Fiscal, Vote Yes: Monetary, Vote No!

9th June 09 - Fiscal, vote yes: Monetary, vote no

Richard Koo, chief economist of the Nomura Research Institute, is well known for his examination "Japan’s Great Recession" covering a prolonged period starting in 1990. He has an interesting theory concerning the credit crunch in that we must pay attention to the "cycle" we are in to determine whether a fiscal or a monetary stimulus is the right approach. He considers that the UK is in a "yin" or shadow phase where debt minimisation is to the fore. When this cycle occurs, the economy falls into a "balance sheet recession" and asset prices fall pushing personal and corporate balance sheets into the mire. This is his view of where we are now.

The logical conclusion from identifying the cycle phase as in shadow is that more fiscal stimulus is needed simply because borrowers are few. Once asset prices have fallen substantially, the business (say) is transformed from one concentrating on making money to one that is paying down debt and so diverting cash flows from future growth paths. When this happens (on a personal as well as business front), cash remains in the banking system. It follows that looser monetary policy, for example the current quantitative easing by the Bank of England, has very little effect. It does not matter how low the cost of money becomes due to the reduced demand for debt.

There is evidence to support this theory. While money supply from central banks has grown, broader money supply is lagging. The expansion of commercial bank money into the real economy is actually modest since the banks want to hoard capital and restore profitability. Taken to the personal level, consumers will remain reluctant to shop as the sword of Damocles called unemployment hangs low.

The warning from Mr Koo is that the Japanese great recession could be a harbinger of a UK one.