The latest note from Nomura’s Richard Koo is chock full of insight, which is not surprising since talk of fiscal consolidation, misguided ratings agencies, and balance sheet recessions is his wheelhouse.
As he’s famously observed before, in such recessions like these, spending cuts actually make deficits worse, and so he’s particularly dismayed by the counter-productive actions of S&P.
Fiscal stimulus will reduce budget deficit in balance sheet recession
What I find even more interesting is that Japan’s fiscal deficit increased under the Hashimoto administration, which pursued fiscal consolidation, but decreased under the Obuchi and Mori governments, which gave up on deficit-reduction efforts and began applying fiscal stimulus. Prime Minister Junichiro Koizumi also came into office with a pledge to reduce the fiscal deficit by capping new JGB issuance at ¥30trn, but the economy weakened and the deficit rose. Only after he abandoned that pledge in 2003 did the economy pick up and the fiscal deficit begin to shrink.
These experiences demonstrate that during a balance sheet recession, when businesses and households are struggling to deleverage, the correct policy—fiscal stimulus—is exactly the opposite of what is needed under normal circumstances. Active application of stimulus will ultimately minimize the fiscal deficit.
Standard & Poor’s does not understand this and says America’s AAA* rating may be restored if the government succeeds in trimming its deficit by $4trn. The adoption of such a policy by the US government today would plunge the economy into another Great Depression.
Rating agencies may actually destroy the global economy again
Moreover, the experiences of Japan and more recently Ireland show that once the economy slows as a result of fiscal consolidation, the credit agencies will issue another downgrade, this time citing economic weakness. Even worse, they will disavow any knowledge of the fact that it was the fiscal consolidation they themselves prescribed that sparked the downturn.
For that reason, we need to be extremely wary of actions taken by rating agencies that do not understand the concept of balance sheet recessions. As I noted in my 26 April report, the rating agencies are now poised to destroy the global economy once again. The first time, they exacerbated a massive bubble by assigning AAA* ratings to a raft of questionable subprime securities. This represented a complete abdication of duty for businesses originally intended to serve as an overseer of private-sector finance.
The housing bubble could never have grown as large as it did had the rating agencies not recklessly issued those AAA* ratings, and the balance sheet recession triggered by the bubble’s collapse would not have been nearly as severe.
Elsewhere in the note he slams the ignorance of the Tea Party, and urges Obama to teach the nation about balance sheet recessions, a prospect to which we’d assign 0% odds, given that Obama himself thinks that we should reduce the deficit.