Richard Koo - US Economy Confounds Policymakers’ Hopes

Mr. Koo brings some very interesting points:

Krugman insisted quantitative easing would be effective during balance sheet recession

QE2’s impact on real economy meager at best

Only remaining options: dollar devaluation and protectionism

Failure of QE2 has painted Obama administration into a corner

Obama administration underestimated power of balance sheet recession

Jobs report should help policymakers realize that fiscal stimulus is the only option
It is my understanding that a number of key officials within the Administration have read my book. They include former National Economic Council head Larry Summers, Fed Chairman Ben Bernanke, Council of Economic Advisors director Austan Goolsbee, former NEC head Laura Tyson, and former CEA director Christina Romer.

In spite of the better understanding of Japan’s experience, however, people in the Administration opted for the arguments of Mr. Krugman and Ms. Wells and hoped that QE2 would be enough.

If the recent jobs report is enough to convince them that they were wrong, I think they may finally realize that the only effective policy response is fiscal stimulus, not further monetary easing.

In spite of two and a half years of zero interest rates and six months of QE2, the money supply has grown only very slowly, housing prices continue to fall, and job growth is slowing. There is sufficient evidence that the US cannot generate ordinary inflation during a balance sheet recession, something that Japan learned two decades ago.

Obama administration needs to shift to fiscal stimulus as quickly as possible
Even if senior economic policymakers realize that fiscal stimulus is the only option left, the direction of policy cannot be changed overnight. Mr. Obama, after all, promised voters he would pursue fiscal consolidation.

But if the Democrats made a decision and argued that fiscal stimulus was needed for the time being, the Obama administration could set itself apart from the Republicans, who have staked their political careers on fiscal consolidation.

If Democrats do not have the courage to do that and instead continue to stumble along the current path, the balance sheet recession would make itself felt even more as housing prices continue to fall.

For that reason I think it is essential that the Obama administration alter its policy stance as soon as possible, for the sake of both the US economy and the global economy. Democrats must alter their stance because there is no likelihood of the Republicans changing course given their historical policy stance.

Rating agencies further complicate matters

Republican senator Tom Coburn, who has worked to achieve bipartisan agreement in the Senate, recently dropped out of a bipartisan group to reduce the deficit and said in an interview that “knowing what I know” he would “downgrade [the US] in a minute.” This remark implies that there is very little chance of politicians reaching an agreement by the 2 August deadline.

Warnings by the credit agencies have contributed to a policy debate in which fiscal consolidation is increasingly presented as a fait accompli, with no one daring to ask whether now is the right time to implement such a policy.

With the deadline for approving a new debt ceiling fast approaching on 2 August, fiscal belt tightening is now “the only game in town.” The situation in Washington increasingly resembles that in Europe, where fiscal austerity has become the be all and end all. With flow-of-funds data for Europe and the US offering evidence of continued deleveraging by the private sector, I see little chance of an improvement in the Western economies as long as the march to fiscal consolidation continues.

2011 06 07 - Nomura - Richard Koo - US Economy Confounds Policy Makers' Hopes

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com