Its all very well to assume that Japan can pay off its mountainous debt by running budget surpluses,

As I understand Japan’s challenge they will be running increasing budget deficits – due to horrible demographics and slow GDP growth. That their debt can still be placed cheaply at debt/GDP 200% seems to be due to the market’s comfort with their reserves and government controlled liquid assets. I don’t know enough to assess that thesis.

So is the UK actually suffering a balance sheet recession? Or is it (only) a banking crisis?

What indicators would lead you to conclude it is a balance sheet recession?

Although Koo disparages quantitive easing as useless, I think it plays an important role in ensuring yields can be kept low while the budget deficit spending is executed. This quantitive easing is not available to European governments. Even for governments where it is available, such as Japan, I am not clear exactly what the exit strategy is. Its all very well to assume that Japan can pay off its mountainous debt by running budget surpluses, but this assumes that long end rates can be contained and inflation does not get out of control.

The UK is an interesting case. The UK is running a policy operation straight out of Koo’s how to manual, Running large public deficits to replace private credit demand. However despite quantative easing there are clear signs that financing the budget deficit may not be forthcoming from the financial markets-long end yields are selling off, and the currency is falling. In fact there is no sign of deflation. So is the UK actually suffering a balance sheet recession? Or is it (only) a banking crisis?

However, as much as I liked it, I was dissatisfied with the incompleteness of Koo’s talk, and the analysis above. Why are some basic matters ignored by all the parties here? Perhaps I am missing something in my own analysis, but I don’t think so.

Here’s what’s missing: Any mention of cash flow, and malinvestment. It seems to me that these are absolutely crucial to understanding what is happening, and what is the only sustainable way out of the mess.

There is a problem because property prices where pushed to levels which are not justified by the underlying cash flows. In other words, if a property owner moves out of his property, and rents it out, he cannot generate sufficient rental income to cover his costs, and repay his debts. The valuation is unsustainable in the cold hard light of cash flow. (BTW, the test is the rental the property can achieve in a recessionary market, versus sustainable interest rates.) Why anyone thought it was appropriate to lend such large amounts, and such high percentages LTV, without appropriate margins, has been a mystery to me for years, well before the peak in 2006, when it was obvious that property valuations were far into bubble territory.

Another problem is the malinvestment. Properties were bought to resell at a profir, not for living. So a rather massive oversupply was created. And many were built in outer ring suburbs, far from jobs, leaving an uncomfortable vulnerability to rising oil prices. The drop in the value of such homes was exacerbated by the rise in oil to $146 in mid-2008, which helped to create entire communities of defaulted loans in places like Stockton, California.

In the light of this thinking, it should be obvious that real estate prices have a long way to fall. Prices will not be sustainable, until they fall to levels that can be supported by owner’s incomes, and/or rental cash flows. And without sustainable property values, how can banks expect their loans to be sound? Thus, a combination of equity writedowns and/or loan writedowns will be required until a sustainable valuation for both is reached.

Just as there was a virtuous cycle of rising home prices pushing up economic growth, there will be a vicious cycle on the way down, and this is the problem of the “negative feedback loop” that has been mentioned. But it will not go on forever. Once the balance between valuation, debt, and cash flow is right, the mortgage market can stabilise.

Malinvestment is a somewhat different matter. Some homes may be so far away from jobs, that they will be unattractive at even 30-40% of their original cost. and these may have to be written down that far, because it is unlikely that new jobs will be created anytime soon in their vicinity. The banking system needs a better way of assessing this risk. Important lessons will need learned and remember from the scale of malinvestment that we have seen. This was encouraged by unsustainably low interest rates during the early years of the current decade. Alan Greenspan’s Fed was the villain in the piece, and that is worth remembering too.