Koo, R. (2014) “Fixing the Eurozone“, The European Magazine, 03 September.
The fact that key economies are currently saving instead of borrowing shows how detached the euro zone has become from the wisdom of conventional economics. Yet there is hope.
I have been warning since my first English book, Balance Sheet Recession, that if the U.S., Japan and Europe faced balance sheet recessions, Europe would have the most difficult time because the Maastricht Treaty has no provisions for this type of recession. Unfortunately, my warnings came true with a vengeance.
Today, private sectors of virtually all euro zone countries are saving money and paying down debt despite zero interest rates. According to the latest flow of funds data, the private sector as a group is saving 13.9 percent of GDP in Ireland, 8.6 percent in Spain and 7.5 percent in Portugal, all on a four-quarter moving average basis. The U.S. private sector is also saving 3.9 percent of GDP. The fact that they are saving instead of borrowing at zero interest rates means that these economies are totally outside the realm of conventional economics.
A deflationary spiral
The private sectors are deleveraging because the assets they bought with borrowed funds during the bubble collapsed in value while their liabilities remained, leaving their balance sheets badly underwater. In a national economy, however, someone must borrow and spend the savings generated in order to keep the economy going.
In the usual or textbook world, interest rates go lower when there are too few borrowers and higher when there are too many to ensure that saved funds are eventually borrowed and spent. But when households and businesses face balance sheets underwater, they do not borrow at any interest rate. There are not many lenders either, especially when the lenders themselves have balance sheet problems.
But if the newly generated savings and deleveraged funds find no borrowers even at zero interest rates, they become a leakage to the income stream and a deflationary gap of the economy. If left unattended, the unborrowed savings will start a deflationary spiral, the same spiral that led to the 46 percent shrinkage in U.S. GNP during the Great Depression. The lack of borrowers also explains why monetary policy became largely ineffective in the West after 2008 and in Japan after 1990. Because there was no name for recessions driven by private sector minimizing debt, I termed the phenomenon balance sheet recession.
With monetary policy largely useless, the only way to keep the economy going when the private sector is a net saver is for the government to borrow and spend the unborrowed private savings. Post-1990 Japan took many years to realize that a fiscal response is needed until the private sector is ready to borrow again. The post-2008 U.S., on the other hand, realized that it was facing a Japanese-type balance sheet recession after many of its policy makers read my second English book, The Holy Grail of Macroeconomics. That led them to an all-out effort to stay clear of the “fiscal cliff”. Thanks to their efforts, the U.S. managed to avoid the cliff, and both the economy and private sector balance sheets are continuing to improve.
Relevant posts:
- Turner, Α. (2014) “Facing Reality in the Eurozone“, Project Syndicate, 08 September.
- Melitz, J. (2014) “The discontented members of the Eurozone should consider very seriously the creation of a second euro“, LSE EUROPP Blog, 04 September.
- Giavazzi, F. & Tabellini, G. (2014) “How to jumpstart the Eurozone economy“, VoxEU Organisation, 21 August.