At last, it seems springtime has come to the eurozone: the sap is rising in financial markets, sovereign bond yields are subsiding and the tensions in the banking markets are easing, thanks to the mass injection of liquidity by the European Central Bank.
But Richard Koo, Nomura’s mild-mannered chief economist, begs to differ. He argues that Europe’s leaders have misdiagnosed their economic crisis and is forecasting a return to wintry conditions.
At a time of collapsing private sector demand in several member states, the eurozone’s obsession with slashing public spending will only aggravate its problems, he suggests. Its fiscal compact is more likely to kill the patient than cure it.
For years, Mr Koo has eloquently defended the largely unfashionable view that Japan pursued the right policies to deal with the bursting of its bubble economy. True, Japan may not have grown much over the past two decades but a far worse outcome was avoided: the country skirted a 1930s-style depression that, Mr Koo believes, now threatens the peripheral members of the eurozone.
In an interview, on the sidelines of the Ambrosetti financial forum in Cernobbio, Italy, Mr Koo outlines his theory of “balance sheet recessions”, which runs so much in contrast to current eurozone orthodoxy.
When countries such as Japan experience a slump in asset prices, then traumatised private-sector companies, banks and households will do everything possible to deleverage their balance sheets and pay down debt – even when interest rates are near zero. In such circumstances, the government has no alternative but to increase public spending to prevent a collapse of demand.
“The key point is that if the private sector is deleveraging, the last thing you want is for the government to cut its budget deficit,” he says. “If central banks bring interest rates down to almost zero and nothing happens then it is not an ordinary world.”
Mr Koo says that when Japan listened to the advice of outside experts, such as the International Monetary Fund, and pursued fiscal consolidation in 1997 it tipped into a damaging recession. “The government cut spending and we had five quarters of negative growth and it took Japan 10 years to recover,” he says.
Some European officials at the Ambrosetti forum appeared to be scarcely able to conceal their scorn when listening to Mr Koo’s presentation. They argue it is delusional to believe one can choose between austerity and growth. Austerity, they say, is an indispensable precondition for the return of market confidence and economic growth.
Moreover, a further piling up of public debt to solve a problem of over-indebtedness would be counterproductive. Financial markets would not tolerate a further ballooning of budget deficits in countries such as Spain, Portugal, Ireland and Italy.
Mr Koo accepts that the 17-member eurozone is more complex than Japan: its economies are moving at different speeds and directions and some of them, notably Greece’s, have their own particular challenges.
But he argues that the eurozone’s fiscal compact, which enforces synchronised austerity even for its healthier members, risks repeating Japan’s mistakes of 15 years ago. And he rejects the idea that increased public borrowing would necessarily scare the markets: Japan, the US and the UK are running looser fiscal policies while still enjoying low rates of borrowing.
If eurozone members were to restrict sales of government bonds to their own citizens, he suggests, then they would reduce the risks of damaging capital flight within the euro area.
Mr Koo’s analysis has some supporters. Nouriel Roubini, professor of economics at New York University, says that while fiscal austerity may be appropriate for some eurozone countries it is not valid for all, especially those, such as Ireland and Spain, which have experienced a private sector implosion, like Japan did.
“The right design of policy response for the eurozone would have been massive liquidity injection by the ECB, a weakening of the euro to restore the competitiveness of the periphery and fiscal stimulus in the core and where private sector deleveraging was a problem.”
With such a policy mix absent, Mr Roubini suggests, “Europe could get worse than Japan.”
“Japan had a Great Recession, and a Great Stagnation, but it never had a Great Depression,” he says. “But recession in some eurozone countries could become a depression, just like the 1930s.”
By John Thornhill in Cernobbio
2 April 2012
@ Financial Times