What your experts missed.

To THE EDITOR:

THE INTERNATIONAL ECONOMY'S "Are German Workers Killing Europe? (Summer 2006) was both interesting as well as informative. Numerous opinions mentioned in the symposium, however, failed to reach the core of the problem that arose from the fact that the Maastricht treaty had no provision for the kind of recession Germany encountered during the last six years. This omission forced the German private sector to seek survival in exports to the detriment of other European nations.

The Maastricht treaty never provided for the possibility that a member state would fall into a balance sheet recession, a highly unusual recession that happens only after the collapse of a nationwide asset price bubble. This type of recession starts when a sharp fall in asset prices following the bursting of a bubble leaves companies with impaired balance sheets as their asset prices shrink to a fraction of their liabilities. That, in turn, forces companies into debt minimization instead of their usual profit maximization in order to bring down their liabilities to match their assets.

But when the corporate sector starts paying down debt while the household sector continues to save, a leakage to the income stream equivalent to the sum of household savings and corporate debt repayment is created. This sum constitutes the leakage or deflationary gap because this is the amount of money that comes into the banking system but cannot leave the system because there are no more borrowers left.

Germany, just like Japan after 1990, entered a balance sheet recession following the collapse of information technology and telecommunications share prices starting in 2000. German companies, which borrowed and invested as much as 6.9 percent of GDP in 2000, responded by paying down debt to the tune of 1.8 percent of GDP by 2004. This means the economy lost corporate demand equivalent to 8.7 percent of GDP compared to 2000. Moreover, the German household sector, which also sustained damage following the fall in stock prices, increased savings during this period from 3.7 percent to 6.1 percent of GDP, effectively adding to the deflationary gap the equivalent of 2.4 percent of GDP since 2000. With both the corporate and household sectors saving money, it is no wonder that the German economy faced such difficult times during the last six years.

To make the matter worse, when the companies have holes in their balance sheets and are minimizing debt, no amount of monetary stimulus will prompt them to start borrowing money again. Such a situation, often called a liquidity trap, makes monetary policy largely irrelevant. Indeed, money supply growth in both Japan and Germany remains depressed in spite of historically low interest rates seen in both countries. The contrast here is even more striking for Germany because other Eurozone countries all enjoyed rapid money supply growth under the same ECB monetary policy. Moreover, the government in a balance sheet recession cannot tell the companies not to repair their balance sheets because at the level of individual companies, they are doing the right and responsible thing.

In this highly unusual recession which happens only after the bursting of an asset bubble, the only thing the government can do to help the economy is to do the opposite of the private sector, i.e., the government must borrow and spend the excess savings in the private sector and put them back into the income stream. And that is exactly how Japan managed to maintain the peak bubble-level GDP during the last fifteen years in spite of losing national wealth equivalent to three years' worth of GDP (about the largest loss of wealth in human history during peace time) and the corporate sector paying down debt to the tune of 8 percent of GDP.

In the case of Germany, however, the Maastricht treaty prohibited its government from running a budget deficit greater than 3 percent of GDP. This 3 percent limit, however, was totally insufficient to fill the deflationary gap created by corporate debt repayment and increasing household savings. The net result was stagnant or falling domestic demand, which forced German companies to seek survival in foreign markets.

Today, Germany is running the largest trade surplus in the world, surpassing that of Japan and China. Moreover, Germany can run an almost unlimited trade surplus vis-a-vis other Eurozone countries because they are all under one currency and those running trade deficits cannot devalue their currencies against the Germans to regain their competitiveness. What this means is that the German balance sheet problem is now shouldered to a large extent by other European economies, hence the TIE question: "Are German Workers Killing Europe?"

A while ago, this author, who felt that the above condition is not only unfair to other European countries, but is also dangerous for the region as a whole, had a chance to discuss this issue with an official of the European Central Bank. During this meeting, I argued strongly that the Maastricht treaty should be amended to take account of such recessions so that the balance sheet problem in one country would be kept within its borders. Indeed, the problems all stemmed from the fact that Maastricht signatories never foresaw this type of recession when they decided on the 3 percent limit for budget deficit.

Even though this ECB official agreed with the author's assessment of the German economy, he argued that an exception couldn't be made for Germany because when the single currency was established, it was implicit in the agreement that weak and strong regions within the Eurozone would have to live with each other. He argued that if the economy of California, for example, were depressed and its companies forced to live off demand in other states, there is nothing the central authorities can or should do because those states are all under the same currency.

This analogy to California and the United States in general, however, has a number of problems. First, it is much easier for a worker to move across state borders in the United States than across national borders in Europe where there are language as well as cultural barriers.

More importantly, the above argument assumes that only California has the problem. But when a large number of economies in the region are engulfed in balance sheet recessions at the same time, and if all of them must abide by the Maastricht limit, a fallacy of composition problem is created which will push the entire region into a deflationary spiral. The probability of such an outcome is not zero, but there is nothing in the Maastricht treaty to deal with such a contingency.

If the United States faced such a recession, the federal government would likely enact fiscal stimulus to keep the bottom from falling out of the U.S. economy. In Japan, the government did just that to keep its economy from collapsing during the last fifteen years. This is in spite of the fact that commercial real estate prices in the country fell a whopping 87 percent from the peak. In the case of the Eurozone, however, there is no federal government above the level of the Maastricht treaty to take such action.

Fiscal stimulus is often considered undesirable because of its crowding-out effects on private-sector investments and the government's tendency to misallocate resources. During a balance sheet recession, however, neither problem exists because the private sector is paying down debt instead of borrowing money, and those resources not utilized by the government will simply go unemployed.

Put differently, when private-sector companies are hungry for funds to maximize profits, the fiscal deficit must be controlled and contained, but when companies are minimizing debt following the bursting of an asset price bubble, proactive government with sufficient fiscal stimulus becomes absolutely essential. Unfortunately, the Maastricht treaty was fully designed to cope with the former, but not the latter.

To make the treaty complete, therefore, it should be amended so that those economies experiencing corporate debt repayment are not only exempted from the 3 percent deficit limit but are also required to put in sufficient fiscal stimulus to keep their excess savings problems from spilling beyond their borders.

The challenge of keeping balance sheet problems within national borders is not just for the Eurozone, but global. This is because a large number of economies around the world could fall into balance sheet recession all at the same time. If each one of those economies tried to export its way out, there would be a global fallacy of composition.

During the Great Depression, the greatest of all balance sheet recessions, those countries that tried to stick with balanced budget principles not only ended up experiencing the greatest economic declines, but also caused global fallacy of composition through their beggar-thy-neighbor policies. The casualties included not only economies but also democracies in many countries, with devastating consequences. In order to avoid such an outcome, international organizations such as the International Monetary Fund should be given the power to require member countries with balance sheet problems to mobilize their fiscal policies in order to keep their excess savings problems within their borders.

This time, it was just Germany. And surrounding countries were willing to bear the burden. But this may not be always the case in the future. The time to fix Maastricht is now.

--RICHARD C. KOO, author of Balance Sheet Recession: Japan's Struggle with Uncharted Economics (John Wiley and Sons, Singapore, 2003).