Dangerous Nonsense

Nomura chief economist Richard Koo has recently attracted attention again, as the notion that the US economy is following in the footsteps of Japan's long 'slow motion depression' is gaining credibility on account of the weakness of the economic recovery to date and continued negative private sector credit growth.


Koo has some time ago already invented a new term for the Japanese predicament – he calls it a 'balance sheet recession'. Looking at his arguments, we find that the new term does not convey a new theory – it is simply a warmed over version of the neo-Keynesian 'liquidity trap' theory that holds that a deep recession following an asset bubble becomes impervious to monetary pumping due to a society-wide rise in liquidity preference and must therefore be arrested by a vast increase in government spending. What is so astonishing about all this is that Koo is hailing from Japan. Japan's government has spent enough money to create the biggest cumulative budget deficit of all industrialized nations, putting even such luminaries as Greece to shame, and has absolutely nothing to show for the effort. Moreover, it is a situation that is quickly approaching the 'end game' as the private sector savings rate in Japan declines ever more, and Japan's government can not hope to be able to borrow from foreign investors at the low interest rates it has become accustomed to at home. You'd think that someone residing there and having witnessed the failure of this approach first hand would argue against it. Not so; as you will notice when looking at Koo's presentations and articles , he belongs to the 'they didn't spend enough' school. Seriously.

We have previously commented on the strange tendency of many mainstream economists to be completely undeterred by glaring examples of the failure of the policies they recommend. Koo is clearly such a case. He attempts to explain the failure of Japan's spendathon by arguing that the occasional attempts to lower deficit spending whenever the economy showed signs of life were responsible for returning the economy to recessionary conditions.

This is actually not entirely wrong. Whenever artificial stimulus ends – be it of the fiscal or monetary variety – the wealth-destroying activities engendered by the stimulus and masquerading as 'growth' in the government's statistics tend to stop, and the economy is back at square one. In other words, the true underlying state of the economy is unmasked on these occasions.

Koo's conclusion that therefore, government should simply keep spending until the cows come home, is however entirely wrong. Following his recommendations would only ensure that even more malinvestment and 'regime uncertainty' combine to plunge the economy into an ever deeper hole – which indeed appears to have happened in both Japan from 1990 onward and in the US economic bust of the 1930's.

Koo complains that 'America lacks the necessary commitment to stimulus' , to which we can only say 'let us hope so'. In our opinion this is unfortunately far less certain than Koo surmises. The danger that economic policy makers fall for the dangerous nonsense produced by the likes of Richard Koo or Paul Krugman is in fact extremely high, as most politicians have no stomach for a sensible long term oriented approach to economic policy. Instead, the 'quick fix' , trying to avert short term pain with a view toward winning the next election is the main motivation driving modern-day economic policy-making. As we have noted previously, both the government itself as well as economists of the Keynesian persuasion are attempting to establish that government intervention 'works' by publishing 'quantitative studies' aiming to provide the requisite proof. Such assertions can not be disproved empirically until governments actually refrain from intervening, but they can certainly be disproved by sound economic theory. It is rather obvious that the situation the economy finds itself these days is bad, but instead of admitting that the policies have not worked, the default position of government and its courtier intellectuals is simply: 'it would have been worse had we not intervened'. This puts critics in the position of having to disprove a negative, of the type of 'the absence of evidence is not evidence of absence' – or using Carl Sagan's example: 'Just because we have zero evidence of UFO's visiting earth, does not mean they're not visiting us all the time.' This in fact describes the position of government and its apologists on the intervention question very well: they want us to believe in UFO's, or as Ludwig von Mises put it, in 'Santa Claus' (see further below).

The real Problem

Koo's approach is to look at past economic statistics (his presentation is full of nifty charts) and then coming to completely erroneous conclusions based on them. What Koo, Krugman, DeLong and other proponents of deficit spending overlook is that government spending does not exist in a vacuum. You may well ask yourself, if it is true that increased government spending is a good thing during recessions, then why is it not always a good thing? If government can conjure up wealth by increasing its spending during bad economic times, can it not conjure up wealth at any other time as well? Obviously, there has to be a catch somewhere.

The catch, as Ludwig von Mises has formulated it in Human Action, chapter XXIX, 'The Restriction of Production' is the following:


People expatiate on alleged government encouragement of production. However, government does not have the power to encourage one branch of production except by curtailing other branches. It withdraws the factors of production from those branches in which the unhampered market would employ them and directs them into other branches. It little matters what kind of administrative procedures the government resorts to for the realization of this effect. It may subsidize openly or disguise the subsidy in enacting tariffs and thus forcing its subjects to defray the costs. What alone counts is the fact that people are forced to forego some satisfactions which they value more highly and are compensated only by satisfactions which they value less.

At the bottom of the interventionist argument there is always the idea that the government or the state is an entity outside and above the social process of production, that it owns something which is not derived from taxing its subjects, and that it can spend this mythical something for definite purposes. This is the Santa Claus fable raised by Lord Keynes to the dignity of an economic doctrine and enthusiastically endorsed by all those who expect personal advantage from government spending. As against these popular fallacies there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens' spending and investment to the full extent of its quantity. While government has no power to make people more prosperous by interference with business, it certainly does have the power to make them less satisfied by restriction of production.”

(our emphasis)

The real problem is the all economic activity must be funded – and the creation of money from thin air or the shifting around of existing resources by government edict is not the same as 'funding'. In short, there is no 'Santa Claus'. Economists like Koo do not trust the market economy – they believe that the government must stand ready to intervene to 'fix' its alleged faults. And yet, the government can not use any resources in its interventions that have not first been produced by the market economy.

As we have argued in 'Short and Long Term Cycles' , the credit-induced boom that ended in 2008 consisted of a number of short term cycles, the bust periods of which differed from the current bust insofar as the pool of real funding was still expanding at the time they occurred. Economic production is after all not funded by 'money' – money is merely the medium of exchange that makes the division of labor and the complex modern market economy possible. It is ultimately funded by real saved goods. As long as this pool of real funding still expands, monetary pumping and deficit spending appear to have a positive effect, as the wealth-consuming economic activities they encourage can for a time co-exist with the the real production of wealth that is still ongoing. Also, given that economic growth is reckoned in monetary terms, a vast expansion of the money supply can always create the illusion of 'growth' – after all, the government's methodology of GDP accounting does not reflect the true growth of the money supply. Instead is uses a number of gimmicks like 'hedonic indexing' and the absurd 'GDP deflator' to adjust the data for what it views as 'inflation' – not to mention that government spending actually 'adds' to GDP.

While we can not directly measure the state of the pool of real funding, we can infer that the long uninterrupted credit boom has distorted the economy's production structure enormously, and has led to consumption of real capital as more and more resources were diverted into wealth-destroying activities. These are simply put all those activities that would not exist in an unhampered market economy without monetary pumping and government's deficit spending. They would be unprofitable as a direct result of their failure to conform to true consumer wants. Real funding for them would not be available (this is not to say that entrepreneurial mistakes are not possible in a free market economy, but they are soon weeded out).

It is true that consumption spending is currently on the retreat – private economic actors have rightly concluded that the need to rebuild their savings is acute. By acting in this manner they are not 'depriving' the economy of anything, as Keynesian 'under-consumption' theories would have it – rather, they are laying the foundation for future economic growth. Both the maintenance of existing capital and the creation of new capital requires as a sine qua non the saving of real goods. If government proceeds, as has happened in Japan and as Koo and others propose, with spending the savings of private economic actors via deficit spending, it will perforce delay the advent of a genuine self-sustaining economic recovery. This can not be otherwise, as these savings will once again diverted into loss-making, capital-consuming activities. It is simply not possible for the government to allocate scarce resources more efficiently than the private sector.

The Solution

The crisis is to the preceding boom in a sense as defeat is to victory in war: the latter has many fathers, while the former is marked by a distinct lack of parentage. Central bankers and governments have spent a lot of effort and ink on denying their complicity in the boom and bust. As a result we now have the same people who created the mess in charge of leading us out of it. That this is unlikely to work should be clear to anyone with an ounce of common sense.

Regulatory abominations like the financial reform act (which Zerohedge, in a nod toward its main authors Chris Dodd and Barney Frank colorfully refers to as the 'Donk Act') and experiments in monetary pumping and deficit spending on a hitherto unheard of scale are extremely unlikely to change things for the better. As Doug French notes in his review of the 'Alchemists of Loss':


“Well, right, in a perfect world where you wanted to inspire innovation, creativity, competitiveness, and have a financial system that's panic free, you'd immediately start with 2,300 pages of gobbledygook that has been crafted on the fly by Washington lawyers and staffers while great financial minds like Chris Dodd, Barney Frank, Nancy Pelosi, and Harry Reid calmly think through the details and repercussions.”


It is astonishing that after two years of unprecedented deficit spending, with two back-to-back federal deficits exceeding the $1 trillion mark for the first time in history, economists like Koo are complaining about there not being enough 'stimulus'. Most people are probably aware that prior to the bust there was too much credit-financed spending, and yet we are now supposed to believe that the problems this has created can be alleviated by more of the same? It should be self-evident that this can not be true, even if one has no inkling of Austrian capital theory.

We must stress here that there is no 'painless' way for the economy to readjust. Koo and others are looking for a 'painless solution' grounded in accounting identities, but these are , to quote Patrick Barron, 'baloney'.


“The key fallacy embedded in Keynesian economics and the GNP equation is the idea that government spending adds to an economy's health. In reality, the opposite is true: government spending subtracts from an economy's health. The real economy is the private economy — there is no other. Government spending must come out of the private economy.” […]

“The common man may not know the term "tragedy of the commons", but he knows it when he sees it. As the scramble for public resources ensues, however, another economic phenomenon kicks in: the fallacy of composition, which states that what benefits one segment of the economy at the expense of everything else cannot possibly prove beneficial for the economy as a whole. Put simply, we cannot all subsidize each other and come out ahead. While most want to be subsidized by others without having to pay anything in return, special interests from all sides ensure that the looting becomes universal.

Keynesianism institutionalizes the tragedy of the commons and believes that the fallacy of composition does not apply. It ignores the fact that government spending must come either from tax dollars or from the printing presses, both of which harm the common man. Instead, Keynesianism promises that we can all pick one another's pockets — and all get rich doing it!”


So what is the solution to the problem? Neither the Fed's policy of interfering with interest rates and pumping up the money supply, nor more government spending are likely to provide anything but a short term illusion of increasing prosperity – a fact that people in Japan (ex Richard Koo, evidently) can by now certainly attest to. If it were otherwise, there would not be any economic problems for us to consider – we'd have arrived in a Utopia without economic scarcity long ago. As inconceivable as it is for the planners, the solution is to do nothing at all. In fact, we would amend this undoubtedly sound advice by recommending government concentrate on dismantling as many regulations that are hampering the economy as possible, while massively reducing both its spending and taxation. The less interference there is with market processes, the faster genuine economic growth will return. The reallocation of scarce resources to their best use is going to be experienced as a period of recession – this can not be avoided. However, the less government interferes with this process, the shorter this recessionary period will turn out to be. The choice is between 'short term pain and long term gain' or its opposite. Adopting Richard Koo's proposals will only ensure the latter – an endless economic funk of the sort Japan has been going through for two decades and counting.



Nomura's Richard Koo: His 'balance sheet recession' is just a fancy term for the tired Keynesian 'liquidity trap' theory.

(Photo credit: E.H.)




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