Nomura’s ace economist Richard Koo is out with a new note on the ongoing crisis in Europe.
In it, he takes issue with Germany’s demands for supply-side reforms (labour reform, tax reform, etc.) in the peripheral countries.
Koo argues that supply constraints aren’t the problem. Demand constraints are the problem, and so freeing up supply does nothing.
It makes no sense to demand increased supply from countries suffering demand shortage
But as Japan’s experience under the Koizumi administration makes clear, no amount of structural reform will improve the situation when an economy is suffering from balance sheet problems. Nor is the argument for structural reforms particularly convincing.
Eventually people realise that the solution being proposed by structural reformists (increased supply capability) has little to do with the problem they face (an extreme shortage of demand).
If Spain were not in a balance sheet recession, the structural reforms Germany is demanding would be an entirely appropriate response and would probably meet with little resistance. In the longer term, after all, Spain does need to reform its labour market and pension system.
But the Spanish reality today is a severe balance sheet recession in which private savings have increased by 18% of GDP in a short period of time. This, and not structural problems, is the primary cause of the nation’s recession.
As structural problems have little to do with Spain’s predicament, making structural reforms a condition for assistance does not make for a persuasive argument. Forcing a country in a balance sheet recession to undertake structural reforms in exchange for financial aid is like the proverbial man who runs after two hares and catches neither. The structural reforms will not make much headway and will do nothing to address the balance sheet recession. That is where Spain is headed today, and I suspect it will continue in that direction until German policymakers realise that the balance sheet recession and structural problems must be addressed separately.
Now there is a good criticism to be made of people who are always calling for Reagaonomic or Merkelnomic supply-side reforms.
For example, hedge fund manager Mark Dow has a great post criticising the US-based economists who want to see Reagan-like reforms implemented in the US. Whereas in the early 80s, there were a lot of gains to be made by freeing up supply, none of the conditions are the same now. So a lot of people are guilty of the old saw about “if your only tool is a hammer, then every problem looks like a nail.”
But whereas Koo is calling people out for tired reforms that make no sense in the European context, he too is guilty of the same thing, since to him, just about every economic crisis these days is a balance sheet recession.
This idea of a balance sheet recession is what makes Koo unique. He believes that the crisis in Japan and the US were not caused by “business cycles” but rather, a crumbling of the private sector balance sheet, and that the way to remedy this is via fiscal stimulus which allows demand to grow, while also letting the private sector pay off debt.
And there is need for private sector deleveraging in Europe. Ireland and Spain had bad housing bubbles, the aftermath of which have really done a number on private balance sheets. BUT! This is not really the core of the European problem.
George Soros had the best one-sentence explanation of the European crisis in a recent speech,w hen he said:
In retrospect it is now clear that the main source of trouble is that the member states of the euro have surrendered to the European Central Bank their rights to create fiat money.
This is it.
Yes, there are other problems out there. Spain and Ireland had huge property bubbles. Nobody trusts Italy’s government. Greece spent like crazy and is seen as terribly corrupt.
There are shades of the Balance Sheet Recession in parts of Europe, but mostly it’s a distraction from the issues at hand.
Note: Cullen Roche, who is also a big fan of the Balance Sheet Recession explanation of the economic malaise, has made the same obsevation about Koo’s overdiagnosis of it.