Koo: Europe Must Treat its Pneumonia, Ignore the Diabetes
Richard Koo made some interesting comments in his latest research piece making an appropriate analogy for the Euro crisis:
“Eurozone suffers from both pneumonia and diabetes
…I said the eurozone was currently suffering from two diseases—pneumonia and diabetes—an analogy I drew on frequently in Japan more than a decade ago. Structural reforms are akin to a treatment for diabetes patients, who must eat carefully and exercise more to improve their long-term physical condition.
A balance sheet recession, on the other hand, is more like pneumonia. If it is left untreated, the patient’s condition can deteriorate rapidly. The patient can even die if proper treatment is not administered in the first three days. These two illnesses sometimes occur simultaneously, which complicates matters because the treatments are in a sense contradictory. Diabetes sufferers must restrain their intake of food, while pneumonia patients can die without ample nourishment.
Eurozone should treat pneumonia first
When the two diseases occur together, the physician must give precedence to the pneumonia, which demands immediate treatment. The diabetes can be left for later. I added that regardless of what may be appropriate for Greece, where problems are due to previous governments’ fiscal profligacy, insisting on austerity for Spain, Portugal, and Ireland is the wrong answer. It will only cause conditions to worsen. This conclusion was utterly different from what my hosts had in mind, but I added two examples from Japan and the US: the austerity policies implemented by the Hashimoto government in 1997 and Federal Reserve Chairman Ben Bernanke’s recent warnings about the so-called fiscal cliff.In the former case, the Hashimoto government chose to increase taxes and cut spending at a time when the private sector was minimizing debt in spite of zero interest rates. The economy duly collapsed, sending the fiscal deficit from ¥22trn in 1996 to ¥38trn in 1999, an increase of 68%. It took Japan nearly a decade to bring the deficit back to its starting level. In the latter case, the Fed chairman, who has demonstrated an understanding of the dangers of a balance sheet recession, used the powerful metaphor of a “cliff” to warn Congress about the dangers of engaging in premature fiscal consolidation. Finally, I noted that the Cameron government, which came to power in the UK on a platform of bold fiscal retrenchment, is now seeking to change direction after watching the local economy behave in an entirely unexpected fashion.
To sum up my impressions of Berlin, German politicians are starting to question the strongly held beliefs that have brought them this far. This marks a change from the situation just a year ago, when policymakers were still brimming with confidence. Some of them even said last week that they needed to spend more time studying the experiences of Japan and other countries.
But at the same time they lack their American and British counterparts’ understanding of balance sheet recessions, and rectifying this will take time. I therefore expect German policymakers will continue to focus on treating the patient’s diabetes while largely ignoring his case of pneumonia.”
I’m not sure I love Koo’s analogy here though since I believe it too misses the real disease. The balance sheet recession is a symptom of a larger issue – the unworkable currency system. So curing the balance sheet recession (for instance, with government deficits via lower taxes or higher spending) doesn’t necessarily fix the real problem. The fact is, the Euro currency was designed to fail since it’s a single currency system with no floating exchange rates and no supranational entity to eliminate the solvency issue at the national level. So balance sheet recessions are inevitable in such a monetary system. But fixing the BSR doesn’t fix the currency system necessarily. So I’d say the pneumonia is a symptom of a disease that is much more dangerous. We can fix the pneumonia now, but given the flawed currency system, it’s guaranteed to come right back.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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9 Comments
Koo is infatuated with his balance sheet recession idea. So I think he’s biased to conclude that all of the world’s problems today are BSR’s. But I think you’re right here. The BSR is a symptom. Not the cause.
It’s possible to do both. Fix the BSR and fix the currency with one policy change. Eurobonds would do the trick.
Agree. But fixing the currency union and solving the BSR are two different things. Ultimately, you have to fix the broken currency union.
Besides the fact that eurobonds in whatever disguise are violating the Mastricht and Lisboa Treaties (which doesn’t count much because nobody cares), they are also strictly against the German and various other EZ constitutions (which counts a lot), and of course against the interests of the taxpayers in the creditor nations like Austria, Netherlands, Finland and Germany (which will count more and more, considering that these people are increasingly fed up with -basically- subsidizing the lifestyles of others and keeping zombie banks all over the EMU alive.
With eurobonds one might satisfy ‘the markets’ for some time but in parallel they make an enemy of 120 million or so of EMU people vs. the rest. Is that what you want? If you don’t sooner or later want a war between the ClubMed and the rest of the EMU, forget forever the out of touch with reality ideas of mutualization and socialization of the solvencey problems of the ClubMed’s banks, nations and people.
The EMU can’t be fixed. So it should be dismantled, asap. Which should have been done years ago (or even better, the dangerous thing should never have been started in the 1st place).
The EMU can be fixed permanently by transforming Europe into a New Roman Empire. An totalitarian Dictatorship ruled by one Caesar with absolute power. Any group who rebels against necessary policies would simply be put down like a rabid dog under a Dictatorship. This was the intention of the EU’s founders, and if the Europeans want to fix the Euro, they have to finally realize their Founder’s dream.
Heartily disagree. Europe’s founders, far from wanting a dictatorship, sought something even more unimaginable: a perfect balance of states among which no single state could dream of hegemony, and thus would never resort to military aggression. Dictatorships, with a few exceptions, tend to fall apart at the seams faster than anyone expects. Ask the junta in Myanmar, for example. North Korea is a case unto itself, at least for now. But multicultural dictatorships have a very limited shelf life.
IMO, it’s not much of a stretch to say that the Euro is doing exactly what it was designed to do.
In other words, it was created along the lines of Austrian economic theories, as a sort of artificial gold standard. It would intentionally force austerity if/when government spending got out of line.
Back in the day, I was strongly in the Austrian mode of thought. So I thought this was borderline genius. Nowadays, not so much (Thanks, Cullen!)
I’m concerned that there are probably millions of Europeans who are still thinking, “See, this is the way things were supposed to work. Everything is going as planned!”
Austrian theory didn’t get its name because it was developed in Argentina. Just sayin….
The problem with Koo’s analogy is that the current problem is nothing like pneumonia, and the necessary moves are nothing like it’s treatment.
The European “illness” has been around for years while the treatment has been, and continues to be, insufficient. If the Euro-crisis were like pneumonia the patient would already be dead.
Koo and C.R. are both infatuated with their BSR. The BSR (as many times stated before) is the result of the private sector having too much debt and being unable to service that debt (interest payments). But yet they both attribute the mess in Europe’s to the flawed monetary system. And the problems like in the US only became only worse when the economy went into “a recession”.
That’s why rising interest rates are so toxic. That increases the interests costs for those debtors. Remember what happened from 2004 to 2006 with short term interest rates and what it did to the subprime mortgages interest payments ? I remember a case where the interest rate on a mortgage went up from 4% (in 2004) to 8% (in 2006).
The US , Europe, China and Japan all need structural reforms but there’re too many vested interests that block those reforms. Write off (a lot of) debt and the economy can recover again.