Why Richard Koo’s idea won’t save the Eurozone

By Felix Salmon
April 16, 2012
paper at INET last week; it comes with associated slides, here.

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A lot of people were looking forward to Richard Koo deliver his paper at INET last week; it comes with associated slides, here. Koo is the intellectual father of the idea of the balance-sheet recession — an idea which was born in Japan, has increasingly been adopted in the US and the UK, and which is now gaining traction in the Eurozone.

Koo’s diagnosis that Europe is in a balance-sheet recession, which he defines as a post-bubble-bursting state of affairs where individuals and companies choose to pay down their debts rather than borrow money, even when interest rates are at zero. That certainly seems to be the problem in Spain; Koo’s charts can be hard to read, but what you’re seeing here is a massive borrowing binge by the Spanish corporate sector — the dark-blue line — suddenly turning into net savings after the crisis hits. And to make matters worse, Spanish households — the red line — did exactly the same thing. As a result, the government had to run a massive deficit after the crisis; the four lines always have to sum to zero.

spain.tiff

In this kind of a recession, monetary policy — reducing rates to zero — doesn’t work. And tax cuts don’t work either: they just increase household savings. You need government spending, at least until the economy has warmed up to the point at which companies and individuals start borrowing again. And the good news is that in a balance sheet recession, government spending is pretty much cost-free, since interest rates are at zero.

That’s the good news in Japan and the US and the UK, anyway. But it’s not the case in Spain. This is a big problem with the single currency, as Koo explains: it encourages capital to flow in exactly the wrong direction.

When presented with a deleveraging private sector, fund managers in non- eurozone countries can place their money only in their own government’s bonds if constraints prevent them from taking on more currency risk or principle risk.

In contrast, eurozone fund managers who are not allowed to take on more principle risk or currency risk are not required to buy their own country’s bonds: they can also buy bonds issued by other eurozone governments because they all share the same currency. Thus, fund managers at French and German banks were busily moving funds into Spanish and Greek bonds a number of years ago in search of higher yields, and Spanish and Portuguese fund managers are now buying German and Dutch government bonds for added safety, all without incurring foreign exchange risk.

The former capital flow aggravated real estate bubbles in many peripheral countries prior to 2008, while the latter flow triggered a sovereign debt crisis in the same countries after 2008. Indeed, the excess domestic savings of Spain and Portugal fled to Germany and Holland just when the Spanish and Portuguese governments needed them to fight balance sheet recessions. That capital flight pushed bond yields higher in peripheral countries and forced their governments into austerity when their private sectors were also deleveraging. With both public and private sectors saving money, the economies fell into deflationary spirals which took the unemployment rate to 23 percent in Spain and to nearly 15 percent in Ireland and Portugal.

With the recipients, Germany and Holland, also aiming for fiscal austerity, the savings that flowed into these countries remained unborrowed and became a deflationary gap for the entire eurozone. It will be difficult to expect stable economic growth until something is done about these highly pro-cyclical and destabilizing capital flows unique to the eurozone.

The solution to this problem is eurobonds. If all the eurozone countries funded themselves jointly and severally, then the yields on European government debt would be very low, and there would be no fiscal crisis in Spain.

But that’s not the solution that Koo provides to the problem that he quite correctly diagnoses. Instead, he said at the INET conference that the way to bring Spanish government bond yields down would be to massively decrease the number of people allowed to buy Spanish bonds.

This doesn’t make any sense to me at all. After all, in any market, the greater the number of potential buyers, the higher the price. But I’ll let Koo try to explain:

Eurozone governments should limit the sale of their government bonds to their own citizens. In other words, only German citizens should be allowed to purchase Bunds, and only Spanish citizens should be able to buy Spanish government bonds. If this rule had been in place from the outset of the euro, none of the problems affecting the single currency today would have happened.

The Greek government could not have pursued a profligate fiscal policy for so long if only Greeks had been allowed to buy its bonds, since private-sector savings in the country was nowhere near enough to finance the government’s spending spree…

The new rule will also resolve the capital flight problem by preventing Spanish savings from flowing into German Bunds. This will prompt Spanish fund managers facing private sector deleveraging to invest in Spanish government bonds, just as their counterparts in the US, UK or Japan must buy bonds issued by their own governments. That would allow Spanish government bond yields to come down to UK—if not to US—levels. With low bond yields and high bond prices, talk of a sovereign debt crisis would also disappear.

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.

It wouldn’t.

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.

Koo is absolutely right that the flow of savings out of Spain is doing absolutely gruesome things to the Spanish economy: you can’t possibly grow when your companies and households are paying down debt, and all your national savings are fleeing the country. So maybe there’s a case for fully-fledged capital controls. But Koo’s weak-tea version would only serve to decrease, rather than increase, demand for Spanish government bonds. Their price would go down, their yields would go up, and Spain would be in an even worse position than it’s in now.

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