Richard Koo – Government response to debt deflation

This video of a speech by Richard Koo was noticed by a couple of our readers over on Steve Keen’s blog. It is well worth the 1 hour and 9 minutes of watching for anyone with even a small amount of interest in recent macroeconomic history. It is also a very timely message for the US and European governments as they decide on their next macroeconomic moves. I have decided to re-post it on MacroBusiness as I am sure it will spur a bit of a conversation between our readers who can make it through 69 minutes of powerpoint slides.

and a PDF transcript version of the slides thanks to The Prince

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  1. Two things after watching the video:

    1) When the voters are afraid, they start saving instead of spending. It’s hard to convince them to run a deficit, and the size of the deficits suggested by the slides is impossible even during the good times.

    2) How the money is spent matters. The money should be spent on investment that gives a rate of return.

    This can be achieved through public/private programs like the NBN : it doesn’t appear on the government’s balance sheet, and it’s a monopoly so the rate of return is guaranteed. Finding that kind of project will be difficult though.

  2. An interesting and persuasive presentation. Timely too, when nations are facing increasing calls to cut spending and enact various austerity measures. Yes, the deficits are enormous – but as Koo argues, this is not your ordinary run-of-the-mill recession but a deep balance sheet recession. No-one is borrowing nor lending/spending. Savings remain in the banking system and are not regenerated into productive enterprise. Could go on forever! It becomes a deflating spiral – and only Government appears to have the ability to adequately spend the amounts required to get everything ticking over once more.

    Certainly my view as to what the US should be doing right now. I like big projects so I lean towards major infrastructure – the big stuff that generates jobs, lots of them, skilled and unskilled. That attract an array of support services (architecture, engineering, project management etc) and builds project of lasting generational wealth.

    If the US doesn’t solve its balance sheet recession and growing unemployment problems soon, the erosion may be too great to salvage.

    The issue of eventual paydown of deficit is not really discussed in great detail (or I missed it), I think because if action isn’t taken to ‘rescue’ these economies now, any question of debt repayment will simply be academic.

    My 2c.

    • What Koo also points out is that a change of direction mid-stream is actually more damaging and prolongs the issue. Japan attempted it twice and both times were big failures.

      That however is exactly what the US is considering as I type, which suggest they have learnt absolutely nothing from recent economic history.

      What I also thought while watching it was the fact that people seem to be able to accept that asset rises can go on for decades and balloon into massive sizes, yet people expect that once they collapse that the solution should take 6 months, and if it doesn’t then it must be a failure.

      House prices in the US ( and OZ for that matter ) were building on a credit bubble that took 20 years or so to create, how exactly does anyone expect that to unwind in less than a decade ?

      • I have argued to Prof Bill Mitchell on several occasions that from the veiwpoint of policy makers, economic history is far less important than current political reality. All that really matters is what the broad electorate THINK they know.

        I fully agree that the US is courting disaster with debt ceilings, attempts to get the deficit “under control” etc – but I think it’s what a majority of the electorate want. It makes sense to most people that the government needs to get it’s spending under control and that government debt and deficit are the cause of the problem (rather than symptoms). The reality of sectoral balances makes no sense at all to most people.

        Thus, the electorate will continue to demand that their government take up a big stick and whack them with it, in the belief that this is good for everyone. And what the electorate wants, the electorate usually gets.

        • Montgomery Burns

          but I think it’s what a majority of the electorate want

          I don’t. Having lived there until late last year the main concern among people I mixed with was am I going to lose my job, am I going to find a job.

          The deficit has been beaten up as a political issue by nutjobs who don’t understand the monetary system to scare the bejesus out of masses. Best summarized by the commentator who called Obama a dick(head) on air and then got suspended. They are all dick(head)s.

          • “The deficit has been beaten up as a political issue by nutjobs who don’t understand the monetary system to scare the bejesus out of masses”

            Completely agree.

            But I think you will find that most people have a negative veiw of goverment debts and deficits.

            Try asking people if the government should once again stimulate if the economy if conditions weaken – you will get a resounding “no!” from most. The senseless mass-hyteria peddled by the MSM regarding the BER and insulation programmes has reinforced that negative attitude.

          • Montgomery Burns

            TBP has some material you might want to use in a post about 4-6 weeks ago. Ritholz listed all the debt ceiling rises since the depression …the count was 30-40, and many were accompanied by the same hand wringing as now. From memory he included excerpts from commentary of the day.

        • In every economy, jobs and job security is paramount. All else flows from that. The US has official jobless at 9% and Shadowstats at around 16% (sounding like Spain…). As you say Montgomery, of most concern to people is the ability to have paid employment and the knowledge that if that particular job goes, there are others to go to. (Unfortunately, from what we read here they seem to be burger-flipping and Walmarting at minimum wage – but even these are sought after when there is no alternative).

      • True, changing direction mid-stream was damaging and simply prolonged with situation. Each time the Japanese government reduced its deficit the economy deteriorated. Is anyone listening? I do hope so.

        As he said, it’s not the same as balancing the household budget – which appears to be the simplistic level “the fix” is portrayed as – a fix which seems to have grabbed a hold of Obama (economically illiterate) and the Republicans (and some Democrats) in the US.

        There have been stirrings though – and now apparently even Bernanke understands. I seen ads “Why are we building this bridge over there (some foreign land) when we should be building bridges here”. Unfortunately, delayed by the political game going on. If they don’t act soon, it will be a case of Nero fiddling (Congress) while Rome burns (USA economy).

        In regard to house prices, I think they have unwound quite rapidly (a few years) in the US and we may yet see the same thing here – I’m confident the RBA would ideally engineer a slow burn rather than a wildfire.


    • When the opposition party goes into a ‘deficit scare’ campaign, it limits the ability of the government to run a deficit. This is happening in Japan, US, UK, Australia, etc. China is immune because it’s not a democracy, and there is no opposition.

      A job generating project is not sufficient. It must pay its own way as well. Take the example of roads : instead of a road to nowhere, the new road should be a toll way replacing a major thoroughfare, and the existing road scraped (or converted to bike lane) to guarantee a monopoly profit. Of course the action will creates economic distortion, however it may still be preferable to unemployment and deficits.

  3. After watching the video I have sat deep thinking for over an hour. Then another 15 minuits after reading the above comments. Excelent… thank you.

    I would like to add to Ronis comment the question of efficent use of capital. The private sector stuffed it up by paying to much for assets and they are replaced with the government who build roads to nowhere?

    Other questions bubling away in my head from this are

    My gut is telling me this is all wrong, we need to take our medicine (ecanomic pain) drop our GDP’s and start again.

    If we allow ineficient use of capatal by government (building roads to no where) then isnt that called Communism? Alternativly government investment in pure science has worked (spin offs from the space race) as has other big picture projects (Snowy Mountians Hydro).

    The last comment is more political, has the end result in Japan’s solution resulted in a community disenfranchised to the point where they allowed the Yakuza to run Fukushima power plant (or the unions to run the warves in Australia)?

    • Bill Mitchell has been saying this for years. What Koo is saying is right, but I want the government to be actively involved to use fiscal policies right from the start , that is to pro-actively stop asset bubbles from forming in the first place, through progressive taxation. Why in the world hasnt Henrys tax recommendations been implemented?? . Fiscal policies are not a blunt tool like Monetary policy and target specific financial flows and helps in the better distribution of wealth.

      More stimulus after a debt orgy by the private sector caused partly by the misguided government mandate to pursue surplus and partly by turning a blind eye is not what I have in mind of good governance, although a better governance than cutting stimulus.

      The other problem which Bill Mitchell mentions is that the Government has losts its capacity plan and execute large fiscal policies because of continued outsourcung of it to the private sector. So when it gets to crunch time we get Pink Batts!!

      • Torchwood1979

        “Why in the world hasnt Henrys tax recommendations been implemented??”

        The Rudd Government’s response to the Henry Review was utterly appalling. I know there was a good 15 years worth of reform work in it but they cherry picked the few recommendations that seemed politically palatable and discarded the rest, using the nationalisation of state hospitals as cover. However the RSPT turned out to be a backfire because they underestimated the campaigning power of the mining industry.

        Sadly I have even less faith that the Opposition under Abbott could tackle real tax reform.

        • RSPT failed, deservedly so, because it was a shoddy, ill-conceived, poor drafted, inequitable piece of dross!

          • Torchwood1979

            Agreed that the RSPT Swan put together was a disaster, but the mining companies did a damn good job of convincing the populace that any RSPT will be economic suicide.

        • Alex Heyworth

          Maybe once they are in power the Libs will actually listen to the Treasury boffins. There was a time when politicians actually listened to the public service policy departments, whose main function was to advise them. That has been completely destroyed over the last fifteen years, most disastrously by Rudd. He obviously hadn’t read Machiavelli’s advice to seek counsel from a wide range of advisers and to insist on frankness.

  4. Koo’s observations are very good.

    But if mispriced credit contributes to the formation of conditions for a balanced sheet recession perhaps the starting point should be an acceptance that it is folly to use interest rates to stimulate economic activity simply becuase inflation is behaving.

    Holding interest rates down when inflation is low is part of the problem.

    Of course once you are in the prsent mess you cant give money away but does it follow that it is sound policy to keep rates down in the hope of attracting a few credit cowboys to speculate on the carry trade?

    Perhaps interest rates should have a lower bound and if that results in some liquidations and the reallocation of plant, macinhery and staff to new businneses so be it.

    Koo understands the problem but i think he glosses over the difficulty of a solution. The may be no avoiding some pain.

    At least with a welfare safety net people will not starve.

    We may actually take more care in future when the men from wall street state.

    “hi I am a banker and I am here to help”

    • I think Koo did say that usual interest rate levers do not work in balance sheets recessions – where even 0% real rates did not result in stimulating the economy which simply continued to pay down debt!

    • >Holding interest rates down when inflation is low is part of the problem.

      The IRs are half the problem. The other issue is that the asset being speculated on with the credit isn’t included in the inflation basket, so there is no feedback loop created.

      I question what the interest rate would have been in all of these countries if the governments had “prudently” added housing to the basket of inflation. When I say “prudently” I mean weighted on the percentage of private sector debt to GDP used to service it.

      We had house prices going at double digits for the last couple of years while being told that inflation was low, yet now that house prices are falling we are being told “inflation is just around the corner”.

      Seems a bit backwards to me…

      • Good point! Ah, the subterfuge of official statistics.

        It was amusing when Koo related confronting the US Fed officials responsible for the report – pointing out errors (of a fairly basic kind – essentially guessing) and they exclaim “Oh, you found out”. If more people paid closer attention, I do sometimes wonder just what might be found out.

      • Agreed. Imputed rent is not enough because valuations during bubble phases are not derived from rent, they are derived from the capacity of the lender to borrow.

        The nominal (or slightly hedonic) change in housing price needs to be added to the CPI basket, as housing is a consumption good/cost of living good.

        Imagine what IR would have been if CPI was growing at 5-6%, instead of the declared 3-4% during the last housing bubble?

        This solution also sidesteps the “problem” of central banks leaning against asset bubbles (which they admit the world over they have no way on knowing what is what).

        And as a feedback, it then provides a better measure for lenders to calculate serviceability, although I still think this is flawed and we need a different regulatory approach (e.g limiting lending not based on the owner’s cashflow, but valuing the house on the imputed rental cost, based on a DCF using the 10 year government bond yield)

        But good luck getting that put into the Consumer Lending regulations….

        • Torchwood1979

          The central banks and governments generally use the free market excuse when it comes to asset bubbles. IIRC the former Irish Finance Minister said it wasn’t any of his government’s business what people decided to pay for houses. One mega problem – in a world where central banks and not the market determines interest rates the cost of credit isn’t decided by the market. And when governments lend uneven tax support to one asset class over another that’s hardly a free market either. Bubble? What bubble?

      • “The other issue is that the asset being speculated on with the credit isn’t included in the inflation basket”

        Could agree more. All that housing debt increases the private sector money supply, but is spent specifically on houses, and therefore causes inflation in housing assets.

        Seems pretty obvious, but of course mainstream economists don’t take private debt into consideration, assuming one person’s asset is another’s liability and they therefore cancel each other out. In an accounting sense they do, but in the meantime the private sector’s awash with cash to spend on housing… until it reaches a limit of borrowing capacity.

  5. Until Australia gets a treasurer with balls like Paul Keating, the Henry tax reforms will gather dust. I liked Saul Eslakes version of the mineral resources tax better than the Henry one though.

  6. There is only one take away from the entire presentation (pdf), that is of interest to me.

    Exhibit 29, page 30.

    Authoritarian Vs Democracy.

    We do not live in an “et ceteris parabus” world. Welcome to Geo-Strategic issues.

    When the dark Prince of the East speaks, Sean listens.

    In speech given by A. Putin on the “Commanding Heights” of the economy circa 2002-

    To paraphrase: The wars of the early 21st Century will not be like the wars of the 20th Century. They will not be fought with conventional weapons-tanks, planes missiles, etc. but more on an economic and financial basis.

    We have been watching this play out since then-2002.

    Do you understand how the Soviet Empire’s fall was engineered? If you do then you know how the coup was performed in the West.

    We engineered our own demise. “We have met the enemy and he is us”-Walter Kelly Pogo.

    Could the dickheads engaging in WW1 have foreseen the utter demise of the existing governance architecture and economic strucure of both Europe, its colonies and other nations post war?

    The coup leaders in the West just don’t understand that they will deliver “Authoritarian” governance in the West. Or if they do, it will be them pulling the strings.

    So all this bullshit that you thought “they” were becoming like us is only half right. The other half is that we will become like them.

    We can’t expect the American People to jump from Capitalism to Communism, but we can assist their elected leaders in giving them small doses of Socialism, until they awaken one day to find that they have Communism. Khrushchev.

    Poor old Nikita could not forsee the collapse of communism. Authoritarianism in the form of Corporatism and capture of the commanding heights of the economy, under socialism is the new way.

    How will it be delivered in the West?
    “first ascertain exactly the position of the various capitalists, then control them, influence them by restricting or enlarging, facilitating or hindering their credits, and finally they can entirely determine their fate.” Lenin. Any one seeing China do this? Oil States? Russia? Etc.

    A new Bretton Woods style a la G20: If it inclusive, we lose. We concede certain rights and priveleges.
    If it exclusive, then we lose. We lose on the “moral high ground” of culture. We told them to change and compete. Do we want them to tell their populations that free enterprise in the West is a theft mechanism and a stick to beat them with?

    A joke on the streets of Moscow these days: “Everything the Communists told us about communism was a complete and utter lie. Unfortunately, everything the Communists told us about capitalism turned out to be true.” —John Nellis, World Bank.

    Now turn that statement on its head. Everything the capitalists told us about capitalism was a complete and utter lie. Unfortunately, everthing the capitalists told us about communism is true.

    We are so screwed.

  7. What Koo does not realise is that Japan was in a different situation to the world today.

    Japan was able to finance its deficits because its corporations agreed to purchase JGBs with their hard earned money.

    They were able to do this because Jap corporations earned money by selling things to the rest of the world, when the rest of the world was on a credit binge.

    That is now over.

    • Japanese business is simply not investing : they save the money they earned from export and then then they simply sat on the cash. This is a mirror of what is happening in the US right now with big corporate profits. Businesses are simply not investing.

      Chinese businesses in contrast invest WAY too much, even if it means building roads to nowhere or entire ghost cities in the desert. It’s at the opposite end of the spectrum.

      The difference between the countries is ‘inflation’. When inflation is running at over 10%, you can’t sit on a pile of cash and do nothing with it.

      • You’re right. What I wonder is that is where Lloydie thinks China is/was now ie selling things to the rest of the world because of the credit binge, the most recent of which surely eclipses the former. Do you?