Richard Koo made some interesting comments in his latest research piece making an appropriate analogy for the Euro crisis:
“Eurozone suffers from both pneumonia and diabetes
…I said the eurozone was currently suffering from two diseases—pneumonia and diabetes—an analogy I drew on frequently in Japan more than a decade ago. Structural reforms are akin to a treatment for diabetes patients, who must eat carefully and exercise more to improve their long-term physical condition.
A balance sheet recession, on the other hand, is more like pneumonia. If it is left untreated, the patient’s condition can deteriorate rapidly. The patient can even die if proper treatment is not administered in the first three days. These two illnesses sometimes occur simultaneously, which complicates matters because the treatments are in a sense contradictory. Diabetes sufferers must restrain their intake of food, while pneumonia patients can die without ample nourishment.
Eurozone should treat pneumonia first
When the two diseases occur together, the physician must give precedence to the pneumonia, which demands immediate treatment. The diabetes can be left for later. I added that regardless of what may be appropriate for Greece, where problems are due to previous governments’ fiscal profligacy, insisting on austerity for Spain, Portugal, and Ireland is the wrong answer. It will only cause conditions to worsen. This conclusion was utterly different from what my hosts had in mind, but I added two examples from Japan and the US: the austerity policies implemented by the Hashimoto government in 1997 and Federal Reserve Chairman Ben Bernanke’s recent warnings about the so-called fiscal cliff.
In the former case, the Hashimoto government chose to increase taxes and cut spending at a time when the private sector was minimizing debt in spite of zero interest rates. The economy duly collapsed, sending the fiscal deficit from ¥22trn in 1996 to ¥38trn in 1999, an increase of 68%. It took Japan nearly a decade to bring the deficit back to its starting level. In the latter case, the Fed chairman, who has demonstrated an understanding of the dangers of a balance sheet recession, used the powerful metaphor of a “cliff” to warn Congress about the dangers of engaging in premature fiscal consolidation. Finally, I noted that the Cameron government, which came to power in the UK on a platform of bold fiscal retrenchment, is now seeking to change direction after watching the local economy behave in an entirely unexpected fashion.
To sum up my impressions of Berlin, German politicians are starting to question the strongly held beliefs that have brought them this far. This marks a change from the situation just a year ago, when policymakers were still brimming with confidence. Some of them even said last week that they needed to spend more time studying the experiences of Japan and other countries.
But at the same time they lack their American and British counterparts’ understanding of balance sheet recessions, and rectifying this will take time. I therefore expect German policymakers will continue to focus on treating the patient’s diabetes while largely ignoring his case of pneumonia.”
I’m not sure I love Koo’s analogy here though since I believe it too misses the real disease. The balance sheet recession is a symptom of a larger issue – the unworkable currency system. So curing the balance sheet recession (for instance, with government deficits via lower taxes or higher spending) doesn’t necessarily fix the real problem. The fact is, the Euro currency was designed to fail since it’s a single currency system with no floating exchange rates and no supranational entity to eliminate the solvency issue at the national level. So balance sheet recessions are inevitable in such a monetary system. But fixing the BSR doesn’t fix the currency system necessarily. So I’d say the pneumonia is a symptom of a disease that is much more dangerous. We can fix the pneumonia now, but given the flawed currency system, it’s guaranteed to come right back.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.