Europe Dispensing Wrong Fiscal Medicine in Koo Warning

German Chancellor Angela Merkel
Angela Merkel, German chancellor. Photgrapher: Boris Roessler/AFP/Getty Images

European policy makers are dispensing the wrong medicine by tackling the euro-area’s fiscal ills with austerity, according to Richard Koo, chief economist of Nomura Research Institute.

The budget cuts and structural reforms prescribed to nations such as Spain by German Chancellor Angela Merkel and European Central Bank President Mario Draghi are in Koo’s eyes akin to the treatment of diabetes sufferers, who must eat carefully and exercise to improve their long-term health.

The trouble is Europe’s cash-strapped peripheral countries have the economic equivalent of pneumonia, which is more deadly and is best beaten by ensuring ample nourishment, said Koo. To the 58-year-old former Federal Reserve economist that means greater fiscal stimulus if the euro crisis is to end soon.

“The patient can have both, but doctor has to cure the pneumonia first even if the treatments contradict those required for the diabetes,” Koo said in an interview in Tokyo yesterday. “In Europe, austerity is the only game in town.”

The advice goes to the heart of Koo’s theory that like their Japanese counterparts in the 1990s, policy makers in Europe are failing to see that their region is suffering from a “balance-sheet recession.”

Rock-Bottom Rates

That’s when the end of an asset boom cripples companies and households with debt they need to minimize and leaves them with little desire to borrow and spend even with rock-bottom interest rates. Koo’s solution is to offset private sector savings with government spending, the opposite of what Merkel and Draghi are advocating in the euro-area, where Spain is mulling whether to become the latest country to request a sovereign bailout.

“If governments do nothing, economies enter a deflationary spiral,’ said Koo. ‘‘When you look around Europe you see balance-sheet recessions.’’

The lessons of Japan’s lost decades are getting a sounding this week as the International Monetary Fund hosts its annual meetings in Tokyo. The world’s third largest economy has grown less than one percent on average in the past two decades and average consumer prices have fallen in seven of the last 10 years.

Boom, Bust

A Taiwanese-American, Koo was born in Japan before moving to San Francisco when he was 13. He studied economics at the University of California-Berkeley and John Hopkins University before winning a fellowship from the Fed in Washington.

Supposed to stay on at the Fed when that ended, he ran into President Ronald Reagan’s public sector hiring freeze, prompting him to move to the Fed Bank of New York, where he worked on issues such as Latin American debt. In 1987 he returned to Tokyo to join Nomura, planning to return to the U.S. after a couple of years. Instead, he remained through Japan’s boom, bust and subsequent malaise, honing his ‘‘balance-sheet recession” argument which was detailed in 2008’s “The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession.”

Koo is now taking the experience of Japan to Europe, making four trips to the continent this year and awaiting a translation of his book into German.

While he has addressed policy makers on his travels, his views may not be getting traction where it counts. Merkel said Sept. 28 that Europe must curb its budget deficits and doing so will generate long-term benefits. Draghi said Oct. 9 that there is no alternative to austerity even if it hurts output.

Spanish Deficits

In the case of Spain, Koo says the euro area’s fourth-largest economy is in pain following the collapse of a housing boom which led households and companies to boost saving to a net 6 percent of gross domestic product after borrowing and spending 12 percent of GDP as the property bubble inflated.

While the government initially ran budget deficits to offset a loss in private demand equal to almost 20 percent of GDP, the economy took a turn for the worse in 2010 when it began cutting back as the Greek-led crisis gripped markets, he says.

He makes the case that this was the wrong choice by noting that despite the budget consolidation, private savers fled for German bonds, causing Spanish yields to rise even further. The 10-year Spanish bond reached a peak of 7.62 percent in July.

Koo uses Japan’s experience to demonstrate the errors he sees being repeated in Europe. In 1997, Prime Minister Ryutaro Hashimoto’s government increased taxes and cut spending, while pushing structural reforms to offset the pain. The problem was the private sector was trying to lower debt and already failing to respond to zero interest rates, he said.

European Stimulus

The result was five consecutive quarters of contraction and falling tax revenues, provoking a 68 percent increase in Japan’s fiscal deficit. Even though Hashimoto reversed course, it took Japan a decade to haul back its budget deficit, Koo said.

Europe can avoid a similar trap if the ECB and IMF agree Spain and other crisis-torn countries can revive stimulus and nations in better shape such as the U.S. and Germany spend the capital flooding their economies, said Koo. He also proposes a rule prohibiting euro-area governments from selling debt to the citizens of another country, limiting the ability of private savings to move abroad and hurt yields.

While Koo acknowledges such policies may not find favor among Germans or investors, he says a recent trip to Berlin persuaded him some in Germany warm to his ideas. He suspects investors also may rethink their ardor for austerity if stimulus meant there was a prospect of growth recovering.

“We’ll keep at it and maybe in two years or hopefully sooner, people will get it’s a different disease requiring a different treatment,” Koo said.

He is more hopeful his ideas will gain a following in the U.S., noting Fed Chairman Ben S. Bernanke has read his book and is warning against premature fiscal consolidation as $600 billion in government spending cuts and tax increases loom unless the law is changed.

“If they’re not careful, the U.S. could fall off the fiscal cliff,” he said, estimating it amounts to 3 percent of GDP, the same as Japan’s 1997 budget cuts.

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