From an April 2010 presentation by economist Richard C. Koo:
“If you try to reduce government spending [in a balance sheet recession] environment, unless you are absolutely certain that…the money the government refused to borrow will be borrowed and spent by the private sector quickly…fiscal reform will fail.”
You can watch the presentation here, and view the accompanying slides here. Koo’s message, based on his study of Japan and the Great Depression, cannot be overstated in the current economic environment, with Europe embarking on widespread austerity, rising deficit hysteria in the U.S., the IMF counseling mature economies to cut spending and raise taxes, and hyperinflation hysteria going viral.
IN A BALANCE SHEET RECESSION, PREMATURE FISCAL REFORM WILL FAIL. It’s a simple but critically important observation. If the private sector desires to repair its balance sheet (and society wishes to avoid severe deflation and serial default), then the public sector must run deficits until the private sector is willing and able to pick up the slack again.
In addition to Koo’s data on Japan, exhibits 22 and 23 are interesting – the double dip in U.S. employment in 1937-38 followed federal budget tightening that started in 1936 — and in Germany, unemployment fell like a stone from 15% to under 5% thanks to government deficits of 5-15% of GDP (discomforting evidence that there were material economic reasons for the Nazis’ electoral success — we pray that no country’s political landscape will have to shift that radically again to break away from punitive policy measures).
[UPDATE 5/25/2010 - Marshall Auerback has pointed out to us that comparing U.S. and German economic statistics from the 1930s is fraught with peril. For example, German figures counted labor camp prisoners as 'employed', while U.S. statistics did not count workfare recipients given their novelty; see Marshall's "Time for a New 'New Deal'". If anyone who knows Richard Koo reads this, you might want to pass it along to him.]
We’d also point out that if our suspicion that demographic cycles are a significant factor in balance sheet cycles is valid, then any near term movement towards fiscal tightening in the U.S. would be about ten years too early — smaller deficits might be appropriate, but a balanced budget or surplus would be rather destructive.
If Koo and deflation phobes are right, then gold is the latest bubble; if inflation phobes are right, then Treasuries and the USD are. Both camps can look at the data to make their case. But in our view, only one camp makes a sound argument about the underlying financial and behavioral conditions, and in a ‘real’ (i.e., non-monetary) sense it has strong support from research on demographic cycles.
We continue to believe that we are in a Keynesian historical moment. But as long as Democrats continue to agitate for PAYGO and higher taxes, they are likely to cede a good deal of control to Republicans and their spending cuts.
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