Richard Koo, famous analyst at Nomura is out with a new report on Cyprus. He worries about the response and believes that Europe is taking the wrong approach. Koo notes:
The standard approach is simply not applicable during a systemic financial crisis, when large numbers of banks face the same problem—instead, the entire system must be rescued. During the Latin American debt crisis of the 1980s, for example, the US managed to avoid both credit crunch and any losses for taxpayers by spreading the cleaning up over a decade. And in the wake of Lehman’s collapse in 2009, US authorities adopted a policy of “pretend and extend” for commercial real estate loans under which banks were instructed not to call in loans that no longer satisfied credit standards. That action helped prevent further declines in real estate prices.
Japan’s post-bubble period, the Ministry of Finance’s decision not to require rapid write-offs of bad loans helped Japan avoid a severe recession, apart from when it embarked on premature attempts at fiscal consolidation.
The Eurogroup’s adoption of a strategy with the potential to destroy people’s trust in the banking system is a dangerous move, in my view. If the concerns sparked by this announcement were to spread from Cyprus to countries such as Spain and Ireland, where falling real estate prices have left the financial system in tatters, the eurozone could face a new and far more dangerous phase in the financial crisis.
The most entertaining part of the report from Richard Koo is regarding Germany. Germans commonly complain that they should not be forced to bail out the ‘lazy’ Southern Europeans. Although Koo does not say it in these words he essentially states that Germany was once the ‘lazy man of Europe’. His provocative argument can be found below (Koo first starts off with a brief explanation of the German economy post tech bubble):
Eurozone clings to “structural reforms” without understanding cause of recession
Another worrying phenomenon in evidence both in Italy and in Germany, where I participated in a policy debate late last year, is that many pundits and policymakers seem to feel that “structural reforms” are the answer to everything.
Lacking a fundamental understanding of the problems in the eurozone, they tend to blame everything on insufficient structural reform. Faced with a situation in which monetary accommodation is powerless and fiscal stimulus is only temporarily effective and unable to prime the economic pump, many assume that structural problems must be the reason why standard macroeconomic policies are not working.
But there are two factors that can render monetary and fiscal policy impotent: structural problems and the impairment of private sector balance sheets following the collapse of an asset price bubble.
In the latter case, the private sector is forced to minimize debt and stop borrowing even if interest rates drop to zero, rendering monetary policy powerless. And although government borrowing and spending will give a temporary boost to GDP, the economy will turn down again as soon as the stimulus is discontinued because the private sector cannot engage in forward looking behavior until its balance sheet repairs are complete.
Here is the kicker paragraph. Presented without any commentary (except the ‘bolding’):
Structural reform arguments also surfaced in post-IT bubble Germany
Structural reform arguments also surfaced in post-IT bubble Germany When Germany was dealing with the aftermath of the IT bubble that collapsed in 2000, the economy’s unresponsiveness to ECB accommodation prompted many to pin the blame for the nation’s economic slump on structural problems. Germany proceeded to engage in a variety of structural reforms but the economy failed to recover.
Many Germans were upset, demanding to know why the economy had not improved even though the nation had implemented all the structural reforms it had been asked to.
In the end, ECB monetary accommodation intended to rescue Germany had the effect of fostering asset bubbles in the eurozone periphery, and Germany pulled out of its balance sheet recession by boosting exports to these overheated markets.
Ironically, the Germans are now complaining about the lazy southern Europeans who refuse to implement the tough structural reforms that enabled Germany to become so competitive. They do not realize that the ECB effectively sacrificed Europe’s periphery whose balance sheets were not affected by the IT bubble in order to save the German economy. Their confusion is born of a lack of understanding of balance sheet recessions.
Fortunately, Fed Chairman Ben Bernanke in the US and FSA Chairman Adair Turner in the UK now know what a balance sheet recession is, and there is a growing recognition that the recessions in these two economies are attributable to private-sector deleveraging and not to structural problems.
