Summary: Whatever happens during this recession, one thing is almost certain: the US government’s balance sheet will be trashed. Wrecked, perhaps beyond repair. This post discusses what we should do to mitigate the damage, and why such extreme spending is necessary.
As described in “The most important story in this week’s newspapers” (22 May 2008), the government has borrowed $6.4 trillion to finance past expenditures (aka “net public debt”, posted here). The government — us, collectively — owe an estimated $57 trillion in past promises to pay (the debt) AND future promises (social security, government pensions, medicare, etc).
That’s bad, perhaps beyond our ability to pay by means of future taxes. The alternatives are stark:
- cut expenses — the budget consists almost entirely of interest, defense/security, and social services.
- renege on our promises — cutting pensions, social security, medicare via taxation of benefits, and means-testing).
- inflation — reducing the debt in real terms.
- big tax increases.
None of these are easy or certain remedies. All may be necessary, and even together might be inadequate.
The worse news: we will run massive deficits over the next few years. Deficits of one or two trillion dollar deficits, for at least two or three years. Perhaps, if we continue to follow Japan’s path, for ten years or more. Since the boomers are already staring to retire — and the recession will force many into involuntary early retirement — this a bad time to be adding to the government’s debt load.
This makes it vital that we make good use of the government’s spending. We must focus on things that will generate cash in the medium-term to help pay-off the debt we are incurring.
Unfortunately the debasement of the English language (alternatively, its replacement by Newspeak) makes clear thinking difficult for us. Many folks have lost the idea that investment means spending cash to generate even more cash in reasonable short time with reasonable certainty. Instead they believe “investment” means “spending on things I like and hope will make the world a better place.” That way lies bankruptcy and ruin for our political regime, because this might be a very long downturn.
I strongly recommend reading the following, one of the most insightful essays about this crisis I have seen. These are words representing hard-earned experience, which we can either learn from — or repeat Japan’s mistakes. This is another powerful presentation from the Center for Strategic and International Studies (CSIS). Koo draws on Japan’s experience in the twenty years since their crash, explaining why the US might require years of massive fiscal stimulus — government spending — to keep the economy on life support until the private sector burns off its excess debt.
“‘Plan B’ for the Global Financial Crisis“, Richard C. Koo (Chief Economist of the Nomura Research Institute, Tokyo), presentation at the Center for Strategic and International Studies, 22 October 2008 — Here is a PDF of his slides. Bold emphasis added. Excerpt:
The on-going financial and economic difficulties in the US have not only defied many earlier forecasts of quick recovery, including those from the Fed, but are also showing signs of stress that many experts are calling the worst since the Great Depression. The ever worsening outlook, in turn, is multiplying the fear of both market participants and the general public, greatly worsening the deflationary pressure in the economy. The fact that European and Chinese real estate bubbles are also bursting at the same time is adding a global dimension to the problem.
The US (and the world) is extremely fortunate, however, in that Japan, the second largest economy in the world, had gone through something very similar just 15 years earlier, and its experience can tell us volumes about what to expect and what not to expect in this kind of recession. Although many Americans may balk at the idea that the US has something to learn from Japan, the truth of the matter is that the magnitude of the house price bubble in the US from 1999 to 2006 (138% increase) is virtually identical to the one Japan experienced between 1984 to 1991 (142% increase). Furthermore, according to the house price futures listed in Chicago Mercantile Exchange, the magnitude of the decline in house prices (33% decline from the peak in 4 years) will also be similar to the Japanese experience (37% decline from the peak in 4 years) 15 years earlier. This is shown in Exhibit 1.
Similarities do not end there. The largest estimate of losses financial institutions may incur in the current crisis was provided by the IMF in its October 2008 Global Financial Stability Report, which placed the price tag at $1.4 trillion of which $820 billion would be incurred by banks. The latter amount is close to the total non-performing loans Japanese banks wrote-off during the post-bubble period which was $952 billion at the exchange rate of 105 yen to the dollar.
Although the US has not experienced a “lost decade” yet, many signs are far worse in the US this time around compared to Japan 15 years ago. For example, the well criticized Japanese banking problems in the 90s never got to the point where the central bank has to enter the market for an extended period to make sure that banks are able to meet their daily payment responsibilities. In both the US and in Europe this time around, however, the lack of trust between the banks are so serious that central banks have been forced to provide liquidity directly to the banks for over a year, with no end in sight.
Although there are many differences between the Japanese and US experiences, the Japanese lessons provide the nearest thing to a roadmap of post-bubble-2 economy, and US policy makers will be able to greatly shorten the pain and suffering of the American people if they put those lessons to good use. In particular, the Japanese experience taught us that recessions brought about by the bursting of a nation-wide asset price bubble are fundamentally different from ordinary recessions in many key aspects
First, the bursting of a bubble invariably mean destruction of many private sector balance sheets as assets bought with borrowed funds collapse in value while the debt incurred to purchase those assets remain at their original values. Many businesses and households may find themselves with negative net worth. When these businesses and households start paying down debt or increase savings in order to regain their financial health and credit ratings, the economy enters what may be called “balance sheet recession” where monetary easing by the central bank fail to stimulate the economy or asset prices. Monetary policy loses its effectiveness because those with debt overhangs are not interested in increasing borrowing at any interest rate.
The Bank of Japan brought interest rates down from over 8% in 1991 to almost zero in 1995, but there was absolutely no response from the economy or asset prices which continued to weaken. Bernanke Fed brought interest rates down from 5.25% in September 2007 to 2% by April 2008 in the fastest monetary easing in Fed’s history, but the economy and house prices continued to fall. With so many banks and households in the US worried about the health of their balance sheets, further monetary easing by the Fed is likely to fare no better than the Japanese easing to zero interest rates 15 years earlier.
{FM Note: the actual Federal Funds rate has been from 1/4% to 1/2% rate since October 29, far below the “policy rate” of 1%.}
With nobody borrowing money and everybody paying down debt or increasing savings, even at zero interest rates, deflationary spiral becomes a real possibility in this type of recession. This is because those savings and debt repayments that are not borrowed and spent represent leakage to the income stream, and if left unattended, the economy will continue to lose aggregate demand equivalent to the unborrowed amount until either private sector balance sheets are repaired, or the sector has become too poor to save any money. The US fell into this spiral during the Great Depression, the worst balance sheet recession in history, and lost 46% of its GDP in just 4 years. Unemployment rate also rose to 25% by 1933.
… The Japanese GDP never fell in spite of massive fall in asset prices and massive increase in private sector debt repayment because the government borrowed and spent the increased savings and debt repayment. With the government actively putting this sum back into the income stream through its fiscal policy, there was no reason for the GDP to contract. In other words, Japan proved to the world that, even if real estate prices decline by 87% and the private sector is obsessed with debt minimization instead of profit maximization, it is still possible to keep the GDP from falling as long as government puts in an appropriate sized fiscal stimulus from the beginning and maintain that stance until private sector balance sheets are repaired.
… This means the key macro policy response in this type of recession should be an increase in government spending to keep the GDP from falling so that households and banks have the revenue to repair their balance sheets. Micro-economic responses, such as what to do with Fannie Mae or AIG are important, but they are no substitute for a comprehensive macro-economic response to maintain GDP because without revenue, no attempt to repair private sector balance sheets will succeed. Monetary easing is probably better than nothing, but it should not be relied on as the principle policy response when the private sector is minimizing debt and is in no position to respond to lower interest rates.
Not everything went well in Japan. Because the concept of balance sheet recession was not yet known in economics in the 90s, trial-and-error with largely ineffective monetary, structural and other policies continued. Moreover, because of the lack of conceptual understanding, the critical importance of fiscal policy in maintaining income stream in this type of recession was never fully appreciated, with the result that every time the economy showed signs of recovery with fiscal stimulus, it was assumed that the conventional pump-priming worked and the stimulus itself was cut “in order to rein on budget deficit.”
But no sustained recovery is possible in a balance sheet recession without the recovery of private sector balance sheets, and premature withdraw of stimulus invariably resulted in economic downturn. That prompted another fiscal stimulus, only to see it cut again after the improvement in the economy. This stop-and-go fiscal stimulus lengthened the total time of Japan’s recession by at least five years if not longer. A similar premature withdraw of fiscal stimulus in the US in 1937 also lengthened the duration of Great Depression until the onset of World War II.
The US will do well to make sure that this mistake is not repeated. In particular, Washington should enact a medium term (at least three to 5 years) seamless package of government spending to assure the public that they can count on the government to keep the economy going for the entire period. Such a commitment will go a long way in removing the fear of falling into a deflationary spiral and allow the private sector to plan for an orderly repair of its balance sheets. This stance of the government should be maintained until people are willing to borrow money again. If and when that point is reached, the government must embark on fiscal consolidation in order to avoid crowding out private sector investments.
Although more government spending means larger budget deficit, the Japanese experience indicate that the deficit will be far larger and the economy far weaker if the government failed to put private sector debt repayment and savings back into the economy’s income stream. The Japanese attempt in 1997 to reduce deficit, for example resulted in 5 quarters of negative growth and shocking 72% increase in budget deficit by 1999. The 2001 attempt to rein on deficit also resulted in weaker economy, falling tax revenue and larger deficit. These perverse results happen because in the absence of private sector investment demand, any reduction in government demand translates almost dollar-for-dollar to the reduction in aggregate demand, thus starting the deflationary cycle. In other words, in this type of recession, pro-active fiscal policy will result in higher GDP and lower deficit than reactive fiscal policy implemented after the economy had already collapsed.
Some may worry that, with savings as low as they are in the US today, who will buy the Treasury bonds issued to finance additional government spending? Some analysts argue that such concerns will raise interest rates in the US. Viewed from the perspective of balance sheet recession, however, these concerns are exaggerated. In this type of recession, the economic weakness is due to the private sector paying down debt or increasing savings in spite of ultra-low interest rates. The excess savings of the private sector therefore increases, and the economy weakens because no one in the private sector is willing to borrow and spend that money. Under these circumstances, the amount of borrowing and spending the government must engage in to keep the GDP from falling should be exactly the same as the sum of increased savings and debt repayments in the economy. As long as the fiscal stimulus is equal to the increase in private sector savings, it should not cause funding problems or lead to higher interest rates.
Koo continues on to discuss other aspects of this crisis. I recommend reading this in full, along with the slides.
Afterword
If you are new to this site, please glance at the archives below. You may find answers to your questions in these.
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To read other articles about these things, see the FM reference page on the right side menu bar. Of esp relevance to this topic:
- about the Financial crisis – what’s happening? how will this end?
- about the End of the post-WWII geopolitical regime
- some Good News about America!
Forecasts on the FM site about solutions to the crisis:
- A happy ending to the current economic recession, 12 February 2008 – The political actions which might end this downturn, and their long-term implications.
- A solution to our financial crisis, 25 September 2008
- A quick guide to the “Emergency Economic Stabilization Act of 2008″, 29 September 2008
- Prof Roubini prescribes first aid for America’s economy, 4 October 2008
- Effective treatment for this crisis will come with “The Master Settlement of 2009″, 5 October 2008
- Dr. Bush, stabilize the economy – stat!, 7 October 2008
- The new President will need new solutions for the economic crisis, 9 October 2008
- A brief note about our financial system: Intermediation, disintermediation, and soon re-intermediation, 16 October 2008
- New recommendations to solve our financial crisis (and I admit that I was wrong), 23 October 2008
- A look ahead to the end of this financial crisis, 30 October 2008
- Expect little or nothing from meetings like the G20 – or the Obama Administration, 18 November 2008