So, about that deficit!

Richard Koo, chief economist at the Nomura Research Institute in Tokyo, dropped by CSIS last Wednesday to talk about what the United States stands to learn from Japan’s “lost decade.” A staunch free marketer, and a proponent of fiscal responsibility, Koo told the crowd that the current financial situation, just like the previous Japanese one, is an example of a “balance sheet recession” that can only be solved by massive amounts of government spending. Ben Bernanke, an expert on the Great Depression, knows this and has already asked for another stimulus package. Koo’s basic point (and Bernanke’s understanding) is that to prevent total collapse, the government must be the principle borrower at a time when the private sector is not (even if deficits and the national debt balloon). Here’s why:

• A collapse in mortgages and housing prices means huge amounts of debt for the private sector. In order to clear their balance sheets, companies stop borrowing money (even if the rate is 1% or 0%) and instead use their revenue to pay back banks. At the same time, individuals are saving instead of spending because of the unsure economic climate and personal debt.

• The flow of capital stops, and banks can’t find borrowers. So, although everyone is doing the right thing by saving and paying down debt, a fallacy of composition presents itself. If everyone stops spending money at the same time (correct at a micro level), the economy stops (at the macro level).

• When the private sector is minimizing debt instead of maximizing profits, the only counterweight is public sector spending. Japanese GDP hardly grew over the last 15 years, so the assumption has been that government spending was a waste. However, the only thing keeping the economy afloat was the government. Koo showed that twice during the last decade, attempts to curb government spending not only worsened the economy but also increased deficits. The same thing happened in 1937 in America. In fact, looking at Koo’s graphs of the Japanese recession, the Great Depression, and the current situation, one gets the ominous feeling that history does in fact repeat itself.

Of course, the collapse of housing prices is at the center of today’s crisis as it was for the Japanese slowdown. Koo pointed out, though, that American mortgages (nonrecourse loans), unlike Japanese and European ones, are attributed to the home and instead of the individual, creating incentives to “return the key” and just walk away. This is a key difference (pun absolutely intended). Koo warned that if the number of defaults increases even more, this crisis will worsen very quickly. Koo told a story about a time during the Japanese crisis when he was asked to debate against Paul Krugman. For two hours, Koo defended capital injections and government spending, while Krugman continued to emphasize printing money and low interest rates. Unfortunately, when the government is the only one borrowing, an interest rate cut won’t do much. It looks like the Nobel Laureate was wrong, and he kind of admits it. Getting the United States out of this problem is going to take a while. Massive spending, not tax cuts (tax cuts go back into savings and not to the economy), must be a medium-term situation. Koo said if we can find $30 billion in projects but need $40 billion to get out of this, we still need to spend that $10 billion. There might be a lot more bridges to nowhere, but it’s just going to have to happen. It looks like $700 billion was just the tip of the iceberg. To watch Koo’s talk, click here.