Learning wrong lessons from the crisis in Greece

Richard C. Koo
Chief Economist
Nomura Research Institute, Tokyo
r-koo@nri.co.jp
May 20, 2011

This paper examines the recent euro-zone crisis, which was triggered by the fiscal
problems in Greece, in the light of Japans experience with balance sheet recession from
1990 to 2005.
There are two overlapping themes to the current crisis.

One involves the

artificially created euro; the other, the housing bubbles in the so-called PIIGS countries
(Portugal, Ireland, Italy, Greece and Spain). These bubbles resulted from the lowering
of interest rates in these countries due to the introduction of euro, and the
accommodative monetary policy adopted as the ECB tried to ease the impact of the IT
bubble collapse in 2000 on the German economy, the euro-zones largest.
The collapse of those bubbles has prompted private sectors in these economies to
delever and plunged many euro-zone economies into balance sheet recessions, a rare
type of recession that happens only after the bursting of a nation-wide asset price
bubble financed with debt. The risk is growing however, that countries spooked by the
Greek crisis will repeat the mistakes made by Japan as they pursue fiscal consolidation
in the midst of private sector deleveraging, a highly destructive combination.

Adoption of euro brought down peripheral interest rates sharply

From the start, control over the artificially created euro belonged to the European
Central Bank.

The ECB inherited the German Bundesbanks reputation as an

inflation fighter and, like the Bundesbank, was based in Frankfurt.

Because the

eurozone policy rate was effectively a continuation of Deutschemark interest rate levels,
interest rates for most euro-zone members fell sharply.
The reduction in borrowing costs was felt most keenly in the PIIGS, and above all
in Greece. Exhibit 1 shows 10-year government bond spreads between Germany and
the PIIGS. Ten-year Greek government bonds were yielding 1,800bp more than their
German equivalents in 1993. This spread duly tightened over time and eventually
dropped to just a few dozen basis points after Greece joined the euro in 2001.
1

Exhibit 1. 10-year yield spread, Germany vs. PIIGS

(%pt)

18
17
16
Greece

15
14

Italy

1999:
Euro launched

13

Portugal

12

Spain

11

Ireland

2001:
Greece joins
eurozone

10
9

8
7
6
5
4

3
2
1
0
-1
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Nomura Research Institute, based on ECB data

Exhibit 2. Holders of Greek government debt

(%)

90
80

Domestic financial
institutions

70
60

Overseas
Investors

50
40
30
20
10
0

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: Bank of Greece

One reason for the marked decline in interest rates was the sharply reduced
inflation risk promised by the ECBs inflation-fighting credentials. Another was that
2

the adoption of a unified currency made it easier for foreign investors to purchase PIIGS
debt, including Greek bonds, without concern for currency risk.
At the end of 1994, fully 85% of Greek government debt was held by domestic
financial institutions. By 2007, this ratio had almost completely reversed, with foreign
investors holding over 75% of the nations sovereign debt (Exhibit 2).
Although inflation risk and currency risk had been eliminated, Greeces bonds
still carried credit risk. But until 2008 investors were charging only a few dozen basis
points to assume this risk (Exhibit 1).

Maastricht Treaty curbed credit risk

A key reason why credit spreads contracted was that the Maastricht Treaty
capped fiscal deficits at 3% of GDP. As long as this condition was satisfied, investors
estimated the risk of a sovereign default within the euro-zone to be extremely small.
With the exception of Greece, fiscal deficits in most euro-zone nations did in fact hover
around 3% of GDP through 2006 (Exhibit 3).

Exhibit 3. Euro-zone fiscal deficits

6

(% of nominal GDP)

-3

-6
Germany
Italy

-9

Portugal
Spain
-12

Greece
Ireland

-15
1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Source: Eurostat

The deficit ceiling was introduced because it was thought that a number of
artificial conditions were required to manage this artificially created currency. The
authorities were especially concerned that a euro-zone government might take
3

advantage of the markets trust in the unified currency and the ECB to run large fiscal
deficits, thereby undermining the value of the euro. The Greek crisis and the euros
reaction to it suggest that those concerns were quite prescient, as Greeces fiscal
problems have sparked a major selloff of the joint currency.
Things were fine within the euro-zone framework as long as the market believed
that Greece was keeping its fiscal deficits at around 3% of GDP. The crisis erupted
when the new Greek government announced that the previous administration had been
issuing misleading deficit data and that actual deficits were much larger.

Greek

government bond yields moved sharply higher in response (Exhibit 1), and the 10-year
spread versus German government debt is now more than 1050bp.

What separates Greece from four other PIIGS

Greek government debt yields also increased along with those of the other PIIGS
in the aftermath of the Lehman Brothers collapse in September 2008.

Investors sold

PIIGS debt as the global financial system fell into turmoil, believing their economies to
be relatively fragile. Since last autumn, however, the sharp sovereign spread widening
experienced by Greece has not been observed to the same extent in other PIIGS.

This

difference can be attributed to the combination of two factors specific to Greece, namely
(1) large deficits and (2) an attempt to hide those deficits. None of the other PIIGS
fulfilled both conditions.
Greece ultimately lost much of its fiscal discipline as the adoption of the euro
sharply reduced its debt issuance costs and overseas investors became active buyers of
its bonds. That was the primary cause of the recent crisis. The people who created the
euro knew that the common currency would make it easier for member nations to run
large fiscal deficits. They tried to prevent this from happening with the Maastricht
Treaty, but Greece managed to wiggle out of the Treatys constraints by issuing
misleading data about its deficits.
That is why Germany and some other nations were heavily opposed to aid for
Greece. Why, they asked, should we have to help out a country that did not follow the
rules?

But Germany also bears responsibility for current crisis

While those German sentiments are understandable, they are not the whole story.
As noted at the top of this report, the crisis grew as big as it did because of the collapse
of the IT bubble in Germany and the accommodative monetary policy adopted by the
ECB in order to save the German economy.
4

German households and corporations were deeply involved in the global IT bubble
of 19982000, and the bubbles collapse left both facing severe balance sheet damage.
The Neumarkt, Germanys answer to the NASDAQ, fell 98% from its peak. Individuals
and companies with large investments in IT-related businesses were left holding assets
that were virtually worthless, while their debts remained.
Consequently, savings and deleveraging by the German corporate and household
sectors amounted to a combined 12.8% of GDP in the four years from 2000 to 2005
(10.0% for the corporate sector and 2.8% for the household sector). The corresponding
loss of aggregate demand triggered a balance sheet recession.
In this type of recession, the collapse in asset prices forces the private sector to
minimize debt in order to repair its battered balance sheets. That makes monetary
policy largely powerless because those with balance sheets underwater are not
interested in borrowings at any interest rate, and there will not be many lenders either
especially when the lenders themselves have balance sheet problems. But if everybody
is saving and nobody is borrowing and spending those saved funds, the economy will
continue to lose demand equivalent to the amount of unborrowed savings.

Exhibit 4. German flow of funds

Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
8

Households

(Financial Surplus)

IT Bubble

4
2
0

Rest of the World

-2
-4

Non-financial
Corporations

-6

General Government
-8

(Financial Deficit)
-10
91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

Sources: Deutsche Bundesbank, Federal Statistical Office Germany

Note: The assumption of Treuhand agency's debt by the Redemption Fund for Inherited Liabilities in 1995 is adjusted.

This situation is eloquently described by the flow-of-funds diagram for Germany

(Exhibit 4). The diagram shows which sectors in the nations economyhousehold,
corporate, government, and overseasare borrowing money and which are saving.
5

Sectors located above the zero line in the diagram have a financial surplus, which
means they are either increasing savings or paying down debt. Sectors located below
the zero line are characterized by a financial deficit, which means they are borrowing
and investing by that amount. The four lines are supposed to add up to zero.
Exhibit 4 shows that German businesses were borrowing and investing 6.6% of
GDP at the peak of the bubble in 2000. By 2005, however, they were paying down debt
to the tune of 3.4% of GDP a year. In other words, demand for funds in the German
corporate sector dropped by 10.0% of GDP over the five-year period. Over the same
span, household savings grew by 2.8% of GDP, resulting in a total loss of private sector
demand for Germanys economy of some 13% of GDP.
To stem the resulting economic weakness, the German government needed to
borrow and spend the increase in private savings (13% of GDP).

But German

policymakers had yet to understand the concept of a balance sheet recession, and in any
case, the Maastricht Treaty itself forbade Germany from running a fiscal deficit of more
than 3% of GDP. Absent the necessary fiscal stimulus, the German economy weakened
sharply.

ECB lowered euro-zone policy rate to bolster German economy

Weakness in the euro-zones largest economy implied economic weakness for the
entire currency zone. The ECB responded with substantial monetary accommodation
as it lowered the policy rate to 2%, a level never seen during the Bundesbank era. This
corresponds to the period when ECB president Jean-Claude Trichet boasted that the
French-led ECB had succeeded in bringing interest rates to a level the German-led
Bundesbank had never been able to achieve. In reality, however, interest rates were
low not because the ECB had successfully reined in inflation expectations but rather
because Germany had fallen into a balance sheet recession.
In spite of this action by the ECB, the German economy failed to respond because
its private sector was rushing to minimize debt. House prices fell steadily, and money
supply growth dropped to about half the rate in other euro-zone countries (Exhibit 5).
This German experience was a replica of the Japanese experience exactly a
decade earlier. In the aftermath of the Heisei bubble burst, the Bank of Japan lowered
interest rates from 8 percent in 1990 to almost zero by 1995. But both the economy
and asset prices failed to respond because the Japanese private sector was busy
deleveraging in order to repair its battered balance sheets. As shown in Exhibit 6, the
Japanese corporate sector was a net re-payer of debt even with zero interest rates for a
full ten years starting in 1995. As a result, real estate prices kept on falling, and
6

money supply growth remained extremely slow. These developments are also seen in
the U.S. and Europe since the Lehman shock.

Exhibit 5. Money supply in Germany and the euro-zone

(1999 Q1 = 100, Seasonally adjusted)

250

Euro zone (ex. Germany)

225

Euro zone
200
Germany
175

150

125

Lehman Shock
100

75
95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

10

11

Source: Nomura Research Institute, based on ECB and Deutsche Bundesbank

Exhibit 6. Japans de-leveraging with zero interest rates lasted for 10 years
Funds Raised by Non-Financial Corporate Sector
(% Nominal GDP, 4Q Moving Average)

(%)

25

10

CD 3M rate
(right scale)

20

Borrowings from Financial Institutions (left scale)

15

Funds raised in Securities Markets (left scale)

10

-5

Debt-financed
bubble
(4 years)

Balance sheet
recession
(16 years)

-2

-10

-4

-15

-6
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

Sources: Bank of Japan, Cabinet Of f ice, Japan

and thereby sparked housing bubbles in PIIGS

The ECBs rate cuts, on the other hand, further reduced borrowing costs for other
euro-zone nations and thereby triggered major asset price bubbles.

Thus Europes

housing bubbles developed in precisely the same way as in the US, where Fed chairman
Alan Greenspan had slashed interest rates in response to the collapse of the Internet
bubble. The size of the US and European bubbles was also comparable.
Greek house prices rose from a rebased 100 in 1997 to 280 in Athens and 260 in
all urban areas at the peak in 2008. Still, these increases were mild in comparison
with the gains seen in Spain, Italy, and Ireland (Exhibit 7).

Exhibit 7. House prices in Greece, Spain, Italy and Ireland

(1999=100)

280
260

Italy
Spain

240

Greece
220

Ireland
US

200
180
160
140
120
100
80
1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Source: Nomura Research Institute, based on Bank of Greece, Ministerio de Vivienda, Spain, Bloomberg, BIS, S&P, and
Department of the Environment, Heritage and Local Government, Ireland
Note: Greek prices are in urban areas. Irish f igures are new houses' prices.

PIIGS bubbles pulled Germany out of balance sheet recession

The economic booms (bubbles) sparked in other euro-zone nations by the ECB rate
cuts saved Germany. In effect, they allowed Germany to export its way out of the
balance sheet recession.
Until 2000 Germany was running a small trade deficit. By 2007, however, it had
passed Japan and China in the trade tables and was running the worlds largest surplus.
EU member nations were responsible for almost all of the gains, with euro-zone nations
accounting for two-thirds of its exports to Europe.
8

This did not mean Germany

suddenly became super price-competitive. After all, Germanys trade surplus with the
US grew only moderately during this period, and the country ran steady deficits with its
Asian trading partners (Exhibit 8).

Exhibit 8. German balance of trade

(mn, seasonally adjusted)

12000

Eurozone (EU16)
10000

8000

6000

US
4000

2000

-2000

Asia
-4000
95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

10

11

Source: Deutsche Bundesbank

Germany benefited most from unified currency

Although the ECB lowered interest rates out of concern for Germany, the German
economy did not respond at all because it was in a balance sheet recession.

Instead,

the rate cuts fueled housing bubbles in the PIIGS. Germany, in turn, was able to pull
itself out of the balance sheet recession by vastly increasing its exports to these booming
economies.
If Germany had not belonged to the euro-zone, the ECB would not likely have
lowered interest rates as far as it did, and the housing bubbles in the PIIGS would not
have grown as large as they did. In that hypothetical world, Germany would have had
to address the balance sheet recession, which was not responsive to monetary easing, on
its own.

The only options would have been a substantial devaluation of the

currencysomething the Bundesbank loathed to door massive fiscal stimulus of the

kind pursued by Japan.
Japans private sector was deleveraging to the tune of nearly 10 percent of GDP
9

per year (of which about 6 percent was due to corporate debt repayment, and 4 percent
due to savings by the household sector) between 1995 to 2005 in response to a
devastating 87 percent decline in commercial real estate values nation-wide. But the
Japanese government was able to maintain the GDP at above the bubble-peak levels for
the entire period by borrowing and spending the unborrowed savings in the private
sector. Although this government action added 460 trillion yen to the public debt
between 1990 to 2005, it managed to maintain at least 2000 trillion yen of Japans GDP
during the 15-year period compared to the case where the government took no such
action.
In that sense, Germany benefited more than any other country from the adoption
of the euro. Germanys fiscal deficits did not increase substantially after the bubble
burst only because the ECB fostered housing bubbles in other euro-zone nations (which
had not participated in the IT bubble) in an attempt to save the German economy.
Today the resulting housing bubbles have collapsed, and the PIIGS fiscal deficits
have widened as their economies weaken. Against this background it is open to debate
whether Germany is qualified to criticize these countries for running budget deficits.
After all, it was largely because the ECB lowered interest rates to 2% to save the
German economy that the PIIGS are now experiencing balance sheet recessions.

Financial interdependence between Germany and PIIGS

An analysis of the current crisis from a financial perspective reveals another
mutual interdependency. It was German and French banks that were responsible for
the lions share of lending to the PIIGS, and to some extent that was an inevitable
outcome.
After the IT bubble burst and Germany fell into a balance sheet recession, the
nations private sector had no demand for loans.

As Exhibit 4 shows, Germanys

corporate sector was characterized by a massive financial surplus (i.e., it was paying
down debt). German households also increased their savings during this period. The
German government, meanwhile, was prevented by the Maastricht Treaty from
borrowing more than 3% of GDP, although in the end its fiscal deficits slightly exceeded
that threshold. German banks therefore saw a huge inflow of savings from households
and businesses that could not be invested domestically.
Their only option was to lend the money overseas.

And one of the main

destinations was the PIIGS, whose economies were booming as a result of the housing
bubbles. German banks also did not need to worry about currency risk lending to the
PIIGS because these countries were also members of the euro-zone.
10

Policy errors led to major distortions in real economies and financial

sectors
In the 1990s, Japanese banks also faced a balance sheet recession where the loan
demand declined sharply. But because the Japanese government was issuing large
quantities of debt, domestic banks were able to invest surplus funds without going
overseas.
German banks were unable to do the same because their government was
reluctant to run larger fiscal deficits. As a consequence, the banks found themselves
forced to lend money to the PIIGS and Eastern European nations and to buy US CDOs
(collateralized debt obligations) and other securitized products fashioned from subprime
loans. The fact that so many lendersparticularly in Germanyfound themselves in
this situation almost certainly aggravated the housing bubbles in the US and the
PIIGS.
In the end, the German governments attempt to keep its fiscal deficit within the
Maastricht constraints despite the balance sheet recession forced German businesses to
rely on increased exports to the PIIGS and German banks to rely on increased lending
to the same. The governments inability to adopt the right policy at the right time due
to the Maastricht constraints created huge distortions in both the real economy and the
financial sector.

Many European nations currently in balance sheet recessions

What kind of measures are needed going forward? This issue is considered from
two perspectives, one being the question of how to manage national economies today
and the other being structural problems unique to the euro-zone.
Regarding the first question, all of Europeincluding the UKis now moving
ahead with fiscal consolidation, spurred on by the Greek crisis. With the exception of a
few nations, however, these policies are terribly misguided and, if implemented, could
cause a further deepening of the European economic crisis.
The reason is that most countries in Europe now find themselves in severe
balance sheet recessions, with both the household and corporate sectors striving to pay
down debt and increase savings. When the private sector is deleveraging in spite of
ultra-low interest rates, the governments only option is to step in and take the opposite
actioni.e., to borrow and spend the private sectors surplus savings (the savings that
were not borrowed and spent by businesses and households). Otherwise, demand will
contract by the unborrowed amount and the economy will fall into a deflationary spiral.
11

The last time this type of deflationary spiral was allowed to develop was during
the Great Depression in the U.S. where the private sector was deleveraging massively
following the collapse of share prices starting in October 1929 but the public sector
refused to borrow money. As a result, the U.S. economy lost 46 percent of its GDP in
just four years from 1929 to 1933.
A number of European countries have experienced a skyrocketing increase in
private savings over the past year or two. The increase in savings is so large that even
government loan demandfiscal deficitswhich has increased sharply since the
Lehman crisis, are not large enough to absorb it.

Exhibit 9. Spanish flow of funds

Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
12

(Financial Surplus)

Households

Rest of the World

Shift from 2007

in private sector:
17.11% of GDP

Corporate: 11.92%
Households: 5.18%

-4

Shift from 2007

in public sector:
11.15% of GDP

Corporate Sector
(Non-Financial Sector +
Financial Sector)

General Government

-8

(Financial Deficit)
-12

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Sources: Banco de Espaa and National Statistics Institute (INE),Spain, and Eurostat

Exhibit 9 is a flow-of-funds diagram for Spain. Between 2007 and 2010,

household-sector savings increased by 5.18% of GDP, and corporate-sector savings
(including debt repayments) rose by 11.92% of GDP. Private savings therefore rose by
a combined 17.11% of GDP over this two-year period. In other words, people who had
been borrowing and spending a great deal of money suddenly stopped and began saving
instead, eliminating private demand worth 17% of GDP.

The fact that this was

happening with the lowest interest rate in Spanish history indicates that Spain is
clearly in a balance sheet recession. If the Spanish government had stood by and done
nothing, the economy could have contracted by 17%, leading to Great Depression-like
conditions.

12

Spain and Ireland need and can finance more fiscal stimulus
The Spanish government responded with an economic package that transformed
the nations fiscal surplus in 2007 into a substantial fiscal deficit. At 11.15% of GDP
over two years, however, the stimulus was unable to offset the full 17.11% decline in
private demand. Spains unemployment rate is over 20%, the highest in the euro-zone.
In other words, Spanish deficit is large, but is not large enough to stabilize the Spanish
economy.

Exhibit 10. Irish flow of funds

Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
15

Corporate Sector

(Financial Surplus)

(Non-Financial Sector + Financial Sector)

Shift from 2006

in private sector:
21.55% of GDP

10

Rest of the World

Corporate: 7.29%
Households: 14.26%

General
Government

-5

-10

Shift from 2006

in public sector:
16.78% of GDP

Households

(Financial Deficit)

-15

2002

2003

2004

2005

2006

2007

2008

2009

Sources: Eurostat, Central Statistics Of f ice, Ireland

The flow of funds data from Ireland (Exhibit 10) shows that from 2006 to 2009, its
private sector (households, non-financial and financial corporations) increased savings
to the tune of 21.55% of GDP, the largest jump in savings as a percentage of GDP in
Europe if not in the world. Furthermore, this deleveraging was happening with lowest
interest rates in Irish history, indicating that Ireland is clearly in a balance sheet
recession.
During the same period, Irish government deficit increased by 16.78% of GDP. In
other words, 78% (17 divided by 22) of excess savings in the private sector was put back
into the economys income stream by the government borrowing and spending.
However, that still left a deflationary gap of nearly 5% of GDP which threw the Irish
economy into the deflationary spiral. The recent fiscal consolidation measures made
the matter far worse by widening already formidable deflationary gap even wider. As a
result, the Irish GDP is now 20 percent below its peak. In other words, even though
13

Irish deficit was large, in view of the magnitude of private sector deleveraging, it was
not large enough.
The vicious cycle Ireland has found itself in recently may be repeated in other
European countries if the lessons from the country are not incorporated into policy
making in the rest of Europe. In particular, Ireland has shown that when the countrys
private sector is deleveraging, any attempt at fiscal consolidation will result in
disastrous economy with rising, not falling fiscal deficit. Those results, in turn, bring
about lower bond prices and higher CDS spreads.

Portugal and the UK are in same boat as Spain

Portugal faces a similar situation. Since 2008, businesses and households
increased savings by a combined 7.6% of GDP, while the fiscal deficit has increased by
only 5.08% of GDP (Exhibit 11).

Exhibit 11. Portuguese flow of funds

Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
12

(Financial Surplus)
Rest of the World

Shift from 2008

in private sector:
7.60% of GDP

Households

Corporate: 5.56%
Households: 2.03%

General Government
Shift from 2008
in public sector:
5.08% of GDP

-3

-6

Corporate Sector

-9

(Non-Financial Sector +
Financial Sector)

(Financial Deficit)

-12

95

96

97

98

99

00

01

02

03

04

05

06

07

08

09

10

Sources: Banco de Portugal, Instituto Nacional de Estatstica, Portugal, and Eurostat

Although not a member of the euro-zone, the UK has seen private savings grow by
8.71% of GDP since 2006 (Exhibit 12). This amount exceeds the 7.29% increase in the
fiscal deficit (as a percentage of GDP) over the same period. The fact that U.K. house
prices are still falling and its money supply growth still stagnating in spite of massive
quantitative easing combined with the lowest interest rates in the U.K. history suggests
14

that the country is squarely in balance sheet recession.

In summary, all of these countries are generating more private sector savings
than increases in the fiscal deficit. All of these countries are facing large deficits not
because their politicians wanted to give away more pork, but because their domestic
demand was collapsing due to private sector minimizing debt by increasing savings. If
anything, the stimulus delivered so far has not been large enough to offset decline in
demand from the private sector deleveraging and sustain economic activity.

Exhibit 12. UK flow of funds

Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
10

Households

(Financial Surplus)

Corporate Sector
(Non-Financial Sector +
Financial Sector)

Rest of the World

Shift from 2006

in private sector:
8.71% of GDP
Corporate: 4.98%
Households: 3.73%

4
2
0

Shift from 2006

in public sector:
7.29% of GDP

-2
-4
-6

-8

General Government
-10

(Financial Deficit)
-12

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: Of f ice f or National Statistics, UK

It should also be noted that in balance sheet recessions, private sector has no
choice but to repair its battered balance sheets. In other words it will continue to
repair its balance sheets whether the government is running a deficit or a surplus.
This means so-called Ricardian Equivalence, where the private sector increases savings
in response to public sector running large deficits, is entirely irrelevant during balance
sheet recessions.
There will also be no crowding out problems with fiscal stimulus during balance
sheet recessions. This is because, during this type of recession, the government is
simply trying to put the unborrowed savings in the private sector back to the economys
income stream. The resource misallocation problem of fiscal stimulus is not an issue
either because, in balance sheet recessions, the resources not employed by the
government will most likely go unemployed which is the worst form of resource
15

allocation.

But conditions in Greece are completely different

The situation in Greece, in contrast, is very different from the five countries
discussed above. Greek private savings have increased by just 2.92% of GDP since
2008, largely due to reduced borrowings by its corporate sector. At the same time, the
public sectors funds deficit increased by 3.96% of GDP, underlining a growing
dependence on overseas funds (Exhibit 13).

Exhibit 13. Greek flow of funds

Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
16

Rest of the
World

(Financial Surplus)

12

Shift from 2007

in private sector:
2.92% of GDP

Households
8

Corporate: 3.04%
Households: -0.11%

General
Government

-4

Shift from 2007

in public sector:
3.96% of GDP

-8

Corporate Sector
(Non-Financial Sector +
Financial Sector)

-12

(Financial Deficit)

-16

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Sources: Bank of Greece, Eurostat

Greece differs from the examples above in that it actively took advantage of
foreign investors appetite for local debt after the euro was adopted to engage in
profligate fiscal spending by publishing inaccurate budget deficit numbers.

Even

though there was a temporary corporate deleveraging from 2008 to 2009, it was far from
sufficient to finance the increases in fiscal deficits. This means the Greek government
has no choice but to restore fiscal discipline.
Greece, however, now depends on foreign investors to absorb more than 75% of its
government debt. Given this reality, its only option in the short term is to rely on
support from the IMF and other EU countries while making improvements in the fiscal
balance.

In order to maintain credibility during this transition period, the Greek

government may want to consider the option mentioned at the end of this paper, i.e.,
16

announce that in not-too-distant future (for example five years), the Greek government
will sell government bonds only to Greek nationals. Such a drastic and game-changing
commitment to fiscal discipline may win the credibility of its foreign creditors for the
transition period.
For Italy, there was some deleveraging by the private sector from 2007 to 2009
when the increase in private sector savings outstripped the increase in government
deficit. This is shown in Exhibit 14. Recently, however, the private sector lines have
come down again. This may indicate that the balance sheet damage to Italian private
sector was minimal and that the things are returning to normal in the country.

Exhibit 14. Italian flow of funds

Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
12

(Financial Surplus)

10

Households

Shift from 2008

in private sector:
0.87% of GDP

6
4

Corporate: 4.35%
Households: -3.48%

Rest of the World

0
-2

Shift from 2008

in public sector:
1.68% of GDP

-4
-6
-8

Corporate Sector
General
Government

(Financial Deficit)

(Non-Financial Sector +
Financial Sector)

-10
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Sources: Banca d'Italia, Eurostat
Note: For 2010 f igures, 4 quarter averages ending with Q3/'10 are used.

Bundling five PIIGS together is nonsense

The analysis above should make it clear how dangerous it is to bundle the five
PIIGS together simply because they all have large fiscal deficits.

An examination of

private savings trends demonstrates that, at the very least, Spain, Ireland and Portugal
are now in balance sheet recessions and are generating substantial quantities of private
savings that should go a long way in financing their government deficits. In fact,
country such as Ireland can no longer be considered low savings country.
Businesses and households in these countries are rushing to deleverage which
17

means that the money multiplier at the margins is zero or negative. As Exhibit 5
shows, the euro-zone money supply has increased very slowly since the Lehman crisis
despite massive injections of liquidity by the ECB.

As long as the private-sector

deleveraging process continues, monetary policy is largely impotent and only fiscal
stimulus can prop up the economy. Premature attempts at fiscal consolidation are
likely to end in disaster, as did the deficit-reduction efforts of Japans Hashimoto
government in 1997.
After the Hashimoto administration pushed ahead with its fiscal consolidation
plans, ignoring the private sectors rush to minimize debt, Japans GDP contracted for
five consecutive quarters (based on data at the time).

As a result, tax receipts fell

sharply as shown in Exhibit 15. Far from achieving the planned 15trn reduction in
the fiscal deficit (3% of GDP), the government actually increased the deficit by 16trn
or 68%. Subsequent fiscal deficits required for Japan to recover from this policy error
easily exceeded 100trn or 20% of Japans GDP, and the recession was prolonged
accordingly.

Exhibit 15. Premature fiscal reforms in 1997 and 2001 weakened economy,
reduced tax revenue and increased deficit
(Yen tril.)

(Yen tril.)
70

70

Tax Revenue Hashimoto

Obuchi-Mori
fiscal
Budget Deficit
fiscal
60

reform

stimulus

Koizumi
fiscal
reform

Global
Financial
Crisis

60

50

50

*
unnecessary
increase in
deficit:
103.3 tril.

40

40

30

30

20

20

10

10

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
(FY)
Source: Ministry of Finance, Japan
*: estimated by MOF

Fiscal consolidation in Spain, Ireland, Portugal, or UK would be dangerous

For Spain, Ireland, Portugal or the UK to embark on fiscal consolidation in the
18

midst of severe balance sheet recessions would repeat Japans 1997 policy blunder.
The fact that a number of countries are attempting to do so simultaneously makes the
situation even more precarious.
These countries should not try to trim their deficits until it can be confirmed that
private loan demand has recovered and the private sector will support the economy by
borrowing and spending the (private) savings that the government is no longer
borrowing in the form of tax hikes and spending cuts.
This discussion should also make it clear how foolish it is for these nations to
observe the Maastricht Treatys 3% ceiling on fiscal deficits during balance sheet
recessions. If they abide by this rule while their private sectors continue to deleverage,
their economies will weaken and their fiscal deficits will actually increase, just as
happened in Japan in 1997.

The German Problem: Private sector debt aversion could be as severe as

that of Japanese counterparts
Today, Germany is once again making a forceful case for fiscal austerity.

The

biggest problem in this regard, however, is Germanys own private sector, as German
households and businesses have stopped borrowing since the IT bubble burst.
Household savings in Germany have hovered around the elevated level of 6% of
GDP since climbing to 6.5% in 2005 and are now rising again. Meanwhile, net savings
(including debt repayments) by the corporate sectorwhich is normally responsible for
the lions share of borrowing in an economyhave remained around 23% of GDP after
peaking at 3.4% in 2005. This means on a net basis, the German private sector is not
borrowing money at all.
This aversion to borrowing is a replica of the Japanese aversion to borrowing ever
since the latter cleaned up its balance sheets around 2005.

By 2005, Japanese

corporate balance sheets were fully repaired and the corporate deleveraging also came
to an end. But the businesses are only borrowing minimal amounts even with very
willing bankers and interest rates that have been the lowest in human history (Exhibit
6). This is because they were so traumatized by the horrible experience of paying down
debt under most difficult circumstances and are now saying to themselves never again.
German companies are now in the same mind set.
This aversion to borrowing may be considered the exit problem of balance sheet
recession. This is in contrast to the entrance problem of balance sheet recession
which consists of paying down debt in order to repair balance sheets in the midst of
shrinking economy and falling asset prices.
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Given a situation in which households are saving a great deal and businesses are
saving instead of borrowing, the only way for Germany to sustain its economy is for (1)
the government to absorb surplus private savings by running massive fiscal deficits or
(2) other nations to continue running large trade deficits with Germany.

Neither of

these options is sustainable in the long run. Accordingly, if Germany hopes to sustain
its economy it must either persuade households to reduce their savings or persuade
businesses to borrow more.
The past experience of numerous nations shows that it is extremely difficult to
alter household savings rate with government policy. The only remaining option, then,
is to modify the behavior of businesses. But if German businesses are experiencing the
same kind of debt aversion characterizing Japanese companies that went through the
post-bubble debt hell, overcoming those attitudes will be no easy task.

Rising

corporate savings and continued debt repayments at a time of historically low interest
rates in Germany suggest that the trauma is quite severe. If German companies are in
fact experiencing the trauma of debt aversion, the government will have to provide
incentives large enough to cure that trauma.

Germany has benefited from euro in very different sense from Greece
Recently pundits in Europe have been debating the question of whether Germany
or Greece would be the first to leave the euro-zone. If Germany were to abandon the
euro, in the face of massive German trade surpluses, its new currency would likely rise
sharply.

But if currency appreciation cut off the nations exports and large trade

surpluses at a time of net savings by both the household and corporate sectors, the only
way the government could sustain GDP and employment would be to run massive fiscal
deficits.
In that sense, Germany has benefited from the euro in the exact opposite sense
from Greece. Being part of the euro-zone enabled Germany to curb its fiscal deficits by
boosting exports to euro-zone markets. Greeces euro-zone membership, on the other
hand, enabled it to continue to engage in profligate fiscal policy by selling its debt to
foreign investors, especially those in Germany. Viewed in this light, the economies of
Germany and Greece are both unhealthy, but in very different ways.

Defective clause in Maastricht Treaty should be revised immediately

The second issue concerns structural problems specific to the euro-zone. For
more than 10 years I have argued that the Maastricht Treaty is defective because it
does not consider the possibility of a balance sheet recession. The treaty envisions only
20

a textbook world in which private-sector agents are always striving to maximize profits.
It does not consider the balance sheet recession world, in which households and
businesses are striving to minimize debt in spite of zero interest rates.
This is understandable inasmuch as the concept of a balance sheet recession did
not exist in the economics profession when the Maastricht Treaty was being discussed
in the 1990s. Had people known about it and incorporated their understanding of this
recession in the Treaty, policy responses by the ECB and Germany after the IT bubble
collapsed would probably have been very different.
If the Maastricht Treaty had required countries in balance sheet recessions to
respond with adequate fiscal stimulus and thereby prevent the damage from spreading
to other euro-zone nations, Germany would not have needed to depend on exports as
much as it did after the bursting of its telecom bubble. Nor would the ECB have had to
lower interest rates to the extent that it did, sparking housing bubbles in Spain and
Portugal in the process.
And if German banks had been able to invest in their own governments debt, they
would not have had to acquire so many Greek government bonds and US subprime
securities. In that sense, the policy distortions brought about by the Maastricht Treaty
are one of the underlying causes of the current crisis and that this omission in the
Treaty should be rectified without further delay.

Economies in balance sheet recession should be exempted from 3% cap

on deficits
The 3% ceiling on fiscal deficits makes sense in an ordinary (non-balance sheet
recession) world. Once an economy is certifiably in a balance sheet recession, however,
it should be exempted from the requirement. In fact, it should be obligated to engage
in ample fiscal stimulus to prevent the damage from spreading to other euro-zone
nations. Only then will the Maastricht Treaty allow an appropriate policy response to
conditions in both the textbook world and the balance sheet recession world.
The 3% ceiling on fiscal deficits was effective in producing a convergence of
government debt yields within the euro-zone. It became clear in the current crisis,
however, that once a country falls afoul of the rule, penalties will not workin fact,
support will be necessary.
Furthermore, the cap forces all euro-zone countries to accept the same fiscal,
monetary and currency policies despite their very different income levels and industrial
structures. That may not present problems when the euro-zone economy is doing well,
but during crises it can further aggravate the situation by depriving individual
21

governments of policy flexibility.

Euro-zone needs rule prohibiting foreigners from buying government debt

There is one way to allow governments to maintain a degree of fiscal policy
freedom while preventing fiscal problems in individual nations from threatening the
stability of the entire euro-zone, la Greece. That is to establish a rule preventing
foreigners from buying government debt. For example, the Greek government should
be allowed to sell its bond only to Greek nationals.
Such a rule would not only restore fiscal discipline in individual countries, but
also prevent fiscal problems in one nation from threatening the broader currency area
by making fiscal policy an internal issue. If the Greek government were to default, for
example, it would only be a problem for the Greek public and could be considered
separately from the health of the broader euro-zone.

Moreover, those who are

protesting in the streets of Athens can no longer afford to do so because they can no
longer blame everything on rich and fat German and French bankers.
Limiting the sale of government bonds to own citizens is a miniscule constraint on
free capital flows because the citizens of euro-zone will still be able to buy corporate
paper of other member countries where the efficiency gains from free capital
movements really matter. Indeed it is difficult to see any efficiency gain in allowing
German banks to buy Greek government bonds. On the contrary, the German bank
purchases of Greek government bonds allowed the latter to run ever more profligate
fiscal policy which, in the end, reduced efficiency gains for everyone.
Artificial constraints are required to maintain the artificially created currency
zone called euro-zone.

The Maastricht Treatys 3% cap on fiscal deficits as a

percentage of GDP represented a first attempt at such a constraint. The current crisis,
however, has made it clear that this constraint (1) cannot deal with a balance sheet
recession and (2) cannot address a situation like the one we saw in Greece.
Replacing the 3% cap with a rule stating that only domestic investors may buy
government bonds would restore fiscal discipline in these countries and enable
authorities to respond appropriately to balance sheet recessions. It will also free the
ECB from worrying about fiscal conditions of member governments and concentrate its
efforts on running the monetary policy.
The ECB of course should be able to buy and sell government bonds of member
countries in its execution of monetary policy.

The European Financial Stability

Facility (EFSF) should also be able to purchase member countries government debt
during crisis situations. But no private sector entities should be allowed to buy public
22

sector debt of another member country to prevent the latter from running irresponsible
fiscal policies.
In retrospect, limiting the sales of government bonds to own citizens should have
been the key provision of the Maastricht Treaty from the very beginning of euro. If all
member countries adopted this provision instead of the 3 percent rule in 2000, none of
the problems we are facing today would have materialized.

Revamping Maastricht could save euro-zone from double-dip recession

The Maastricht Treaty, of course, has an extremely strong legal foundation, and
revising it would be no easy matter. But we cannot afford to put off a revision of the
Treaty now that Spain, Ireland, and Portugal are in balance sheet recessions.
Spain, Ireland, Portugal and the UK have embarked on fiscal consolidation in a
bid to prevent a Greece-like crisis from unfolding in their own economies.
Unfortunately, they have focused only on the size of their fiscal deficits and have not
recognized that private savings trends in their countries are very different from those of
Greece. If these countries push ahead with deficit-reduction efforts, the euro-zone and
the broader European economy is likely to undergo the same kind of double-dip
recession that Japan experienced in 1997 and the US in 1937.
Like the euro-zone today, Japan in 1997 saw its currency decline in value as
capital fled overseas. As a result, asset prices fell even further, and the economy and
the fiscal deficit grew steadily worse just like Ireland today.

This deterioration

continued until the Obuchi administration adopted an aggressive fiscal policy. It is

hoped that these countries in Europe will stop making rushed fiscal consolidation
decisions based solely on the size of their fiscal deficits and instead choose policies that
better reflect private sector deleveraging trends in their economies.

23