Richard Koo: Roller coaster ride for bond market participants

Nomura Securities Co Ltd, Tokyo Japanese Equity Research Flash Report Richard Koo r-koo@nri.co.jp

14 December 2010
The worlds bond markets have been on a two-week roller coaster ride. The week before last, the US jobs report appeared to show clear signs that any recovery in the labor market would be delayed. But that was followed last week by the announcement of an agreement between President Obama and the Republican Party that was seen as having positive implications for the economy. The November payrolls report, released on Friday, 3 December, came in below market expectations. However, some attributed the weak results to excessively strong October data, and the general view seemed to be that the results for October and November should be viewed together. * Surprise agreement between President Obama and Republican Party The suddenly announced agreement between President Obama and the Republicans came as a surprise to many. The president secretly negotiated this deal with key Republican officials without consulting senior officials in his own party. News of the agreement initially sparked a heavy sell-off in the bond market. The resulting rise in yields was large enough to suggest that the downtrend in interest rates was finally over. The sell-off also led to higher mortgage rates. The agreement contains broad-ranging economic stimulus in the form of a two-year extension of the Bush tax cuts for all taxpayers, including high earners, full expensing of investments, an extension of unemployment insurance, and a reduction in payroll taxes. I do not think the extension of Bush tax cuts themselves will spark an economic recoveryafter all, those tax cuts were unable to prevent the current recession. Most of the increase in unemployment insurance benefits will probably be earmarked for consumption, but it is difficult to tell how much the payroll tax cuts will boost spending. With the US household sector still deleveraging, I project that most of the tax cuts for that sector will either be saved or used to pay down debt. On the other hand, full expensing and other provisions may help. The IMF estimates the plan would lift US GDP by about 1%. Altogether, the package can be expected to provide a certain amount of support for the economy (compared with a situation in which nothing was done), although it remains to be seen whether the Democrats will approve all of the measures. * Use of credit cards in US drops precipitously Thanksgiving Day, the third Thursday in November, marks the start of the Christmas shopping season. This year saw the lowest use of credit cards in the 27-year history of the survey. Only 17% of US consumers used credit cards during this period, down nearly half from the corresponding ratio for 2009. On a quarterly basis, credit card use in Q3 was off a full 11% from the same quarter a year ago. This is especially noteworthy given that the economy was already extremely weak in 2009 Q3. Part of the reduced activity, of course, is attributable to stricter card issuance standards adopted since the financial crisis, which are said to have caused 15 million Americans to lose their credit cards. More recently, however, credit card companies attitude towards lending has undergone a change. With profits depending on people using credit cards, issuers are now engaged in a fierce competition and have unveiled a variety of incentives to encourage consumers to make greater use of their cards. However, there has been little response from consumers, reflecting the continued efforts of US households to minimize debt. (issued in Japanese on 13 Dec 2010)

Please read the important disclosures and disclaimers on pp. 9-10 gl

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* Collapse of housing myth and rising US household savings Last week I was talking with someone I met at a certain store in New York who insisted he would never use that stores credit card again. I asked why, because I happen to carry the same card and have been very happy with it. He answered that he had spent too much with the card and now regretted it terribly. Many US consumers now find themselves in similar circumstances, and that is reflected in the credit card usage data noted above. I attribute this change in sentiment to concerns driven by the high unemployment rate coupled with the fact that US housing prices, after going 70 years without ever dropping, have declined substantially, leaving many people owing more than their homes are worth. This marks a 180 turnaround from the world in which steadily rising home prices represented a form of savings. Now, instead of increasing, these savings are in many cases shrinking. Japans real estate myth began with the end of World War II and lasted 45 years, and its collapse had a major impact on consumers behavior. The US housing myth was alive for a full seven decades. Accordingly, we should not underestimate the psychological shock resulting from its collapse. * US tax deductions for various types of interest continued from Great Depression to 1970s Some market participants believe that with the US household savings rate as high as it is, savings are more likely to decrease than increase going forward, and that a reduced savings rate would quickly spark a recovery in the US economy. But if the current increase in US household savings is driven by the collapse of a 70-year housing myth, I think US consumers propensity to save may well remain at elevated levels. Americans who lived through the Great Depression, which began with the stock market crash of 1929, experienced a long-term trauma that left many of them insisting they would never again borrow money. This aversion to debt caused the after-effects of the balance sheet recession to linger on for decades because businesses and households were not borrowing and spending private savings even after their balance sheets were repaired. The US government responded by creating a variety of tax deductions for interest in an attempt to make it easier for people to borrow money. Until the 1970s virtually all types of interestranging from interest on credit card loans to interest on automobile loanswere deductible in the US. * Upward pressure on savings rate will take time to correct Starting in the 1970s, however, US households savings behavior began to move in the opposite direction, leading eventually to excessive borrowing and insufficient savings. The government responded by gradually phasing out most deductions for interest, home mortgages being the key exception. But it took more than 40 years since the Great Depression to reach that point. That Japanese businesses and households remain averse to debt even today, some 20 years after the real estate bubble collapsed, also suggests that this type of trauma takes a great deal of time to get over. I think it can be argued that the US will require less time to recover. The US bubble was relatively mild in comparison with that of Japan, where 20 years ago it was said that the land underneath the Imperial Palace was worth as much as the entire state of California. However, I see a real possibility that the collapse of the 70-year housing myth and the consequent increase in the savings rate will continue until housing prices start to rise again. After all, the movement of US housing prices (but not commercial real estate) is surprisingly similar to that of Japanese prices 15 years ago in terms of the percentage increase, the duration of the increase, the percentage decline, and the duration of the decline.

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* Re-examining US deleveraging process Last week the Fed released flow-of-funds data for 2009 Q3. The numbers indicated that the private sector deleveraging process continues, although the pace of increase in savings has moderated somewhat. As I noted in the 13 July 2010 edition of this report, the flow-of-funds data for the US for the past two years have some serious problems and cannot be taken at face value. The data divide the economy into five sectorshouseholds, nonfinancial businesses, financial institutions, government, and the rest of the worldsuch that the financial surpluses or deficits for all five sectors sum to zero. The data are used to determine which sectors in the nations economy are saving (= financial surplus) and which are borrowing and investing (= financial deficit). For the last two years the sum of these five figures has been nowhere near zero, as Exhibit 1 shows (note that, in Exhibit 1, nonfinancial corporates and financial institutions are grouped together as the corporate sector).
1. US flow of funds data since 2008 are unreliable

(as % of nominal GDP) 8 Households 6 4 2 0 -2 -4 -6 -8 -10 -12 General government

Financial surplus or deficit by sector (Financial surplus) Rest of the w orld Numbers do not add up at all

Shift from 2006 in public sector: 8.50% of GDP Corporate sector (non-Financial + financial) IT bubble Housing bubble

(Financial deficit) 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 (CY)

Note. 2010 is Q1-3 average. Moreover, in standard flow-of-funds data, the financial surpluses or deficits for five sectorshouseholds, nonfinancial businesses, financial institutions, government, and the rest of the worldsum to zero. Source: Fed, US Department of Commerce

The fact that these five figures do not sum to zero is an indication that some or all of the figures are not accurate. But without these data it is impossible to determine the scale of the deleveraging process currently underway in the US private sector. That is why I presented two measures of the private sector in the 13 July report: one defined as households plus the corporate sector, and the other defined as zero minus the sum of government and the rest of the world, drawing on the property that the financial surpluses and deficits of the five sectors must sum to zero (Exhibit 2). The first measure is shown in the graph as a narrow line; the latter, as a thicker line. In theory these two lines should trace exactly the same paths. Historically there has always been some divergence between the two, but recently the disparity has grown much larger. A look at the gap between the two measures for the past few years shows that if the narrow line is correct, private sector deleveraging represents at most about 8.28% of GDP. But if the thicker line is accurate, the private sector deleveraging process could amount to as much as 13.29% of GDP, which is far greater than the 8.5% (of GDP) increase in the governments fiscal deficit during this period. That would suggest that there are still substantial deflationary gaps in the US economy.
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2. Increase in financial surplus varies greatly with definition of private sector

(as % of nominal GDP) 10 8 6 4 2 0 -2 -4 -6 -8 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 (CY)

Note. 2010 is Q1-3 average. In standard flow-of-funds data, the financial surpluses or deficits for five sectorshouseholds, nonfinancial businesses, financial institutions, government, and the rest of the worldsum to zero. However, US flow-of-funds data does not sum to zero, particularly over the past two years when the financial crisis has led to numerous difficulties with household and corporate statistics and major discrepancies. It is now impossible to ascertain financial surpluses or deficits for the private sector (nonfinancial businesses, financial institutions and households) with any degree of certainty. This is why we have provided two definitions for the private sector, namely (1) nonfinancial businesses, financial institutions and households and (2) all five sectors minus government and the rest of the world, and compared the two sets of figures. Source: Fed, US Department of Commerce

(2) "Private sector" as a residual after government and foreign sectors 13.29% of GDP

8.28% of GDP (1) "Private sector" as obtained by adding corporate, households and financial sectors

* Statistics prevent accurate measure of deleveraging On my recent visit to Washington, I was able to speak with some of the people responsible for compiling this data series. I took the opportunity to ask them about the causes of these problems with the flow-of-funds data over the past two years. They replied that the financial crisis had thrown their estimates completely off course and that they themselves were not sure what to do about it. Figures for households and businesses in the flow-of-funds data are estimated based on the results of various surveys, and the financial crisis has created serious problems for the estimation process. I was even told that it would be another two years before more accurate data were available. Over the next two years, they said, new data will be used to enhance the precision of figures that can currently only be estimated. * Pessimistic estimates may be closer to reality But for the policymakers and market participants who must evaluate the economy now, two years is far too long a time. When I asked the economists which of the two lines illustrating private savings behavior was closer to the reality, they said the thicker line was probably a better approximation of actual economic conditions. Their reasoning was that the thicker line can be estimated using just two types of primary data: the trade balance and fiscal balance. The estimation process is therefore far simpler than that required for the thinner line. That would imply that, as the flow-of-funds data are corrected going forward, it is far more likely that the thinner line will move closer to the thicker line than the other way around. That, in turn, suggests that the increase in savings and minimization of debt in the US private sector will continue. US private savings increased by 13.29% of GDP between 2006, when savings hit bottom, and the present. That is not far from the corresponding figures for Ireland (21.93%) and

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Spain (18.30%), which also have fallen into balance sheet recessions as their housing bubbles collapsed. It is also worth noting that, at 8.67% of GDP, US private savings are large enough in absolute terms to finance most of the nations fiscal deficit, which recent estimates put at 9.91% of GDP (Exhibit 1). * Americans no longer averse to saving With US borrowings from the rest of the world having dropped from a peak of 6.03% of GDP in 2006 to just 1.24% today, the US can no longer be characterized as having an extremely low savings rate. We tend to automatically assume that the US does not save enough because that was the case for many decades. However, the data cited above demonstrate that current conditions in the US are very different from those that obtained in the past. The US now has a massive surplus of private savingsmoney that is saved but not borrowed and spent by the private sectorand that has triggered a balance sheet recession. On a brighter note, the existence of this surplus means the US private sector is now capable of financing the bulk of that countrys fiscal deficits. That, in a word, is why US long-term interest rates have fallen as much as they have in spite of the governments large fiscal deficits. If the government were to embark on fiscal consolidation at a time when the private sector is saving more despite zero interest rates, aggregate demand would shrink even further, leading to more weakness in the economy. And the resulting drop in tax revenues and increase in government outlays could actually lead to larger fiscal deficits, much as happened in Japan in 1997. * Agreement reached by President Obama and Republicans a step in the right direction In that sense, I think President Obamas agreement with the opposition Republican Party to carry out further economic stimulus is a step in the right direction. It would have been even better if the package had centered on government spending instead of tax cuts, which are unlikely to provide a significant boost to the economy. In Washington, the general explanation for the focus on tax cuts was that all 60 of the new members of Congress who were elected in November are proponents of small government and would therefore be amenable to tax cuts but not increased government spending. But tax cuts provide little stimulus when the private sector is deleveraging because they do not necessarily lead to new spending. They do, however, produce a definite increase in the fiscal deficit. Tax cuts therefore increase the national debt while having relatively little impact on the economy and can further increase the size of government as a percentage of GDP. * Mistaken view that fiscal stimulus is inefficient alive and well in US At a conference I participated in during my recent trip overseas, there was a debate over the multiplier effect of fiscal stimulus in the US. I was rather surprised to find that US financial specialists are repeating the mistakes of their counterparts in Japan a decade ago. Specifically, they continue to use the past results of quantitative models to estimate the multiplier effect of fiscal stimulus. As such models generally indicate the elasticity is no higher than 1.3, they argue that the economic expansion resulting from fiscal stimulus will be unable to offset the corresponding increase in the fiscal deficit. I would argue that this number is useless today because it was measured before the US fell into a balance sheet recession. The figure depends on the quantitative models key assumption that the US economy would limp along at zero growth even without any fiscal stimulus. These models do not assume todays balance sheet recession world in which, absent fiscal stimulus, each

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surplus dollar saved by the private sector reduces final demand by the same amount, triggering a downward spiral in GDP. It was only because the government borrowed some 8% of GDP every year that Japans GDP stabilized at 0% growth during that nations balance sheet recession. Had the government stood by and done nothing, Japans economy would have shrunk by 8% a year. In other words, these quantitative models and the elasticities derived from them can be useful when the economy is at or near equilibrium, but are utterly useless when the economy is so far from equilibrium that the government must run fiscal deficits worth 8% of GDP just to keep output from contracting. * Fiscal elasticity far higher during balance sheet recessions When Japans bubble collapsed, for example, national wealth worth three years of GDP was swept away in the worlds worst-ever financial tsunami. With households and businesses facing heavy balance sheet damage, excess private savings amounted to some 8% of GDP. Had nothing been done, Japans GDP would have contracted by about 8% a year. At the very least, output would have fallen back to the pre-bubble level of 1985. The cumulative gap between 1985 GDP and actual GDP from 1990 until businesses finished paying down debt in 2005 amounts to some 2,000trn. As Japans national debt increased by 460trn during this period, that means the government succeeded in supporting 2,000trn of economic activity with 460trn in additional debt. In other words, fiscal stimulus had an elasticity of four or five. Although this number is much larger than 1.1 or 1.2 figure typically mentioned for Japans fiscal stimulus, it is not hard to understand why. The economic impact of the government stepping in to borrow and spend money that would ordinarily be borrowed and spent by the private sector is reduced by the amount the private sector would have borrowed and spent. But during a balance sheet recession, the private sector is not borrowing and spendingin fact, it is paying down debt. Consequently, any money borrowed and spent by the government is fully reflected in higher final demand. It is therefore only natural that the elasticity of fiscal stimulus would be dramatically larger during such a recession. When properly measured, the elasticity of fiscal stimulus during such periods is very highseveral times the estimates arrived at using data from ordinary periods. If balance sheet recessions were a frequent occurrence, it would be possible to derive reasonably accurate estimates of fiscal elasticities for such periods. But there was not a single occurrence between the Great Depression of the 1930s and Japans experience in the 1990s. Accordingly, we simply do not have the data needed to accurately measure elasticities during such periods. * Europe and US may repeat Japans mistakes We have shownusing the example of the 2,000trn in output that was saved in Japan and the fact that the fiscal stimulus provided by World War II quickly pulled the worlds economies out of depressionthat fiscal stimulus can be a potent tool during a balance sheet recession. Unfortunately, participants in the US fiscal debate remain oblivious to this point and continue to discuss the pros and cons of fiscal policy using fiscal elasticities measured when the economy was not in a balance sheet recession. This implies that economists are heavily underestimating the elasticity of fiscal stimulus during such recessionsjust as their counterparts in Japan did a decade agomaking policymakers reluctant to implement further stimulus. This reluctance leads to further economic weakness. The situation in Europe is no different from that in the US. I therefore have to conclude that the western nations have learned nothing from Japans lessons and are likely to repeat its mistakes.

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* Fiscal positions of European nations grow increasingly precarious It would appear that Germany and the IMF have finally realized the severity of the fiscal problems facing countries like Ireland and Spain and are beginning to work in earnest on aid packages for these countries. When I visited the IMF on my recent trip to Washington, it was clear that the Fund viewed assistance for Ireland as being critical. Officials I spoke with were driven by a sense of urgency, knowing that if the IMF and the EU were unable to stop the crisis from spreading, problems could propagate from Portugal to Spain, with devastating consequences. The IMF knows it needs to take a stand in Ireland. The Funds strategy is to buy time by providing assistance, during which time the problem countries are to engage in fiscal consolidation to the extent that it is truly necessary. Here, truly necessary means that without IMF aid, Ireland would have to cut fiscal expenditures starting with the easy items, which would not necessarily be a positive for the nations future. * Focus on fiscal consolidation creates vicious cycle for EU While this kind of viewpoint is important, the continued emphasis on fiscal consolidation worries me. If this focus persists in spite of the fact that Ireland is experiencing a severe balance sheet recession, the Irish economy could enter a downward spiral even if the spending cuts are made in areas where cuts are needed. Even if the IMF helps Ireland redeem its bonds, no turnaround in the economy can be expected as long as the government insists on cutting spending during a balance sheet recession. The risk is that such action will only cause the fiscal deficit to grow. Irelands nominal GDP has already fallen as much as 20% from the peak on two factors: the balance sheet recession, which was triggered by the collapse of the nations real estate bubble, and the governments pursuit of fiscal austerity. To the extent that the decline in GDP exceeds the decline in the nations fiscal deficit, the latter will continue to increase as a percentage of GDP. Moreover, Japans experience in 1997 and again in 2001 shows that fiscal austerity during a balance sheet recession has the potential not only to weaken the economy but also to increase the absolute value of the fiscal deficit. If the deficit rises when output is falling, its size relative to GDP will also increase. * Ireland a textbook example of vicious cycle driven by fiscal consolidation Ireland has fallen into precisely this trap. I think the vicious cycle would only grow worse if the nation were to implement further austerity measures under these circumstances. If this state of affairs has contributed to the sell-off in Irish government bonds, the government will need to shift its policy focus from fiscal consolidation to fiscal stimulus if it hopes to emerge from the vicious cycle. In Europe, unfortunately, both governments and the private sector seem to be focused exclusively on fiscal consolidation. Particularly for the orthodox individuals in charge of the ECB, the EU and the OECD (by orthodox I mean they do not understand the mechanisms of a balance sheet recession), fiscal rectitude has become the only game in town. They are oblivious to the fact that austerity is a fundamental policy mistake during a balance sheet recession. * IMF concerned but unable to change course Some people at the US-based IMF are worried about this riskperhaps because of the growing contingent of people, like Princeton Prof. Paul Krugman, who are talking about balance sheet recessions. However, even they have been unable to move past the belief that the markets would not tolerate fiscal stimulus in Ireland. In response, I proposed that it was time for the IMF to come up with a Plan B, given the danger that continued attempts at fiscal consolidation could send Europe into a 1930sstyle deflationary spiral. I recommended that the Fund draw up an alternate plan based

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on fiscal stimulus in the event that its primary plan, which centers on fiscal consolidation, fails. Unfortunately, few at the IMF have a sense of urgency regarding this issue. Most think Plan A will work with some fine tuning. I see no way out for Europe. If it continues to pursue fiscal consolidation in the midst of a balance sheet recession, it is likely to make things worse. * US supports economy with fiscal stimulus while EU undermines economy with austerity As the recent agreement demonstrates, the US has displayed a certain amount of flexibility in its response. Fed Chairman Ben Bernanke has also recommended on numerous occasions that fiscal stimulus be maintained. That is not to say that there are no problemsthe fiscal stimulus elasticities being used by policymakers do not reflect current conditions, and the fiscal stimulus that has been implemented is heavily biased towards tax cuts. Nevertheless, the US is taking action, and I think it will probably continue to support the economy next year. In Europe, on the other hand, fiscal consolidation has become the only game in town even as many nations face severe balance sheet recessions. Even ECB president JeanClaude Trichet has been arguing that fiscal consolidation is necessary. With few potential catalysts for a change of course, we need to consider the possibility that conditions in Europe will continue to deteriorate. A single country within the eurozone can achieve little unless the ECB, EU Commission, and the IMF stand together and declare fiscal consolidation during a balance sheet recession to be a policy misstep. But with the ECB and EU led by orthodox individuals who remain unaware of the very existence of balance sheet recessions, I see little chance of a meaningful change in policy direction. Richard Koos next article is scheduled for release on 12 January 2011

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