FT Alphaville " Richard Koo's semi-successful attempt to persuade Germans about balance sheet recession Nomura's Richard Koo has written a fascinating account of his meeting with "a number of influential politicians, academics, and senior government officials" in Berlin last week. First, he heard that some Germans don't think Greece should have ever been admitted to the eurozone. One of them even said Greece was not really a modern nation-state, Koo writes. Another politician/academic/official was more positive, saying both Greece and Ireland had become more competitive of late, as wages and prices had fallen. The nation-state comment was a little shocking, but all-in-all, none of this is very surprising. What really piqued our interest was Koo's account of the German sense of opportunity in this crisis: There was a unanimously held belief that nothing will improve without extensive structural reforms and that any aid provided in the absence of such reforms will do little more than buy time. Yes, there's some irony to the "buying time" argument, but overall that sentiment is one that we've heard countless times now. But the (recent) historical experience that is behind the zeal is more interesting: These politicians were not even satisfied with the state of structural reforms in their own country, arguing that Germany still had much work to do. Well, the IMF agrees there. Anyway, here's the crucial stuff, with our emphasis: But based on their experience of the difficulty of implementing these reforms, they believe firmly that this represents a once-in-a-lifetime opportunity to pursue similar initiatives in southern Europe. When Germany implemented its reforms around 2005, there was no time to waste because German businesses were moving one factory after another to the low-wage countries of eastern Europe. Even so, they said there was tremendous political opposition. What they learned from this experience was that such reforms were possible only under crisis-like conditions. That experience contributed to their view that the current economic crisis represented an excellent opportunity for fundamental reforms in southern Europe. Perfect opportunity? In other words, Germany's own trying experiences around 2005 had convinced them that the unfolding crisis in southern Europe represented a once-in-a-lifetime opportunity. Chancellor Angela Merkel's tendency to talk about the need for structural reformswhenever she has a chance is based on her own experience of the difficulty of implementing those reforms in Germany. But check this out: One member of parliament close to Ms. Merkel said the Chancellor is not opposed to fiscal stimulus itself but cannot accept fiscal stimulus without structural reforms. Wow! But wait: Koo says while he found some common ground on the subject of Greece, he and the Germans were miles apart on Spain and Italy, and his own balance sheet recession argument hadn't really reached the policymakers there. Back to square one, then. So he told them about Japan in 1997, and the US fiscal cliff, in an attempt to explain balance sheet recessions inevitably spawn massive private sector debt retrenchment, leading to a deflationary spiral. Koo's first effort did not go so well: While the Germans politely listened to my explanation of this new (for them) concept, they continued to insist the competitiveness issue could not be resolved without structural reforms. At this point, Koo writes, he was running short of time to elaborate with these non-economically-trained folk on exactly why the balance sheet/deflation problem was just as important, but somewhat more urgent, than the structural reforms. So he resorted to a medical metaphor, with a patient suffering both pneumonia and diabetes - both need treating, but the former needs treating right now. You'd think his hosts would have heard the likes of this many times already (we certainly have), but not really. And... jackpot! The politicians seemed to understand what I was saying, with one remarking that sometimes a patient being treated for cancer needs a shot of morphine. Or maybe not: The problem here is German politicians" view that the painful structural reforms carried out around 2005 were solely responsible for the gains in German competitiveness and that it is inexcusable for southern European states that have not engaged in similar reforms to come begging for help. Koo struggled valiantly on, advancing his view that the whole crisis was caused by a massive increase in Spanish private savings which were then invested in German, rather than Spanish, sovereign debt. Plus his solution: that eurozone governments be prevented from selling their debt to the citizens of other countries. And... they listened willingly, and although not all agreed with his analysis, the outcome was sort of encouraging. To sum up my impressions of Berlin, German politicians are starting to question the strongly held beliefs that have brought them this far. This marks a change from the situation just a year ago, when policymakers were still brimming with confidence. Some of them even said last week that they needed to spend more time studying the experiences of Japan and other countries. But at the same time they lack their American and British counterparts" understanding of balance sheet recessions, and rectifying this will take time. I therefore expect German policymakers will continue to focus on treating the patient's diabetes while largely ignoring his case of pneumonia. Related links: George Soros: How to shift Germany out of "can't do" mode - FT Gideon Rachman: We isolate and overload Germany at our peril - FT Richard Koo posts passim - FT Alphaville This entry was posted by Kate Mackenzie on Wednesday, July 4th, 2012 at 8:30 and is filed under Capital markets. Tagged with germany, Greece, imbalances, Richard Koo.