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Generational Dynamics Web Log for 24-Dec-2008
The effects of massive fiscal stimulus.

Web Log - December, 2008

The effects of massive fiscal stimulus.

A study comparing Japan's deflationary spiral with ours shows the way.

Nikkei 225 Index -- Tokyo Stock Exchange -- 1984-2007 and 1914-2007.

Nikkei 225 Index -- Tokyo Stock Exchange -- 1984-2007 and 1914-2007.

Japan seems to run 10-20 years ahead of the United States, at least in the area of stock market crashes.

Japan had a major stock market crash in 1919, leading to a new bubble 65 years later, beginning in 1984, and a new stock market crash in 1990.

The US had a major stock market crash in 1929, leading to a new bubble 66 years later, beginning in 1995, and a major financial crisis beginning in 2007, probably with a new stock market crash to come soon.

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The current stock market bubble correlates with bailouts and stimulus: This is another refutation of Richard Koo's stimulus theories.... (14-Oct-2009)

Fiscal stimulus programs in 1930s and today: Did Hitler really do everything right?... (1-Apr-2009)

The effects of massive fiscal stimulus - Part II: President-elect Barack Obama is turning apocalyptic in his speeches.... (12-Jan-2009)
The economic outlook for 2009 : How we got to where we are today, who's to blame, and where we're going in 2009. (5-Jan-2009)

The effects of massive fiscal stimulus.: A study comparing Japan's deflationary spiral with ours shows the way.... (24-Dec-2008)

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Thus, for people trying to understand what's coming, we have two big examples to look at: America in the 1930s, and Japan in the 1990s.

Now, an October presentation by Richard C. Koo, Chief Economist at Nomura Research Institute, compares Japan's 1990s deflationary spiral with America's in the 1930s and today. (The web site has links to the presentation slides (PDF) and to a video of the 1½ hour presentation.)

Koo says that what has happened in Japan -- a "balance sheet recession" -- is not in any economics textbook, and he now sees the same thing happening not only in the US, but in Europe, in Asia, and around the world.

I watched the entire 1½ hour presentation, and I was transfixed. This comparison of Japan with the US provides a great deal of insight into where the American and world economies are going.

A "balance sheet recession" occurs as follows (this is my way of formulating Koo's description):

A credit bubble creates trillions of dollars in assets, and also creates trillions of dollars of liabilities.

When the bubble bursts, the assets disappear. (Housing prices fall, mortgage-backed securities become worthless, etc.)

But the liabilities don't disappear. They remain as debt on the balance sheets of businesses and households. This is the "balance sheet recession."

For years thereafter, businesses and households pay down debt, taking huge sums of money out of the economy.

When everyone is paying down debt, the money supply shrinks, leading to a deflationary spiral.

Monetary policy -- reducing interest rates to zero and quantitative easing -- no longer works. This puts money into the banking system, but since banks and everyone else are paying down debt, there are no lenders and no borrowers.

Koo points out that this violates much of mainstream macroeconomic theory, which assumes that people and businesses will want to borrow money when interest rates are nearly zero. But monetary policy simply stops working.

Since monetary policy stops working, a government has to resort to fiscal policy -- a huge fiscal stimulus package. The purpose of this is to keep the GDP from falling. The government does the opposite of what the private sector is doing. The private sector is paying down debt, refusing to borrow and spend. The government borrows and spends huge amounts of money.

Richard Koo's presentation, exhibit 6, shows Japan's GDP kept growing during the 1990s.

Richard Koo's presentation, exhibit 6, shows Japan's GDP kept growing during the 1990s.

Koo addressed several issues that arise:

Who is going to lend all this money that the government will be borrowing?
The answer to this question is mind-blowing: There is no problem whatsoever, because the amount of fiscal stimulus is exactly equal to the national savings generated by everyone paying down debt. In other words, the savings of American people and businesses will pay for the borrowing.
It's worth noting that recent events seem to support Koo's claims. He gave this presentation in October. Since then, the yields on Treasury bills have crashed to zero, as investors compete to lend money to the government. So what he said would happen appears to be happening already.

Won't the dollar weaken, become very inflationary?
Koo gave the following answer: The dollar would weaken, but since the same thing is happening to countries around the world, the dollar will remain at parity with other currencies. (This is not a fully satisfactory answer for me.)

What's the best way for the government to spend money -- social programs, infrastructure projects, or military/war/weapons?
Koo had previously said that tax cuts do not have the desired effect, since people will not spend the tax cuts, and will simply use the money to pay down debt. He didn't discuss social programs, but I would assume that the result is the same.
Koo said that there's no macroeconomic difference, but he added that the most effective spending program would be the military, since it creates jobs, but produces products that "are useless." Infrastructure projects, he said, aren't as effective because they produce useful products. He said that he hates this conclusion.
I would add the following, from the point of view of Generational Dynamics: One of the motivations for crisis wars is that when a man can't feed himself and his family, then he will blame his enemies, and he will have no objection to going to war. That's a microeconomic view of how a financial crisis leads to war. What Koo has done is clearly provide a macroeconomic view.

Koo notes that Europe needs to do a similar massive fiscal stimulus, but won't be able to because individual countries are prevented by the 1992 Maastricht treaty from spending more than 3% of GDP on fiscal stimulus.

As long-time readers of this web site know, I've been saying since 2002 that we're headed for a 1930s style Great Depression. I've read and commented on millions of words of stuff by people like Ben Bernanke, Paul Krugman, and other mainstream economists, and, as I've said many times, it's all crap. (In fact, during the course of his presentation, Koo also said that Bernanke, Krugman and mainstream macroeconomists were wrong.)

Koo's presentation is the first thing I've heard in years that's causing me to reassess some conclusions. I'm going to have to think about this for a few days or weeks, but these are my first thoughts:

I have always thought that the reason that the Japanese economy came out of the 1990s deflationary spiral so unscathed is because they were able to generate income by exporting to the US and China, which were in bubbles. Koo didn't address this point, and it's crucial.

The examples of fiscal stimulus given by Koo were after 1933 in the US, and after 1997 in Japan. At those points, the deflationary spiral had been going on for several years, and was already mostly spent. It's not clear to me that big fiscal stimulus will work nearly as well today, still very early in the deflationary spiral. In today's political terminology, there aren't enough "shovel-ready" projects available to fund, to offset the huge amounts of money lost to the economy from paying off debt.

Koo's presentation addresses keeping up GDP during a "balance sheet recession," but other things are unchanged -- and in many cases he says as much. The massive fiscal stimulus won't stop bankruptcies, won't stop the real estate crash, won't stop foreclosures. It won't stop job losses and unemployment, but will replace lost jobs with different "make-work" jobs.

And it won't stop a stock market crash. In particular, the Law of Mean Reversion has not been repealed by anything that Koo said. No fiscal stimulus will cause people to borrow and spend, and so people won't be buying new cars or new iPods. On the other hand, manufacturers of cheap, functional products will do well. This means that many businesses will still go bankrupt, and/or their stocks will still crash, while other businesses will have a chance to grow. However, before you use this as a current investment strategy, remember that in a stock market crash, even good stocks crash, because people have to sell their good stocks to generate cash to pay off debts and meet margin calls.

Nor has generational theory been repealed by anything that Koo said. Koo made only a passing reference to generational concepts when he said that "debt minimization" behavior lasts much longer than necessary. It's a shame that he couldn't have done his analysis with generational and system dynamics concepts in mind, since that would have explained a lot more.

In fact, Koo's theory explain why stock prices kept falling after the crash of 1929, until they had fallen 90% of their peak value by 1933. Just as people don't want to spend money on unnecessary purchases, they also don't want to spend money on stock shares that might lose value. We can expect the stock market to fall to Dow 3000 or lower -- that prediction is not affected by anything Koo says.

We can also still expect a massive, worldwide generational panic and crash -- An elemental force of nature, where millions or even tens of millions of Boomers and Generation-Xers in countries around the world, never having seen anything like this before, and not having believed it was even possible, suddenly try to sell everything in a mass panic. This will bring down computer systems for hours, perhaps even for a day or two, as people watch tv in glazed horror as their life savings disappear. This will seal the "debt minimization" behavior for decades.

Nothing that Koo says repudiates the prediction that we're headed for a Clash of Civilizations World War. To the contrary, Koo's theory provides a macroeconomic justification for the correctness of this prediction.

I have a feeling that I'm going to be commenting on these concepts quite a bit in the next few weeks and months. For now, everyone who's into economics is urged to invest 1½ hours in watching the video of Koo's presentation.

(Comments: For reader comments, questions and discussion, as well as more frequent updates on this subject, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.) (24-Dec-2008) Permanent Link
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Generational Dynamics Web Log for 24-Dec-2008 The effects of massive fiscal stimulus.

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Generational Dynamics Web Log for 24-Dec-2008
The effects of massive fiscal stimulus.