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Roach: Return of the Living Dead

Stephen Roach has written an Op-Ed in today’s Financial Times that is worth reading. He outlines his version of Richard Koo’s Balance Sheet Recession theorem, opining that “the global economy is being hobbled by a new generation of zombies – the economic walking dead.”

His main points are:

  • American consumers are retrenching. In the 3 1/4 years since 2008 began, real consumption growth has averaged 0.5% on an annualised basis, the lowest since World War II. That data point certainly rhymes with the consumer deleveraging of Koo’s balance sheet recession.
  • Zombie companies remain on life support. Roach says the antecedent to this is Japan where Japanese banks extended credit to effectively insolvent companies, postponing a full recovery for two decades. Roach calls this the “Japan disease”. This data point is at odds with Richard Koo’s prescriptions.

Roach’s conclusion:

Washington policymakers are doing everything they can to forestall rational economic adjustments. The Federal Reserve has conducted two rounds of quantitative easing in an effort to get consumers to start spending the wealth effects of a policy-induced rebound in equities. Congress and the White House have embraced home-foreclosure containment programmes and other forms of debt forgiveness.

The aim is to get zombie consumers to ignore their festering problems and start spending again – irrespective of the wrenching balance sheet damage they suffered in the “great recession”. The subtext is Washington condones a revival of reckless behaviour.

That “Washington policymakers are doing everything they can to forestall rational economic adjustments” is certainly the conclusion I have drawn both regarding Japan and regarding the US. I would say, however that the aim is to get zombie banks to ignore their festering problems and start lending again. See the difference? That’s my updated wording. Apologies for not pointing that out in the initial version.

First, on Japan:

If one wants to see what happens when you use stimulus to help keep zombie companies alive and to resist reform efforts, look no further than Japan.

For twenty years now, Japan has been dealing with the consequences of a burst asset bubble in shares and property. And for twenty years, the body politic has been unwilling to make the necessary reforms which would eliminate zombie companies while still helping to repair balance sheets in the private sector. Instead, the Japanese have piled government deficit upon deficit like Sisyphus trying to get consumers to reflate the economy. It has not worked…

What this illustrates is that stimulus cannot be seen as a cure-all in an economy which lacks in domestic demand or in which debt burdens are high. I see this as a cautionary tale for The Europeans and Americans looking at stimulus as some magic bullet which will make structural problems disappear.

I increasingly ask myself whether any advanced democracy has the foresight to implement a targeted monetary stimulus campaign without knee-capping efforts to induce more private sector savings – fiscal stimulus is a whole different affair. Right now, the savings rate in Japan is even lower than in the United States, a direct result of easy money.

In my view, fiscal or monetary stimulus are bridges to a sustainable economic future built on the back of deleveraging, a purge of malinvestments and industry consolidation. Right now, the stimulus in Japan is looking more like a bridge to nowhere.

-Japan: stimulus without reform leads to a policy cul de sac, Nov 2009

Second, on the US:

If the US wants job growth, it will need to reduce private sector debt levels – and that takes time. It does not follow "that the central objective of national economic policy until sustained recovery is firmly established must be increasing… borrowing and lending," as Larry Summers asserts. The government can act as a counterweight to the demand drag but I am very sceptical of claims like Summers’ that doing so would solve a jobs crisis borne out of a debt crisis.

-The jobs crisis is not just about demand, Jun 2011

Third, in general:

in theory, fiscal stimulus can cushion the downturn and hasten real recovery by preventing a spiral into a non-equilibrating economic state.  However, in practice, stimulus has been used as an excuse to maintain the status quo, prop up zombie companies and forestall the inevitable.  This only lengthens the downturn, misallocating even more resources to less efficient uses. And all of the worries I had about social unrest, populism, and protectionism are coming true nonetheless…

Rather than use the period of fiscal stimulus to promote private-sector deleveraging and saving and to purge malinvestment, politicians will simply use this period as a way to continue business as usual, making the problem even bigger down the line

What about monetary policy? Well, in a depression where the constraint is overinvestment, leverage, and debt, the question is not a monetary one.  As Marshall recently suggested, it appears Fed Chairman Bernanke doesn’t understand the basic economics of central banking. Throwing more money into the system will not make credit-worthy borrowers borrow more. Nor will it necessarily induce banks to lend when they fear that many of their prospective borrowers are not credit-worthy.

By lowering interest rates and expanding the money supply, central banks are not inducing more lending; they are trashing cash. You are not promoting saving with 0% rates; you are looking to re-create the asset-based status quo ante. And when there are insufficient lending opportunities, banks are either forced to sit on billions of cash earning nothing or try other ways of making money (proprietary trading, investment in Treasuries, maybe even lending to non-credit worthy borrowers).  Moreover, investors are earning next to nothing as well.  How many people have looked at their money market fund statements with the 0.00% interest staring them in the face and decided to switch into bond, equity or commodity funds? It’s what’s called liquidity seeking return – a major reason the stock market has been buoyed.

-Moving away from stimulus happy talk to focus on malinvestment, Dec 2009

Don’t be fooled by economists telling you the risks of a Japan disease are not real. They are. And when economists are honest like Janet Yellen has been, they will tell you that it is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage. Moreover, Larry Summers is quite direct in telling us that he views the purpose of fiscal policy is to promote aggregate demand via “borrowing and lending, and spending”. How is that consistent with private sector deleveraging? Doesn’t this actively promote the preconditions for the Japan disease?

Here’s how I framed it two years ago as we headed into recovery:

  1. Even if economic and monetary policy have poor longer-term consequences, it does not mean that policy won’t gain traction in the short-term. I see the potential for a cyclical upturn due to the massive stimulus campaign… Ask Alan Greenspan regarding his 2001-2003 easy money campaign. This is what happened in Japan before Yamaiichi’s demise in 1996 – and again before Daiwa and Nikko were merged out of independence.
  2. Even if economic and monetary policy have stimulative short-term consequences, it does not mean that the structural problems have disappeared. They are merely lurking underneath, waiting for the next downturn to re-assert themselves. Again, the Japanese scenario is a cautionary tale on this score.
  3. Asset prices will respond to an upturn, but that does not mean we are about to embark on a new bull market. Japan is the right precedent here again. After the upturn in the mid-1990s, property prices continued to collapse in Japan, sucking many more individuals into the deflationary spiral.

-Turning Japanese and understanding the consequence of policy half-measures, Apr 2009

Rather than adding stimulus with the aim of goosing demand by whatever means available to help the economy reach escape velocity, I would say that the central objective of economic policy is to help the economy reach full employment. Doing so will increase demand, increase output, and cut budget deficits tremendously. Policy makers should aid the economy in reallocating scarce resources to areas that will sustain longer-term productivity growth while doing this. In America, that means fewer resources in finance and housing and perhaps more in technology and infrastructure.

As Stephen Roach writes:

A failure to learn the lessons of Japan – especially that of post-bubble zombie congestion – leaves the US and the global economy in a very tough place for years to come. Growth-hungry financial markets could be very disappointed.

Source: Global economy menaced by return of living dead, Stephen Roach, FT

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

29 Comments

  1. MisterMighty says:

    Ummm…good article.
    In the big scheme of things though…our consumption based civilization is doomed. If we convert China and Pakistan fully to consumers….mother earth collapses.
    We need a new driver and type of growth for the future.

    • David Lazarus says:

      Yes but can you see the GOP giving up their right to cheap gas just so that Pakistan or anywhere else for that matter can develop?

  2. El Viejo says:

    Bravo!
    As an engineer/programmer I have found that when things get bound up or bogged down someone is not being empowered enough. Help them! Empower them! Don’t blame them!
    Economists will tell you that we can’t grow the economy because no one can borrow. I say there is another way to grow the economy: Spend some of that hoarded cash. If an carrot won’t work then use a stick.
    Change the rules at the FED. Allow them to open a window to corporations that need cash. That will remove the cash hoarding fear. If that doesn’t work then tax corporations that are hoarding cash.
    HIRE, INNOVATE, MODERNIZE OR GET OFF THE POT!

    • Tom says:

      Corporate balance sheets are in near pristine condition. The problem is lack of aggregate demand. Only an intelligent fiscal policy can address that.

      • Again this is something we have said before. As I wrote last June:

        The ‘Twin Deficits” story of a US economy out of balance due to large government deficit spending is empirically false and ignores the sectoral financial balances identity. To the degree there are twin deficits, the items at issue are a lack of household savings and current account balances. If policy makers want to increase the household sector’s savings (and reduce its debt levels), then we must either increase fiscal deficits or get businesses to reinvest profits in capital spending.

        Corporate balance sheets may look good but they are not going to reinvest in capital spending without demand – and that means you would need government spending.

        Tom, I think you and I are on the same page generally speaking. However, I don’t think stimulus is a magic bullet. I am also concerned about the effectiveness of that stimulus in an era of the Predator State where lobbyists will try to get government to skew policy toward propping up specific economic sectors like banking or housing.

        • David Lazarus says:

          I agree but fiscal measures are off the table with the Tea Party dominating the debate. What you call the predator state is what I would call the captured state. It is now captured by the banking system who will demand that they are bailed out if you want to save the economy.

          I am for fiscal stimulus, but aimed at a public works program. None should be aimed at bank bailouts. Don’t forget that even housing support is really another bank bailout.

          • David, you are 100% right there. I ue the term “Predator State’ in reference to Jamie Galbraith, who coined it. But you’re right, it is capture.

            Fiscal stimulus is off the table because Obama has discredited it by continuing the bailouts.

            I have also ‘fixed’ this article to reflect my belief that the HAMP programs are part of that legacy.

            As early as February 2009, I argued that Obama took a middle road on stimulus and taxes that leads nowhere which would discredit stimulus as a policy tool. And that is indeed what has happened.
            http://www.creditwritedowns.com/2009/06/obama-takes-middle-road-on-stimulus-and-taxes-that-leads-nowhere.html

            What is the Fed to do in that scenario? I say they should stand pat and leave fiscal to Congress and the President. Others want them t compensate.

  3. Tom says:

    What a sloppy, derivative mish mash of words.
    “Rather than adding stimulus with the aim of goosing demand by whatever means available to help the economy reach escape velocity, I would say that the central objective of economic policy is to help the economy reach full employment. ”

    Der. you write as if “economic policy” is controlled by one person or one institution. It isn’t. Anywhere. In the US, the president and congress negotiate fiscal policy. The Fed, with inputs, directs monetary policy. Perhaps Bernanke is trying to offset what he sees as a currently disastrous fiscal policy with a level of monetary ease that hopefully will prevent a very serious depression.

    It could yet happen. See David Rosenberg’s latest.

    • Tom, it appears you haven’t been reading posts here because we have been banging on about these same issues. Yes, people like Bernanke know full well that QE is of limited utility. Last year, I wrote:

      What Dr. Galbraith is alluding to is the fact that Dr. Bernanke really thinks fiscal policy is more effective than quantitative easing to the degree you want to add stimulus. The breath-taking comment by Paul Krugman a few weeks ago about the Fed needing $8-10 trillion of QE to boost the real economy goes to this. I think you would need even more. But, of course, Bernanke has no input into fiscal policy and right now fiscal policy is a dead issue in Washington. Interest rates are already zero percent. So, Bernanke has decided to fall back on the only thing he has left

      http://www.creditwritedowns.com/2010/11/does-ben-bernanke-believe-the-stuff-he-writes.html

      That passage certainly addresses your concern about why Bernanke is forced into QE. I think that passage also addresses the concerns you have about economic policy not being controlled by a single person or body but by a dynamic political process. I should also add that it is not in Republican’s interest to see Obama successful. See my comments on that here:

      http://www.creditwritedowns.com/2010/10/less-policy-advocacy-and-more-policy-forecasting-at-credit-writedowns.html

      Nevertheless, it is clear that the President is committed to stimulus as a means to achieve escape velocity and not as any sort of program to assist in deleveraging and aiding balance sheet repair in the private sector.

  4. Swedish Lex says:

    After which it all ends with a massive explosion of inflation.

    • David Lazarus says:

      Unlikely as assets are still grossly overvalued. The banks are unable to expand the money supply as no one wants to borrow at the margins that the banks are now demanding as they rebuild their capital base. US real estate is probably 20% overvalued still and UK 45% and Australia 60%. I dread to think what over valuation exists in China as property is bought as a store of value even if it is never lived in, or rented out.

      So I expect asset deflation to be the biggest issue and that is what QE3 will be used for. To stop this happening.

  5. Credit Writedowns says:

    Edward Harrison on Facebook says
    Swedish Lex commented on Credit Writedowns:

    After which it all ends with a massive explosion of inflation.

    • David Lazarus says:

      I doubt that. Most assets are still grossly overvalued and will collapse eventually. Deflation is still the big elephant that no one is talking about. Any inflation will be wiped out by a collapse in asset valuations.

  6. David Lazarus says:

    I have been giving this someone thought. The problem in Japan was that they allowed the zombies to survive, and that has happened this time. Twenty years of analysis has taught the economics profession nothing.

    As for private debt that would have fallen faster if interest rates had been kept higher. That also applies now. If interest rates had a 5% floor then it would have meant that mal-investments would not have avoided failing. It would also have meant that savers would not have been punished by low interest rates. It now means that their incomes have fallen and so when interest rates climb they will underspend for longer to rebuild their savings. Additionally higher rates would have limited the spending binge as well. It would have never allowed a sub prime market to get out of control.

    As for the fiscal stimulus I have two comments. It was too early. Previous bad investments were rescued by the measures. QE is doing this as well. This has long term influences. It still means that people still think that real estate makes a good investment long term. You can see that in the UK from bullish statements from real estate agents, and lenders. In fact in the UK it could be disastrous as many potential first time buyers feel that they will never get on the property ladder. This also means that when austerity measures kick in and they are angry they have nothing to lose. The politicians of the thirties realised that unless people have a stake in society they will be a potential enemy of the state through revolution. Yet today I do not see any sense coming from Washington about this. I wonder what size of underclass will panic the elites. It must be fifty million now but what if they had guns?

    Then when stimulus did arrive they were deliberately badly designed. This is even more true of the UK measures. What I would have preferred is leaving all stimulus until the bad investments had been cleared out and then come in with a large labour intensive plan that will create jobs. Tax cuts were very inefficient.

    I have to agree that the US and UK economies are still tinderboxes waiting to be ignited. With so much bad investments still standing it is only a matter of time before they collapse and put the US on the path to depression, which all they have managed to do is delay the inevitable. Asset prices are still way over valued and I laugh when I hear comments like this time it is different and we are cleverer than before. Such self delusion is remarkable. So overall I totally agree with Stephen Roach, thought I suspect that political ineptitude will make matters worse. I am surprised that Greece took so long to erupt, I thought last year that Greece would riot. I expect Ireland and Portugal as well to have more riots. The UK definitely will have riots though the markets might not realise the significance of them until things are really bad. Many of the events of the thirties could happen again like societal collapses though I think that war is less likely, though more revolutions are inevitable. Eastern and southern europe could be vulnerable here.