Richard Koo spoke over the weekend at the INET conference and once again reminded us all that he understands the current environment better than just about anyone in the world. Koo believes the EMU and UK are making a great mistake by forcing austerity during a balance sheet recession. And while he believes the USA is doing better than their European counterparts he is increasingly concerned about the rhetoric coming out of Washington.
In 2008 when the United States was discussing a stimulative response to the current crisis I said the authorities were misdiagnosing the problem. What looked like a banking crisis (or a credit crisis as the media referred to it) was in fact a household crisis. It seemed obvious to anyone paying attention that the problem didn’t start with the banks. It started with the households who were overly indebted and upside down on their mortgages. Once the mortgage payments ceased en masse the problem spread. The banks weren’t the root cause. But you didn’t hear anyone calling for a bailout of Main Street at the time. All we heard about was how we needed to fix the banks. And so Ben Bernanke began his great monetarist gaffe.
I had had the great luck of reading Richard Koo’s Holy Grail of Macroeconomics around the time of the crisis and the environment we were in (and are still in) was eerily similar to the events he discussed in Japan in the 90’s. In 2008 I discussed the government’s approach. In reference to QE1 I said:
“We have a major capital problem at the U.S. banking level. What Ben Bernanke and Hank Paulson are essentially proposing is an asset swap. The Fed will take on the toxic assets of the banks and they will receive reserves in exchange. This is important because it will alleviate the strains in the credit markets. That’s a good first step, however, it is not a solution to the problem at the household level and THAT is where the real economic weakness is. By introducing this asset swap idea Ben Bernanke is simply altering bank balance sheets. He is not fixing the economy.
So, the government has a partially correct solution. Not the BEST solution, but it gets to the core of the credit issues. They will essentially trade the bad paper for good paper and it will alleviate many of the pressures on the banks. As I have written here many times the banks are the lifeblood of the system. I like to think of the banks as the oil in the engine. If you run out oil the system begins to break down and eventually the engine stops running. You can’t have a healthy functioning economy if the banks aren’t lending. Unfortunately, because this won’t fix any problems at the household level it won’t induce any borrowing. So, it’s a clever way to resolve the banking crisis, however, it doesn’t fix the root of the problem which is at the household level. So, again I ask – is this a “bailout”? You bet your ass it is. Unfortunately, it’s not a bailout of the entire system. It’s just a bailout of the banking system. And their problems are merely a symptom of much bigger problems at the household level.”
This is important because it highlighted the environment of the time. Yes, QE1 was effective because it helped unclog the banking system. There was a credit crisis, but it was merely an offshoot of the larger crisis at the household level. The US economy needed household balance sheets to be cleaned up – not banking balance sheets. The results are clear. While Wall Street notches record bonuses and record profits Main Street is still mired in recession.
In the 90’s the Japanese made a similar mistake. They focused on saving their banking system with the misguided belief that if they saved the banks the rest of the economy would take care of itself. And the channel thru which this prescription “worked” was thru monetary channels. So they cut rates to zero. Implemented QE. So on and so forth with little to no results. But monetary policy primarily works thru increasing private sector debt. It was exactly the thing Japan didn’t need. The fiscal policy they implemented was effective, but was halted on several occasions only to send the economy back into recession.
That brings us to the USA, which is in the exact same situation Japan was in, except we are suffering a household balance sheet recession. And in 2008 our government was convinced by Timothy Geithner, Hank Paulson and Ben Bernanke that if we just saved the banks we would fix the economy. So we embarked on the “recovery” plan that has led us to one of the weakest recoveries in US economic history. Because of the keen focus on the banking system there is a clear two tier recovery. Wall Street is thriving again and Main Street is still struggling.
Thus far, we have run budget deficits that have been large enough to offset much of the deleveraging of the private sector. And though the spending was poorly targeted it has been persistent enough that we are not repeating the mistakes of Japan – YET. By my estimates the balance sheet recession is likely to persist well into 2013. The EMU and UK are making the mistake of cutting their spending in the midst of a balance sheet recession. Koo believes they are doomed to low growth and potential double dip.
And that rhetoric is now spreading to the USA. QE2 has truly been a “monetary non-event”. As many of us predicted at its onset, this program has shown absolutely no impact on the US money supply (much to the dismay of the hyperinflationists). And now its damaging psychological impact (via rampant speculation) has altered the options available to combat the continuing balance sheet recession. While more stimulus is almost certainly off the table given the Fed’s misguided QE2 policy, it would be equally misguided to begin cutting the current budget deficit. Sizable cuts before the end of the balance sheet recession will almost guarantee that the US economy suffers a Japan-like relapse. It’s not too late to learn from the mistakes of Japan.
The full Koo interview is attached: