Throughout the crises in the US and Europe, Nomura’s Richard Koo has been spot on with his assessments of what’s ailing the economy (deleveraging) and what the economy needs (fiscal stimulus) and what won’t do much for the economy (monetary easing).
We caught up with Koo last night by telephone to get his take on the issues of the day.
Among his points:
- Europe is in deep trouble. It needs treaty changes in order to survive in its current form.
- The new hot idea of Fed NGDP targeting is not going to work. In a balance sheet recession, nothing works on the monetary side. In fact, there is a risk in thinking that it can all be solved via this way, especially if it takes the pressure off of Congress to act.
- Even long-term fiscal adjustment in the US is problematic because if people expect fiscal retrenchment in the future, then that will minimize the efficacy of short-term stimulus.
See below for the full interview…
Give us your quick assessment of where you think things are in Europe right now and where you see things going next at this point.
Well, I think Europe is in a pretty grave situation. When their own banks don’t trust each other, and having funding problems, that’s a pretty serious situation already. I think we have to be very careful in distinguishing sovereign debt crisis in that I don’t think that there’s a global sovereign debt crisis because all these countries, U.S., U.K., Japan, with huge budget deficit, huge public debt, the yields have come down to these very low levels, which is what you expect during a balance sheet recession.
But when you look at Europe, that hasn’t happened yet. And quite the contrary, those countries in balance sheet recession that are generating huge private sector savings. Rates have skyrocketed and that’s forcing the countries to cut budget deficit further, but these guys who are already experiencing a balance sheet recession, when the government tries to deleverage at the same time, the economy just gets worse and worse and worse.
One of your suggestions is that countries should only be allowed to sell debt to people within their own country, is this something that could plausibly be put into effect to help the crisis right now?
Well, it’s not going the help the crisis tomorrow in the sense that if the governments announce it tomorrow it will solve all the problems. But I think its a very important end game to show the Eurozone that
there is a way for Europe to operate as a proper currency zone, with this rule in place.
Now, the Euro ran without this rule for the last 10 years. All sorts of legacy problems are at hand, and so we can’t introduce this rule tomorrow, but if people see that with this rule, fiscal policy will be all internalized in individual countries, ECB can concentrate on running monetary policy and they will also provide more flexibility and discipline to individual governments, then maybe something will change.
It will have to be introduced over a five or 10 year period because we cannot do that right now but having this endgame, that yes with this rule Eurozone can operate as a currency zone, should bring some of the governments back into the system.
In the meantime, while Europe pursues treaty changes and rule changes, do you think ECB should stand up as a lender of last resort?
Well under the circumstances, maybe that’s what they have to do. But for all these countries in balance sheet recessions where private sector is minimized in debt at near zero interest rates, money multiples negatives on the margin so no amount of ECB purchases, or large amount of ECB purchases should not add to any inflationary pressure or should not add to money supply for that matter. And so there is quite a bit of leeway for ECB to increase its bond purchases without producing any type of inflationary consequences. The federal reserve has already proven that, the Bank of England has already proven that, and the Bank of Japan has proven that as well. Huge increase in government bond purchases in each of these cases did not add to increase in money supply, did not add to increase in inflation because private sector is deleveraging.
Speaking of central bank actions, the hottest idea is Nominal GDP targetting. I’m curious what you’re response to that would be?
Well, I’m afraid that is not going to be achieved even if the targets are set because if you read my book, you know that there’s so little that monetary policy can do when private sector is minimized in debt.
What’s the fundamental flaw with the NGDP targetting idea?
Well, if the private sector is forward looking and most academic economists are still stuck in the orthodoxy which you know, neo-.classic economics that they teach in universities, the fundamental assumption should say implicit assumption is that private sector balance sheets are clean, private sector guys are maximizing profits, they are all forward looking. And in that environment, monetary policy does have huge amounts of power. And if you want to target nominal GDP, it’s probably within the realm of possibilities.
But when the fundamental assumption of academic economists are violated, that private sector is no longer maximizing profits, they are actually minimising debt because their balance sheets are underwater, then as I explained in my book, there’s very little central bank can do to get GDP or inflation moving. And without the fiscal help, even money supply can shrink, even with all the quantitative easing by central banks.
Is there a harm in trying something like this? Is there a negative outcome or would you just accomplish nothing?
Well, just like quantitative easing, they tried it, the GDP is still growing slowly weakly prices still not doing well. So it’s not a huge harm at least in the first instance, but in two ways I think it’s damaging.
The first instance, is that it distracts the people from talking about the needed policy, which is the fiscal stimulus. And if federal reserve continues to say “well, there’s still some more that we can do,” then people kind of put their hopes on these policies. But even at the best of circumstances, those so-called non-traditional policies achieve very little. I mean, probably better than nothing, but just a little of positive, whereas having the correct fiscal policy can have a huge impact on economy in the current circumstances. Because so many people are pinning their hope on the federal reserve, there’s little discussion on what is the right fiscal policy and that I think is very unfortunate.
And the second part of the problem is that if central banks are viewed in such a way that these guys are going to pump money into the system so that something happens to the nominal GDP, that can cause people to worry that if they’re gonna pump that much money into the system, the dollar may collapse. And that can cause another set of problems like foreign investors dumping U.S. treasuries or something because if they know that central bank has limited capacity but are forced to do something to get the nominal GDP going, people might assume that “Well then, the central banks might really do something crazy,” and thats not good for the credibility of the dollar or the central bank.
On the fiscal side, is there a specific fiscal policy you would advocate? Is there a way that we could spend more that would be particularly effective in your view?
Well fiscal policy ranges from tax policies all the way to government spending and some government spending like military spending is part of fiscal policy. Now with these recessions, in almost all cases except Japan, the countries came out of these recessions with military spending. And military spending increase is effective in these circumstances because it increases demand without increasing supply. I mean, fighter planes, battleships are totally useless, so you don’t increase supply, you just increase demand and thats how you come out of these recessions quickly.
Now, I don’t want to suggest that that’s what the United States should be doing because there are so many other things that can use government funding including infrastructure, education, and so forth. So, anything that has to do with government spending is far better than nothing, and those that are politically acceptable will be probably the only ones that actually get to be spent.
Are you worried about the next step of the supercommittee and what that could mean in terms of imminent fiscal entrenchment?
Well, all of that effort in my view is headed in the wrong direction because U.S. private sector is still deleveraging at these very low interest rates, which suggests that they are not comfortable with their balance sheets. And in circumstances like that, government should be increasing its fiscal stimulus, not decreasing it.
Now, long-term entitlements, I think they can discuss that. And if they find a good formula to reduce problems with this long-term entitlement, they should be encouraged to do so. But even on that point, you have this term called “policy duration effect.” People see that, “Yeah, fiscal stimulus is coming, but it’s only for two years and after that they’re gonna cut budget deficit,” then even those two years with fiscal stimulus might not have the maximum impact when people think that after two years everything will be back to this mess. And if you don’t think your balance sheet is repaired within two years, then you start preparing for the worst today.
And so, the part of the problem with long-term fiscal consolidation against short-term fiscal stimulus… it sounds like the responsible thing to do at one level, but it’s not responsible when you look at the maximum impact of fiscal stimulus that you do have in place at the moment because the policy duration effect will be operating in reverse.
What’s your take on central banks in Switzerland and Japan’s attempts to weaken their currency, how sustainable is this kind of unilateral intervention?
Under ordinary circumstances, unilateral intervention is not particularly sustainable but in the case of Japan, when the country has gone through such horrible natural disasters — nuclear accidents, the earthquake, tsunamis — and it was barely surviving after the (inaudible) shock, and you put a massive natural disaster on top of it. And if you put …a strong currency on top of this, nothing will work. And so I’m usually against unilateral interventions of sorts, but under the circumstances I think Japan is fully justified to do it.
And it’s really crazy that a country having a budget deficit just as large as anyone else and a public debt over 200 per cent of GDP getting this huge inflow from abroad pushing the yen higher and higher. That’s really ridiculous, right?
And actually, Switzerland is facing the same problem. In fact, as I mentioned in one of my reports, when I was on a panel with a Governor of Bank of Japan, that was five or six years ago. Someone asked (the Governor), “Why is the Japanese Yen so weak?” The answer was, well the bond exchange market is a strange place. Two countries that are doing everything right in terms of current accounts, inflation, and growth and employment — Switzerland and Japan — these two countries have the weakest currencies. And UK, US, those with a bubble were trading at much higher prices.
Well, now what we see is the opposite. Swiss Franc and Japanese Yen skyrocketing, the other countries falling. And, if you are in the real side of the economy, try to produce good products for your consumers. This kind of wild gyrations in currencies is just because investors want to speculate. If your authorities are responsible for the living standard of the people, I think you will be forced into doing something, as Swiss National Bank has done what Japanese authorities are doing now.
Going back to the ECB, do you think regardless of anything else, should they be cutting interest rate immediately?
Given that the entire Eurozone is in a balance sheet recession, and some of the most affected countries like Spain, Ireland, and even Portugal are having these balance sheet problems. Cutting interest rates one way or the other I think is largely irrelevant. And, some people are making a big fuss out of it. I consider that a waste of time because if you brought rates down to those low levels and these guys still refuse to borrow money. You know, just raising 50 basis points? I think that was done by Mr. Triche just to keep Germans quiet. It’s entirely political. I don’t think that Mr. Triche really believed that inflation is becoming a big threat or that it’s just around the corner. He just had to do that to show to the Germans that yes, the ECB really cares about inflation, we’re going to preempt all of this, in spite of all the government bond purchases that ECB has to do to keep some of these bond markets going.
Do you think the Euro survives in its current form?
In its current form, it’s gonna be tough, but if they start talking like the way I have suggested, that maybe we can make fiscal policy internal to individual countries, there’ll be some capital controls of course, and so that individual countries can function like ordinary countries, like U.S. and U.K., as far as the budget deficit issues are concerned and that will leave the central bank, ECB, to concentrate on monetary policy. Then I don’t think there’s any reason why the Euro should come apart.
And when the Maastricht Treaty was put together, the concept of balance sheet recesion didn’t exist in Europe, only in Japan. And the treaty is completely defective in the sense that it has no provisions for balance sheet recession. But once those issues are addressed, then I see no reason why the Euro should come apart.