of foreign direct investment (FDI) to significantly expand their export base, create jobs and generate sustainable growth; these FDI projects in turn can be financed by the surplus countries's savings - international companies can issue Euro denominated bonds to finance their investment projects in the Eurozone periphery, which can be bought by the savers from the Eurozone's core (yes, the German pension funds). Surely a more compelling investment opportunity than US subprime real estate and overvalued Spanish real estate in the past or Eurozone government bonds today.

What needs to be done for a FDI-led growth strategy to pan out in the Eurozone periphery? To attract massive amounts of FDI (i) the peripheral countries have to continue to implement structural reforms to become an attractive location for international firms; (ii) the European Union needs to support them by creating incentive mechanisms for international firms to locate some of their operations in the countries (e.g. by classifying these countries as "special EU investment zones", which would offer, among others, exceptional tax advantages to investors for a 10-year period); (iii) on top of it, the European Union needs to finance a yield top-up on Euro bonds issued by international firms to finance their investment projects in the periphery. Thus creating an appealing investment proposition to channel the savings from the core to the periphery via financing of FDI projects.

After seven years of an economic structural adjustment process in the periphery carried out with varying degrees of conviction across the different countries, it is time for the European Union to start thinking about incentive mechanisms to support massive amounts of FDI to flow to the Eurozone periphery financed by the core's high savings. Thus creating a win-win situation for both sides. This has to be the EU authorities' top economic priority. Not an expansionary fiscal policy in the region. Remember: short-term fixes cannot, and will not, solve long lasting structural problems. Only buy time to fix them. 

Boys and girls, dear Eurozone leaders: it's fixing time.

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