Richard Koo: Eurozone Still in Severe Balance Sheet Recession

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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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