Richard Koo is the foremost advocate of the idea that the world’s developed economies are in “balance sheet recessions” where the private sector is foremost concerned with trying to pay down excessive debt, rather than borrowing or investing.
The proper policy response does not come from lowering rates, but rather fiscal stimulus, to replace the lost private sector demand (or more specifically, letting the public sector lever up to contract the private sector deleveraging).
This works fine in Japan, the UK, and the US where governments can spend at will, but it’s a major problem in Europe, where governments are unable to borrow more.
So Richard Koo has a solution, which he’s written about in the past.
This is an except from a note that came out last October.
Balance sheet recession and eurozone-specific problems will persist even if crisis is avoided
Even if all of these measures are successfully implemented, the moral hazard created by rescuing fiscally profligate Greece and the fundamental problem of how to rebuild the economies of countries like Spain and Ireland, which are experiencing severe balance sheet recessions, will remain.
Principal reductions alone will not be enough to foster growth in these countries. As I have argued in previous reports, these eurozone-specific problems can be addressed by the adoption of a rule stating that eurozone governments can sell bonds only to their own citizens.
If countries agree to adopt such a rule within, say, five years of the end of this crisis, the problem of moral hazard in Greece would disappear, and countries like Spain and Ireland would regain the fiscal flexibility needed to deal with their balance sheet recessions.
So what’s the idea here, really?
Well, what’s supposed to happen in a normal functioning economy is governments spend money, that money winds up in domestic banks, and then those banks end up buying domestic bonds, completing the cycle. Rinse, wash, repeat.
What happens in Europe is that a government like Spain’s will spend money, but then that money winds up in a German bank, and then that German banks buy German government bonds. The loop is never closed, and you get crisis.
This chart from CFR is a little old, but it nicely shows how money has been sucked away from PIIGS banks and into German ones.
Not surprisingly, over the last couple of years, German yields have plunged while peripheral ones have soared.
So Koo’s thinking is simple: Don’t allow Germany to sell bonds to non-German holders, and then that Spanish money will be forced to stay in Spain, where it will be recycled back into government bonds, allowing Spain to spend at will to ease the balance sheet recession.
Anyway, Felix Salmon is unimpressed. He thinks that if Spanish investors were prevented from buying AAA German bonds, they’d just buy some other Northern-based credit instrument that would still be safer than buying Spanish sovereign debt.
It’s absolutely true that a lot of Spanish fund managers, in a flight-to-quality trade, are buying up German and Dutch government bonds. It’s also true that Koo’s proposed rule would prevent them from doing that. But it’s emphatically not true that if they couldn’t buy German or Dutch government bonds, they would buy Spanish government bonds instead.
I asked Koo about this, in Berlin, and the conceptual problem quickly emerged. On the one hand, Koo is careful not to say that he wants fully-fledged capital controls preventing Spanish fund managers from investing abroad at all. He’s confining his proposal just to government bonds, and is not including corporate bonds, equities, structured credit, or anything else that Spaniards can currently invest in. But, he still thinks that this one rule would, single-handedly, take the 6% of GDP that the Spanish private sector is currently saving, and divert it directly into the Spanish government bond market, sending yields there plunging.
The fact is that when money flows into US Treasuries or JGBs or Gilts during a balance-sheet recession, that has absolutely nothing to do with the fact that they’re government bonds, and absolutely everything to do with the fact that they’re the dollar- or yen- or pound-based securities with the lowest perceived credit risk. If you ban Spanish institutional investors from investing in Bunds, then they’ll just buy something else with extremely low credit risk instead — AAA-rated corporate bonds, perhaps, or covered mortgage bonds from somewhere in the north, or some other kind of highly collateralized structured credit instrument. None of those things might have quite the degree of liquidity that Bunds can offer, but they’re still safer than Spanish government debt right now.
Salmon is correct that there are just too many technical holes for Koo’s plan to work. The biggest problem is one that Felix doesn’t address: If a saver in Spain puts their money in a German bank, their savings would get used to buy German debt indirectly. So to make this work, you’d have to make cross-border banking illegal. In short, the number of restrictions that would be required to make this work are incompatible with a free-trade currency zone.
But focusing on the technicalities misses the point. It’s better to think of Koo’s idea as a “modest proposal” aimed at showing the exposing flaws of the Euro.
See, a lot of people think that the crisis in Europe is about sovereign debt. But this isn’t really true at all. Only Greece really has an insane amount of sovereign debt. Spain and Italy aren’t really in bad shape on this front. Ireland has very low sovereign debt prior to the crisis.
Smarter people argue that Europe really has an imbalances/competitiveness problem, as the common currency prevents the kind of devaluation that would allow Greece and Portugal and Italy to be competitive with Germany, and establish more trade parity.
But even this answer isn’t totally satisfying, since in the game of world trade, some countries do run persistent trade deficits, and their economies don’t completely blow up.
What Europe has is a really flawed currency.
It’s flawed because unlike the UK, Japan, and the US, each government can’t print their own money, putting them in a severe economic straightjacket.
And then beyond that there’s the problem that Koo is getting at, which is that money doesn’t loop nicely. As we stated above, when Spain spends money that money will often find its way into a German bank, where it will go towards buying German bonds.
This is a critical idea, and it explains why the US, Japan, and the UK could never go bankrupt. People talk about the insane spending in the US and Japan, but it doesn’t matter. Every yen spent by the government eventually finds its way into a bank that will eventually turn it into a Japanese Government Bond. It may take several steps, but it will get there. The loop completes. Same with the US. Every dollar spent will eventually move around until it finds its way back home in the form of a US Treasury. The loop completes.
Koo recognises that Europe has a loop completion problem, and as such his proposal is way more insightful than many of the solutions you hear for Europe… even if it’s technically unworkable.
When the big 3-year LTROs were announced, something you heard a lot of snark like: “Well, gee, we’re just going to have ailing banks prop up ailing sovereigns. How is that sustainable?“
Well actually it is sustainable. Banks buying their domestic debt is how finance works all over the world. Two drunks can lean against each other’s backs and stay standing up.
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