Richard Koo Roller coaster ride for bond market participants 12.14.10

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Nomura, Richard Koo: Roller coaster ride
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  • 1. Richard Koo: Roller coaster ridefor bond market participants Nomura Securities Co Ltd, Tokyo Japanese Equity Research – Flash ReportRichard Koo 14 December 2010 The world’s bond markets have been on a two-week roller coaster ride. The week before (issued in Japanese on 13 Dec 2010) last, the US jobs report appeared to show clear signs that any recovery in the labor market would be delayed. But that was followed last week by the announcement of an agreement between President Obama and the Republican Party that was seen as Please read the important having positive implications for the economy. disclosures and disclaimers on The November payrolls report, released on Friday, 3 December, came in below market pp. 9-10 gl expectations. However, some attributed the weak results to excessively strong October data, and the general view seemed to be that the results for October and November should be viewed together. * Surprise agreement between President Obama and Republican Party The suddenly announced agreement between President Obama and the Republicans came as a surprise to many. The president secretly negotiated this deal with key Republican officials without consulting senior officials in his own party. News of the agreement initially sparked a heavy sell-off in the bond market. The resulting rise in yields was large enough to suggest that the downtrend in interest rates was finally over. The sell-off also led to higher mortgage rates. The agreement contains broad-ranging economic stimulus in the form of a two-year extension of the Bush tax cuts for all taxpayers, including high earners, full expensing of investments, an extension of unemployment insurance, and a reduction in payroll taxes. I do not think the extension of Bush tax cuts themselves will spark an economic recovery—after all, those tax cuts were unable to prevent the current recession. Most of the increase in unemployment insurance benefits will probably be earmarked for consumption, but it is difficult to tell how much the payroll tax cuts will boost spending. With the US household sector still deleveraging, I project that most of the tax cuts for that sector will either be saved or used to pay down debt. On the other hand, full expensing and other provisions may help. The IMF estimates the plan would lift US GDP by about 1%. Altogether, the package can be expected to provide a certain amount of support for the economy (compared with a situation in which nothing was done), although it remains to be seen whether the Democrats will approve all of the measures. * Use of credit cards in US drops precipitously Thanksgiving Day, the third Thursday in November, marks the start of the Christmas shopping season. This year saw the lowest use of credit cards in the 27-year history of the survey. Only 17% of US consumers used credit cards during this period, down nearly half from the corresponding ratio for 2009. On a quarterly basis, credit card use in Q3 was off a full 11% from the same quarter a year ago. This is especially noteworthy given that the economy was already extremely weak in 2009 Q3. Part of the reduced activity, of course, is attributable to stricter card issuance standards adopted since the financial crisis, which are said to have caused 15 million Americans to lose their credit cards. More recently, however, credit card companies’ attitude towards lending has undergone a change. With profits depending on people using credit cards, issuers are now engaged in a fierce competition and have unveiled a variety of incentives to encourage consumers to make greater use of their cards. However, there has been little response from consumers, reflecting the continued efforts of US households to minimize debt. Nomura 1
  • 2. 14 December 2010* Collapse of housing myth and rising US household savingsLast week I was talking with someone I met at a certain store in New York who insistedhe would never use that store’s credit card again. I asked why, because I happen tocarry the same card and have been very happy with it. He answered that he had spenttoo much with the card and now regretted it terribly.Many US consumers now find themselves in similar circumstances, and that is reflectedin the credit card usage data noted above.I attribute this change in sentiment to concerns driven by the high unemployment ratecoupled with the fact that US housing prices, after going 70 years without ever dropping,have declined substantially, leaving many people owing more than their homes are worth.This marks a 180° turnaround from the world in which steadily rising home pricesrepresented a form of savings. Now, instead of increasing, these “savings” are in manycases shrinking.Japan’s real estate myth began with the end of World War II and lasted 45 years, and itscollapse had a major impact on consumers’ behavior. The US housing myth was alive fora full seven decades. Accordingly, we should not underestimate the psychological shockresulting from its collapse.* US tax deductions for various types of interest continued from Great Depressionto 1970sSome market participants believe that with the US household savings rate as high as it is,savings are more likely to decrease than increase going forward, and that a reducedsavings rate would quickly spark a recovery in the US economy. But if the currentincrease in US household savings is driven by the collapse of a 70-year housing myth, Ithink US consumers’ propensity to save may well remain at elevated levels.Americans who lived through the Great Depression, which began with the stock marketcrash of 1929, experienced a long-term trauma that left many of them insisting theywould never again borrow money.This aversion to debt caused the after-effects of the balance sheet recession to linger onfor decades because businesses and households were not borrowing and spendingprivate savings even after their balance sheets were repaired. The US governmentresponded by creating a variety of tax deductions for interest in an attempt to make iteasier for people to borrow money.Until the 1970s virtually all types of interest—ranging from interest on credit card loans tointerest on automobile loans—were deductible in the US.* Upward pressure on savings rate will take time to correctStarting in the 1970s, however, US households’ savings behavior began to move in theopposite direction, leading eventually to excessive borrowing and insufficient savings.The government responded by gradually phasing out most deductions for interest, homemortgages being the key exception. But it took more than 40 years since the GreatDepression to reach that point.That Japanese businesses and households remain averse to debt even today, some 20years after the real estate bubble collapsed, also suggests that this type of trauma takesa great deal of time to get over.I think it can be argued that the US will require less time to recover. The US bubble wasrelatively mild in comparison with that of Japan, where 20 years ago it was said that theland underneath the Imperial Palace was worth as much as the entire state of California.However, I see a real possibility that the collapse of the 70-year housing myth and theconsequent increase in the savings rate will continue until housing prices start to riseagain. After all, the movement of US housing prices (but not commercial real estate) issurprisingly similar to that of Japanese prices 15 years ago in terms of the percentageincrease, the duration of the increase, the percentage decline, and the duration of thedecline.Nomura Research 2
  • 3. 14 December 2010* Re-examining US deleveraging processLast week the Fed released flow-of-funds data for 2009 Q3. The numbers indicated thatthe private sector deleveraging process continues, although the pace of increase insavings has moderated somewhat.As I noted in the 13 July 2010 edition of this report, the flow-of-funds data for the US forthe past two years have some serious problems and cannot be taken at face value.The data divide the economy into five sectors—households, nonfinancial businesses,financial institutions, government, and the rest of the world—such that the financialsurpluses or deficits for all five sectors sum to zero. The data are used to determinewhich sectors in the nation’s economy are saving (= financial surplus) and which areborrowing and investing (= financial deficit). For the last two years the sum of these fivefigures has been nowhere near zero, as Exhibit 1 shows (note that, in Exhibit 1,nonfinancial corporates and financial institutions are grouped together as the “corporatesector”).1. US flow of funds data since 2008 are unreliable (as % of nominal GDP) Financial surplus or deficit by sector 8 Households (Financial surplus) 6 Numbers do not Rest of the w orld 4 add up at all 2 0 -2 -4 Shift from 2006 -6 in public sector: 8.50% of GDP -8 General government Housing Corporate sector IT bubble -10 (non-Financial + financial) bubble (Financial deficit) -12 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 (CY)Note. 2010 is Q1-3 average. Moreover, in standard flow-of-funds data, the financial surpluses or deficits for five sectors—households,nonfinancial businesses, financial institutions, government, and the rest of the world—sum to zero.Source: Fed, US Department of CommerceThe fact that these five figures do not sum to zero is an indication that some or all of thefigures are not accurate. But without these data it is impossible to determine the scale ofthe deleveraging process currently underway in the US private sector.That is why I presented two measures of the “private sector” in the 13 July report: onedefined as households plus the corporate sector, and the other defined as zero minusthe sum of government and the rest of the world, drawing on the property that thefinancial surpluses and deficits of the five sectors must sum to zero (Exhibit 2). The firstmeasure is shown in the graph as a narrow line; the latter, as a thicker line.In theory these two lines should trace exactly the same paths. Historically there hasalways been some divergence between the two, but recently the disparity has grownmuch larger.A look at the gap between the two measures for the past few years shows that if thenarrow line is correct, private sector deleveraging represents at most about 8.28% ofGDP. But if the thicker line is accurate, the private sector deleveraging process couldamount to as much as 13.29% of GDP, which is far greater than the 8.5% (of GDP)increase in the government’s fiscal deficit during this period. That would suggest thatthere are still substantial deflationary gaps in the US economy.3 Nomura Research
  • 4. 14 December 20102. Increase in financial surplus varies greatly with definition of “private sector” (as % of nominal GDP) 10 (2) "Private sector" as a residual 8 after government and foreign sectors 13.29% 6 of GDP 4 2 8.28% 0 of GDP -2 (1) "Private sector" as obtained by -4 adding corporate, households and financial sectors -6 -8 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 (CY)Note. 2010 is Q1-3 average. In standard flow-of-funds data, the financial surpluses or deficits for five sectors—households, nonfinancialbusinesses, financial institutions, government, and the rest of the world—sum to zero. However, US flow-of-funds data does not sum tozero, particularly over the past two years when the financial crisis has led to numerous difficulties with household and corporate statisticsand major discrepancies. It is now impossible to ascertain financial surpluses or deficits for the private sector (nonfinancial businesses,financial institutions and households) with any degree of certainty. This is why we have provided two definitions for the private sector,namely (1) nonfinancial businesses, financial institutions and households and (2) all five sectors minus government and the rest of theworld, and compared the two sets of figures.Source: Fed, US Department of Commerce* Statistics prevent accurate measure of deleveragingOn my recent visit to Washington, I was able to speak with some of the peopleresponsible for compiling this data series. I took the opportunity to ask them about thecauses of these problems with the flow-of-funds data over the past two years.They replied that the financial crisis had thrown their estimates completely off course andthat they themselves were not sure what to do about it.Figures for households and businesses in the flow-of-funds data are estimated based onthe results of various surveys, and the financial crisis has created serious problems forthe estimation process.I was even told that it would be another two years before more accurate data wereavailable. Over the next two years, they said, new data will be used to enhance theprecision of figures that can currently only be estimated.* Pessimistic estimates may be closer to realityBut for the policymakers and market participants who must evaluate the economy now,two years is far too long a time.When I asked the economists which of the two lines illustrating private savings behaviorwas closer to the reality, they said the thicker line was probably a better approximation ofactual economic conditions.Their reasoning was that the thicker line can be estimated using just two types of primarydata: the trade balance and fiscal balance. The estimation process is therefore farsimpler than that required for the thinner line.That would imply that, as the flow-of-funds data are corrected going forward, it is farmore likely that the thinner line will move closer to the thicker line than the other wayaround. That, in turn, suggests that the increase in savings and minimization of debt inthe US private sector will continue.US private savings increased by 13.29% of GDP between 2006, when savings hit bottom,and the present. That is not far from the corresponding figures for Ireland (21.93%) andNomura Research 4
  • 5. 14 December 2010Spain (18.30%), which also have fallen into balance sheet recessions as their housingbubbles collapsed.It is also worth noting that, at 8.67% of GDP, US private savings are large enough inabsolute terms to finance most of the nation’s fiscal deficit, which recent estimates put at9.91% of GDP (Exhibit 1).* Americans no longer averse to savingWith US borrowings from the rest of the world having dropped from a peak of 6.03% ofGDP in 2006 to just 1.24% today, the US can no longer be characterized as having anextremely low savings rate.We tend to automatically assume that the US does not save enough because that wasthe case for many decades. However, the data cited above demonstrate that currentconditions in the US are very different from those that obtained in the past.The US now has a massive surplus of private savings—money that is saved but notborrowed and spent by the private sector—and that has triggered a balance sheetrecession. On a brighter note, the existence of this surplus means the US private sectoris now capable of financing the bulk of that country’s fiscal deficits.That, in a word, is why US long-term interest rates have fallen as much as they have inspite of the government’s large fiscal deficits.If the government were to embark on fiscal consolidation at a time when the privatesector is saving more despite zero interest rates, aggregate demand would shrink evenfurther, leading to more weakness in the economy. And the resulting drop in taxrevenues and increase in government outlays could actually lead to larger fiscal deficits,much as happened in Japan in 1997.* Agreement reached by President Obama and Republicans a step in the rightdirectionIn that sense, I think President Obama’s agreement with the opposition Republican Partyto carry out further economic stimulus is a step in the right direction. It would have beeneven better if the package had centered on government spending instead of tax cuts,which are unlikely to provide a significant boost to the economy.In Washington, the general explanation for the focus on tax cuts was that all 60 of thenew members of Congress who were elected in November are proponents of smallgovernment and would therefore be amenable to tax cuts but not increased governmentspending.But tax cuts provide little stimulus when the private sector is deleveraging because theydo not necessarily lead to new spending. They do, however, produce a definite increasein the fiscal deficit. Tax cuts therefore increase the national debt while having relativelylittle impact on the economy and can further increase the size of government as apercentage of GDP.* Mistaken view that fiscal stimulus is inefficient alive and well in USAt a conference I participated in during my recent trip overseas, there was a debate overthe multiplier effect of fiscal stimulus in the US. I was rather surprised to find that USfinancial specialists are repeating the mistakes of their counterparts in Japan a decadeago.Specifically, they continue to use the past results of quantitative models to estimate themultiplier effect of fiscal stimulus. As such models generally indicate the elasticity is nohigher than 1.3, they argue that the economic expansion resulting from fiscal stimuluswill be unable to offset the corresponding increase in the fiscal deficit.I would argue that this number is useless today because it was measured before the USfell into a balance sheet recession.The figure depends on the quantitative models’ key assumption that the US economywould limp along at zero growth even without any fiscal stimulus. These models do notassume today’s balance sheet recession world in which, absent fiscal stimulus, each5 Nomura Research
  • 6. 14 December 2010surplus dollar saved by the private sector reduces final demand by the same amount,triggering a downward spiral in GDP.It was only because the government borrowed some 8% of GDP every year that Japan’sGDP stabilized at 0% growth during that nation’s balance sheet recession. Had thegovernment stood by and done nothing, Japan’s economy would have shrunk by 8% ayear.In other words, these quantitative models and the elasticities derived from them can beuseful when the economy is at or near equilibrium, but are utterly useless when theeconomy is so far from equilibrium that the government must run fiscal deficits worth 8%of GDP just to keep output from contracting.* Fiscal elasticity far higher during balance sheet recessionsWhen Japan’s bubble collapsed, for example, national wealth worth three years of GDPwas swept away in the world’s worst-ever financial tsunami. With households andbusinesses facing heavy balance sheet damage, excess private savings amounted tosome 8% of GDP.Had nothing been done, Japan’s GDP would have contracted by about 8% a year. At thevery least, output would have fallen back to the pre-bubble level of 1985.The cumulative gap between 1985 GDP and actual GDP from 1990 until businessesfinished paying down debt in 2005 amounts to some ¥2,000trn.As Japan’s national debt increased by ¥460trn during this period, that means thegovernment succeeded in supporting ¥2,000trn of economic activity with ¥460trn inadditional debt. In other words, fiscal stimulus had an elasticity of four or five. Althoughthis number is much larger than 1.1 or 1.2 figure typically mentioned for Japan’s fiscalstimulus, it is not hard to understand why. The economic impact of the governmentstepping in to borrow and spend money that would ordinarily be borrowed and spent bythe private sector is reduced by the amount the private sector would have borrowed andspent. But during a balance sheet recession, the private sector is not borrowing andspending—in fact, it is paying down debt. Consequently, any money borrowed and spentby the government is fully reflected in higher final demand. It is therefore only natural thatthe elasticity of fiscal stimulus would be dramatically larger during such a recession.When properly measured, the elasticity of fiscal stimulus during such periods is veryhigh—several times the estimates arrived at using data from ordinary periods.If balance sheet recessions were a frequent occurrence, it would be possible to derivereasonably accurate estimates of fiscal elasticities for such periods. But there was not asingle occurrence between the Great Depression of the 1930s and Japan’s experience inthe 1990s. Accordingly, we simply do not have the data needed to accurately measureelasticities during such periods.* Europe and US may repeat Japan’s mistakesWe have shown—using the example of the ¥2,000trn in output that was saved in Japanand the fact that the fiscal stimulus provided by World War II quickly pulled the world’seconomies out of depression—that fiscal stimulus can be a potent tool during a balancesheet recession.Unfortunately, participants in the US fiscal debate remain oblivious to this point andcontinue to discuss the pros and cons of fiscal policy using fiscal elasticities measuredwhen the economy was not in a balance sheet recession.This implies that economists are heavily underestimating the elasticity of fiscal stimulusduring such recessions—just as their counterparts in Japan did a decade ago—makingpolicymakers reluctant to implement further stimulus. This reluctance leads to furthereconomic weakness.The situation in Europe is no different from that in the US. I therefore have to concludethat the western nations have learned nothing from Japan’s lessons and are likely torepeat its mistakes.Nomura Research 6
  • 7. 14 December 2010* Fiscal positions of European nations grow increasingly precariousIt would appear that Germany and the IMF have finally realized the severity of the fiscalproblems facing countries like Ireland and Spain and are beginning to work in earnest onaid packages for these countries.When I visited the IMF on my recent trip to Washington, it was clear that the Fundviewed assistance for Ireland as being critical. Officials I spoke with were driven by asense of urgency, knowing that if the IMF and the EU were unable to stop the crisis fromspreading, problems could propagate from Portugal to Spain, with devastatingconsequences. The IMF knows it needs to take a stand in Ireland.The Fund’s strategy is to buy time by providing assistance, during which time theproblem countries are to engage in fiscal consolidation to the extent that it is trulynecessary.Here, “truly necessary” means that without IMF aid, Ireland would have to cut fiscalexpenditures starting with the easy items, which would not necessarily be a positive forthe nation’s future.* Focus on fiscal consolidation creates vicious cycle for EUWhile this kind of viewpoint is important, the continued emphasis on fiscal consolidationworries me. If this focus persists in spite of the fact that Ireland is experiencing a severebalance sheet recession, the Irish economy could enter a downward spiral even if thespending cuts are made in areas where cuts are needed.Even if the IMF helps Ireland redeem its bonds, no turnaround in the economy can beexpected as long as the government insists on cutting spending during a balance sheetrecession. The risk is that such action will only cause the fiscal deficit to grow.Ireland’s nominal GDP has already fallen as much as 20% from the peak on two factors:the balance sheet recession, which was triggered by the collapse of the nation’s realestate bubble, and the government’s pursuit of fiscal austerity. To the extent that thedecline in GDP exceeds the decline in the nation’s fiscal deficit, the latter will continue toincrease as a percentage of GDP.Moreover, Japan’s experience in 1997 and again in 2001 shows that fiscal austerityduring a balance sheet recession has the potential not only to weaken the economy butalso to increase the absolute value of the fiscal deficit. If the deficit rises when output isfalling, its size relative to GDP will also increase.* Ireland a textbook example of vicious cycle driven by fiscal consolidationIreland has fallen into precisely this trap. I think the vicious cycle would only grow worseif the nation were to implement further austerity measures under these circumstances.If this state of affairs has contributed to the sell-off in Irish government bonds, thegovernment will need to shift its policy focus from fiscal consolidation to fiscal stimulus ifit hopes to emerge from the vicious cycle.In Europe, unfortunately, both governments and the private sector seem to be focusedexclusively on fiscal consolidation. Particularly for the orthodox individuals in charge ofthe ECB, the EU and the OECD (by “orthodox” I mean they do not understand themechanisms of a balance sheet recession), fiscal rectitude has become the “only gamein town.” They are oblivious to the fact that austerity is a fundamental policy mistakeduring a balance sheet recession.* IMF concerned but unable to change courseSome people at the US-based IMF are worried about this risk—perhaps because of thegrowing contingent of people, like Princeton Prof. Paul Krugman, who are talking aboutbalance sheet recessions. However, even they have been unable to move past the beliefthat the markets would not tolerate fiscal stimulus in Ireland.In response, I proposed that it was time for the IMF to come up with a Plan B, given thedanger that continued attempts at fiscal consolidation could send Europe into a 1930s-style deflationary spiral. I recommended that the Fund draw up an alternate plan based7 Nomura Research
  • 8. 14 December 2010on fiscal stimulus in the event that its primary plan, which centers on fiscal consolidation,fails.Unfortunately, few at the IMF have a sense of urgency regarding this issue. Most thinkPlan A will work with some fine tuning.I see no way out for Europe. If it continues to pursue fiscal consolidation in the midst of abalance sheet recession, it is likely to make things worse.* US supports economy with fiscal stimulus while EU undermines economy withausterityAs the recent agreement demonstrates, the US has displayed a certain amount offlexibility in its response. Fed Chairman Ben Bernanke has also recommended onnumerous occasions that fiscal stimulus be maintained. That is not to say that there areno problems—the fiscal stimulus elasticities being used by policymakers do not reflectcurrent conditions, and the fiscal stimulus that has been implemented is heavily biasedtowards tax cuts. Nevertheless, the US is taking action, and I think it will probablycontinue to support the economy next year.In Europe, on the other hand, fiscal consolidation has become the “only game in town”even as many nations face severe balance sheet recessions. Even ECB president Jean-Claude Trichet has been arguing that fiscal consolidation is necessary. With fewpotential catalysts for a change of course, we need to consider the possibility thatconditions in Europe will continue to deteriorate.A single country within the eurozone can achieve little unless the ECB, EU Commission,and the IMF stand together and declare fiscal consolidation during a balance sheetrecession to be a policy misstep. But with the ECB and EU led by orthodox individualswho remain unaware of the very existence of balance sheet recessions, I see littlechance of a meaningful change in policy direction.Richard Koo’s next article is scheduled for release on 12 January 2011Nomura Research 8
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