Richard Koo of Nomura is out with a new report on the US economy, Europe and on Japan again (of coursE). Below as some excerpts from the latest note.
The policy-setting committees of central banks in the US, the UK, and Europe all met last week, and on Friday the official July jobs report was released in the US. Although the unemployment rate fell to 7.4%, the reported gain of 162,000 nonfarm jobs was below expectations and past numbers were revised downward. All in all, the report was not a particularly strong one.
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Richard Koo: Eurozone economic data offer little cause for optimism
While industrial output in Germany is still at 2007 levels, France and Spain are producing no more than they were in 1994, and in Italy output has dropped to the levels of 1986.
In the US, industrial production fell to 1997 levels in the aftermath of the Lehman Brothers collapse, but steady gains since then have brought output back to where it stood in 2007. In Japan, output collapsed to 1983 levels in the immediate aftermath of the financial crisis and took a further hit from the Tohoku earthquake in March 2011 but has since recovered to 2002 levels.
Shifting our focus to employment, the unemployment rate for the 17 eurozone economies stood at an all-time high of 12.1% in June vs. figures of 7.4% for the US (July) and 3.9% for Japan (June). Japan’s job offers-to-applicants ratio of 0.92 (June) was also the highest seen since 2005.
All in all, conditions appear to be relatively strong in the US and Japan, while Europe remains in deep trouble, with little cause for optimism at the moment.
Richard Koo: Eurozone still in severe balance sheet recession
While Mr. Draghi repeatedly noted that the ongoing recession is due to “necessary balance sheet adjustments,” he continued to argue in favor of fiscal consolidation, which is counterproductive in a balance sheet recession.
If the government stops borrowing and spending at a time when the private sector has given up borrowing for saving, there is no reason why eurozone economies should improve—if anything, they are likely to continue weakening.
As the ECB president noted, significant progress has been made on financial sector issues such as deposit outflows and the lack of trust between financial institutions, which suggests the negative feedback loop between the financial sector and the real economy is rapidly becoming a thing of the past.
But private loan demand remains depressed in spite of these improvements, as Mr. Draghi acknowledged, and under such conditions a recovery in the real economy is unlikely unless governments do more to borrow and spend the unborrowed savings of the private sector.
Richard Koo: Is 1% inflation too low?
In the US the Fed has been mulling an end to quantitative easing since May, but some argue that QE3 should be continued since US inflation has slipped below 1.5%. Fed Chairman Ben Bernanke has noted the low inflation rate on several occasions, suggesting that he, too, is worried about it.
Econometric analysis has shown that the 2% inflation rate being targeted by the Fed results in the highest level of real GDP growth. That supports the argument that inflation is too low in the US and that the Fed should leave its easing policy in place.
Year-over-year change in the core personal consumption expenditures (PCE) deflator, which excludes food and energy and is said to be the Fed’s preferred measure of inflation, has slowed from just under 2% in mid-2012 to 1.22% in June, roughly where it stood in early 2011 when the Fed was warning of deflation.
A related issue is that price statistics do not properly measure the deflationary effects of technological innovations, which allow products with similar performance to be purchased for less. Some argue that when this tendency is taken into account, a reported rise in prices of around 2% is effectively equivalent to zero inflation, which means a rate of 1.22% is indeed cause for concern.
Richard Koo: Is inflation a boon for consumers?
I have no problem with the argument that some inflation is good for the economy because it encourages people to spend. But I do not think it follows that the financial authorities should therefore target the inflation rate.
There are two issues here. One involves the extent to which people’s living standards will improve in an economy growing because of inflation. The other is whether it is possible to justify the costs of such central bank action. Regarding the first, consider the people who in a non-inflationary world would have focused solely on doing their jobs but, faced with the prospect of inflation, begin thinking about buying real estate as a hedge. Their real estate purchases keep money flowing in the economy and, by pushing real estate prices higher, may lift economic activity via a wealth effect.
But there is also a major cost involved—the time and energy that these people would otherwise have invested in their jobs is directed instead to a field—real estate investment—in which they have little or no experience, detracting from their main occupations.
Richard Koo: The division of labor and the role of money
This point is important because it is only because of a sophisticated division of labor that humanity has achieved such tremendous gains over the years in specialization and productivity, thereby enabling its steady advance.
Richard Koo: Inflation concerns undermine division of labor
Inflation concerns detract from the division of labor that drives economic development by forcing people to spend time thinking about matters unrelated to their specialties.
Richard Koo: Inflation worries also affect satisfaction and utility derived from consumption
Put differently, hasty purchases made under the threat of an inflationary gun may not deliver the same degree of satisfaction or utility as expenditures made without such pressure. The notion that we should foster inflation expectations to increase spending is based on the dubious assumption that all expenditures always result in maximum utility, regardless of price trends.
Richard Koo: Utility of consumption in inflation-free Japan may have been high
I do not know whether the data needed for such estimates are available today, but if they were, I think we might find that meaningful GDP growth rates were actually higher in countries with low inflation, like Japan and Switzerland, than in countries with higher inflation like the US or the UK.
If Japan had been facing severe deflation, the value of money would have been destabilized in the other direction, and the sharp increase in the real value of debt could have weighed heavily on the economy, as pointed out by economist Irving Fisher in the 1930s. But such worries are entirely unwarranted with the sub-1% rates of deflation Japan experienced over the past two decades
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Volatility
Richard Koo: Per capita GDP more important as population ages and shrinks
If our focus changed in this way, we would be seeking an environment that allows everyone to make the most of their specialized skills within the division of labor. In such a world, I think the current monetary policy approach of having central banks pursue a 2% inflation rate because that has been shown to maximize GDP growth in the past will run up against a wall at some point.
Richard Koo: QE should not be taken any further
The surge in the 10-year yield came on the mere mention that the Fed might reduce its purchases of bonds. If the central bank were to actually begin selling the securities it has accumulated, rates would probably react much more violently. Making matters worse is the fact that bank reserves injected into the system under QE already amount to 17.8 times the statutory reserves needed to sustain the US money supply. In other words, the Fed has a long way to go.
Richard Koo: QE has limited impact and is difficult to unwind
That the inflation rate is falling in spite of excess reserves equal to 17.8 times statutory reserves is proof that this policy has had little, if any, impact. The reason is that the US private sector (households + businesses + financial institutions) is not borrowing—in fact, it is saving 6% of GDP despite zero interest rates.
Richard Koo: Normalizing bank reserves could prove headache for next Fed chair
News reports indicate the two leading candidates to replace Ben Bernanke as Fed chair are Vice Chairwoman Janet Yellen and former National Economic Council director Larry Summers. Neither will have an easy time bringing back to more normal levels the excess reserves created in such abundance during Mr. Bernanke’s tenure.
Richard Koo: Treasury’s cooperation should be enlisted in ending QE
If the Fed begins selling long-term Treasurys at a time when the private sector has completed its balance sheet repairs and is starting to borrow money again, the result will almost certainly be a steep rise in interest rates that could stop the long-awaited economic recovery in its tracks.
Richard Koo: Fed should first shift portfolio from long-term to short-term bonds
When the BOJ ended its first experiment with QE in 2006, banks held deposits with the central bank equal to seven times statutory reserves. But since all of these funds had been supplied via the money market, the impact on long-term interest rates when the funds were absorbed (again via the money market) was limited. The 10-year JGB yield rose about 40bp when the removal of QE was announced but returned to its previous level within a few months.
Richard Koo: Consumption tax hike becomes focus of debate
Turning to Japan, the question of whether the government should raise the consumption tax rate as scheduled next April has become a key topic for debate. Some argue that the tax must be raised given the size of the national debt. Others say that raising the tax just as the economy is starting to pick up risks repeating the Hashimoto government’s
mistake in 1997 and could result in the loss of everything.
Some of the tax hike proponents say that if the government does not raise taxes it will lose the markets’ trust and prompt a crash in the bond market. But if so, they need to explain why the JGB market has not crashed yet despite a government debt pile that has grown to 240% of GDP.
Richard Koo: Fiscal consolidation in 1997 was premature
JGB prices have not collapsed despite repeated warnings from the fiscal austerity crowd because, as recent flow-of-funds data show, Japan’s private sector is not only not borrowing but is actually saving more than 9% of GDP, and that at a time of zero interest rates.
With no borrowers in the private sector, most of the nation’s unborrowed savings must be lent to the only borrower left standing—the government—and that is why JGB yields have fallen to levels that would be unthinkable under ordinary circumstances.
Japan has successfully avoided falling into a deflationary spiral also because the government has borrowed and spent those excess private savings. Had it not done so, the economy would have contracted by an amount equal to the unborrowed savings, potentially leading to a Great Depression.
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Japan’s news media ten years ago were caught up in the nonsensical argument put forward by the “reformist” camp that the government had pledged to the international community to bail-in depositors by capping deposit insurance. Not only did a senior Finance Ministry official testify that there was no such pledge, but there had been not a murmur of protest from abroad in spite of the fact that Japan had repeatedly delayed imposing such a cap.
Richard Koo: Hit from tax hike can be offset with fiscal stimulus
So is it possible to raise the consumption tax and still sustain the economic expansion? The answer, of course, is yes. All the government needs to do to offset the negative impact of the tax increase is to implement sufficient fiscal stimulus at the same time.
Richard Koo: Hashimoto government offered only austerity in 1997
The Hashimoto administration’s consumption tax hike in 1997 was in fact just one part of a four-pronged plan aimed at cutting the deficit. The three other measures involved scrapping a special tax cut, shelving a large-scale supplementary budget, and increasing the share of social security costs borne by the public.
The original aim of this plan was to reduce the deficit by ¥15trn or 3% of GDP. But because the government reduced its borrowings and spending at a time when the private sector was saving nearly 6% of GDP (in spite of zero interest rates), the economy fell into a severe recession and contracted for five consecutive quarters, based on data available at the time.
In other words, the consumption tax hike was not the sole cause of the recession—the other three measures also weighed heavily on the economy.
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If the Hashimoto government had only accompanied the tax hike with a corresponding stimulus package, I doubt things would have turned out as they did.
Ideally, tax hike would follow resumption of private-sector borrowing…
In an ideal world, of course, the government would implement measures aimed at encouraging private-sector borrowing and spending—such as accelerated depreciation schemes or tax breaks for investment—and raise taxes only after those measures have taken effect. But if political considerations prevent that, the government needs to administer an accompanying economic stimulus large enough to offset the adverse impact of the tax hike.
Another tax hike failure is unacceptable
The increase in the consumption tax rate to 8% is only a stepping stone. A further rise to 10% is scheduled for October 2015 and is unlikely to be the last—ultimately I expect the tax rate will have to be raised to 15% or 20%. Given the long journey ahead, the Ministry of Finance almost certainly wants to avoid the kind of failure experienced in 1997.
Not only did that experience prolong Japan’s balance sheet recession by at least five years, but it prevented subsequent governments from raising the consumption tax for the next fifteen years.
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Another ’97-like failure could prevent the consumption tax from ever being raised, with severe negative implications for Japan’s future.
