Why monetary policy isn't working and fiscal consolidation will makes things worse

In Monetary policy, The broken transmission mechanism The Economist has a great article on why monetary policy is not working in the USA and Europe:

SINCE the crisis hit in 2008, there has been a sharp divide between those who believe that the monetary authorities have been insufficiently aggressive and those who believe that central banks have done everything possible given that households and businesses have no interest in taking on new debts. For what it’s worth, a poll of more than 300 research associates at America’s National Bureau of Economic Research conducted for an article in the print edition reveals that the overwhelming majority (76%) believe that monetary policy has not been too tight. Nearly half believe that fiscal rectitude has been a principal cause of the slow recovery.

The article then goes on to explain why monetary policy hasn't been effective. It concludes with:

None of this is to say that asset purchases, statements about the future path of inflation and nominal income, or interventions in the foreign exchange markets will have literally no effect. However, it seems clear that current circumstances are causing these monetary policy actions to be far less effective than they otherwise would be. Marginal spenders are constrained by their desire (or need) to retrench. Most of the people who get the biggest benefit from central bank action are the people who already own lots of financial assets (the rich).

The fiscal authorities need to step up and do the job that the central banks cannot. Specifically, by running large budget deficits, governments can maintain the total level of spending in the economy while allowing households and businesses to repay their debts and accumulate savings. This is not a new insight, but it has gained popularity in the last few years thanks to the work of Richard Koo, the chief economist of the Nomura Research Institute who coined the term “balance sheet recession” to describe what happened to Japan after the collapse of its asset bubble in the early 1990s. (The paper is well worth reading in full.) Unfortunately, many governments across the globe seem more concerned with the abstract goal of balancing their budgets than with the important task of restoring their economies to health.

Recommended reading, as is the paper by Richard Koo in the above link. Here's where Koo explains how problems caused by the GFC could cause a depression if not correctly treated:

More importantly, when the private sector deleverages in spite of zero interest rates, the economy enters a deflationary spiral because, in the absence of people borrowing and spending money, the economy continuously loses demand equal to the sum of savings and net debt repayments. This process will continue until either private sector balance sheets are repaired or the private sector has become too poor to save (i.e., the economy enters a depression).

To see this, consider a world where a household has an income of $1,000 and a savings rate of 10 percent. This household would then spend $900 and save $100. In the usual or textbook world, the saved $100 will be taken up by the financial sector and lent to a borrower who can best use the money. When that borrower spends the $100, aggregate expenditure totals $1,000 ($900 plus $100) against original income of $1,000, and the economy moves on. When demand for the $100 in savings is insufficient, interest rates are lowered, which usually prompts a borrower to take up the remaining sum. When demand is excessive, interest rates are raised, prompting some borrowers to drop out.

In the world where the private sector is minimizing debt, however, there are no borrowers for the saved $100 even with interest rates at zero, leaving only $900 in expenditures. That $900 represents someone’s income, and if that person also saves 10 percent, only $810 will be spent. Since repairing balance sheets after a major bubble bursts typically takes many years — 15 years in the case of Japan — the saved $90 will go un-borrowed again, and the economy will shrink to $810, and then $730, and so on.

This is exactly what happened during the Great Depression, when everyone was paying down debt and no one was borrowing and spending. From 1929 to 1933, the U.S. lost 46 percent of its GDP mostly because of this debt-repayment-induced deflationary spiral. It was also largely for this reason that the U.S. money supply shrank by nearly 30 percent during the four-year period.

The discussion above suggests that there are at least two types of recessions: those triggered by the usual business cycle and those triggered by private sector deleveraging or debt minimization. Since the economics profession never considered the latter type of recession, there is no name for it in the literature. In order to distinguish this type of recession from ordinary recessions, it is referred to here as a balance sheet recession. Like nationwide debt-financed bubbles, balance sheet recessions are rare and, left untreated, will ultimately develop into a depression.

Koo also makes a very important point:

Flow of funds data for the U.S. (Exhibit 9) show a massive shift away from borrowing to savings by the private sector since the housing bubble burst in 2007. The shift for the private sector as a whole represents over 9 percent of U.S. GDP at a time of zero interest rates. Moreover, this increase in private sector savings exceeds the increase in government borrowings (5.8 percent of GDP), which suggests that the government is not doing enough to offset private sector deleveraging.

Koo later writes:

Countries in balance sheet recessions such as Spain are desperately in need of fiscal stimulus but are unable to take advantage of the rapid increase in domestic savings and are therefore forced to engage in fiscal conso lidation of their own. That causes the aforementioned $100 to be removed from the income steam, prompting a deflationary spiral. And since the countries receiving those savings are not borrowing and spending them, the broader eurozone economy is rapidly weakening. It is no wonder that the Spanish unemployment rate is over 21 percent and Irish GDP has fallen more than 10 percent from its peak.

Fund flows within the eurozone were following the opposite pattern until just a few years ago. Banks in Germany, which had fallen into a balance sheet recession after the telecom bubble collapsed in 2000, aggressively bought the debt of southern European nations, which were denominated in the same currency but offered higher yields than domestic debt. The resulting capital inflows from Germany poured further fuel onto the fire of housing bubbles in these countries.

There is thus a tendency within the eurozone for fund flows to go to extremes. When times are good, funds flow into booming economies in search of higher returns, thereby exacerbating the bubbles. When the bubbles finally burst, the funds shift suddenly to the countries least affected by the boom.

The problem with these shifts is that they are pro-cyclical, tending to amplify swings in the economy. Countries that are in the midst of a bubble and do not need or want additional funds experience massive inflows. Meanwhile, countries facing balance sheet recessions and in need of funds can only watch as money flows abroad, preventing their governments from implementing the fiscal stimulus needed to stabilize the economy.

[...]

One way to solve this eurozone-specific problem of capital shifts would be to prohibit member nations from selling government bonds to investors from other countries. Allowing only the citizens of a nation to hold that government’s debt would, for example, prevent the investment of Spanish savings in German government debt. Most of the Spanish savings that have been used to buy other countries’ government debt would therefore return to Spain. This would push Spanish government bond yields down to the levels observed in the U.S. and the U.K., thereby helping the Spanish government implement the fiscal stimulus required during a balance sheet recession.

The Maastricht Treaty with its rigid 3 percent GDP limit on budget deficits made no provision for balance sheet recessions. This is understandable given that the concept of balance sheet recessions did not exist when the Treaty was being negotiated in the 1990s. In contrast, the proposed new rule would allow individual governments to pursue autonomous fiscal policies within its constraint. In effect, governments could run larger deficits as long as they could persuade citizens to hold their debt. This would both instill discipline and provide flexibility to individual governments. By internalizing fiscal issues, the new rule would also free the European Central Bank from having to worry about fiscal issues in individual countries and allow it to focus its efforts on managing monetary policy.

In order to maximize efficiency gains in the single market, the new restriction should apply only to holdings of government bonds.  German banks should still be allowed to buy Greek private sector debt, and Spanish banks should still be allowed to buy Dutch shares.

In retrospect, this rule should have been in place since the beginning of the euro. If that were the case, none of the problems the eurozone now faces would have materialized. Unfortunately, the euro was allowed to run for more than ten years without the rule, accumulating massive imbalances along the way. It may take many years to undo the damage. 

Koo concludes with:

It is laudable for policy makers to shun fiscal profligacy and aim for self-reliance on the part of the private sector. But every several decades, the private sector loses its self-control in a bubble and sustains heavy financial injuries when the bubble bursts. That forces the private sector to pay down debt in spite of zero interest rates, triggering a deflationary spiral. At such times and at such times only , the government must borrow and spend the private sector’s excess savings, not only because monetary policy is impotent at such times but also because the government cannot tell the private sector not to repair its balance sheet.

Although anyone can push for fiscal consolidation in the form of higher taxes and lower spending, whether such efforts actually succeed in reducing the budget deficit is another matter entirely. When the private sector is both willing and able to borrow money, fiscal consolidation efforts by the government will lead to a smaller deficit and higher growth as resources are released to the more efficient private sector. But when the financial health of the private sector is so impaired that it is forced to deleverage even with interest rates at zero, a premature withdrawal of fiscal stimulus will both increase the deficit and weaken the economy. Key differences between the text book world and the world of balance sheet recessions are summarized in Exhibit 17.

With massive private sector deleveraging continuing in the U.S. and in many other countries in spite of historically low interest rates, this is no time to embark on fiscal consolidation. Such measures must wait until it is certain the private sector has finished deleveraging and is ready to borrow and spend the savings that would be left un-borrowed by the government under an austerity program.

There will be plenty of time to pay down the accumulated public debt because the next balance sheet recession of this magnitude is likely to be generations away, given that those who learned a bitter lesson in the present episode will not make the same mistake again. The next bubble and balance sheet recession of this magnitude will happen only after we are no longer here to remember them.

Koo has written a great paper. Compulsory reading.