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Richard Koo (2003) coined the term “balance sheet recession” to characterise the endless travail of Japan following the collapse of its real estate and stock market bubbles in 1990. The Japanese government did not act to repair the balance sheets of the private sector following the crash. Instead, it chose a policy of keeping bank rate near zero so as to reduce deposit rates and let the banks earn their way back into solvency. At the same time it supported the real sector by repeated large doses of Keynesian deficit spending. It took a decade and a half for these policies to bring the Japanese economy back to reasonable health.

At the time, a majority of forecasts predicted that the economy would slip back into depression once defence expenditures were terminated and the armed forces demobilised. The forecasts were wrong. This famous postwar “forecasting debacle” demonstrated how simple income-expenditure reasoning, ignoring the state of balance sheets, can lead one completely astray.

Interactive: Key geography, demographics in Ukraine

This narrative ignores one critical fact: Every irresponsible borrower is enabled by an irresponsible lender.

“Following the introduction of the euro,” he said, “a large amount of capital flowed into the countries which are now at the center of the crisis, such as Greece, Ireland, Portugal, Spain, and Cyprus.” What he didn’t say was how much of that capital flowed from Germany. In the second quarter of 2010, German banks had more assets in Greece than banks from any other country except France. They had more assets in Ireland than banks from any other country except the U.K. And they had more assets in Spain than banks from any other country, period.

Before the euro, when Germans saved, their current account balance rose, and with it, the value of the deutsche mark. After 2002 you could save in euros in Dortmund, and without currency risk your bank would invest in euros abroad

Four rescue measures for stagnant eurozone

The EBA has a long record of stress tests that grotesquely underestimate the capital holes in EU banks.

The Federal Reserve is well into its third round of “quantitative easing,” in which it buys longer-term assets to bring down long-term lending rates.

In March, a smaller percentage of working-age people were actually working than at any other time since 1979.

In March, a smaller percentage of working-age people were actually working than at any other time since 1979.

Mystery mostly solved, then; the rich periphery's riches relative to Germany were largely a short-run phenomenon driven by a dramatic short-run divergence in house price trends.

Investors who bet that productivity growth would be much faster in the south were wrong.* All the prices and wages set on the basis of the expectation of faster productivity growth were correspondingly wrong and needed to adjust. Real effective exchange rates were badly out of alignment.

Two things began happening in the euro zone in 2007. Growth in the number of euros spent every year began slowing, and the distribution of euro spending within the euro area began shifting back northward.

In New York and London, banks have set up dedicated crisis teams, and rehearsed elaborate responses.

Citigroup has $84 billion in loans, bonds and other types of exposure to troubled European countries, plus France. The bank’s filings indicate that all but $8 billion of that exposure is offset with collateral it has collected and hedges on the portfolio.

Some banks are testing their systems to deal with the possibility of new currencies and preparing guidance for clients on how to operate in such an environment.

The reason is not hard to fathom. Hobbled by severe damage to private and public-sector balance sheets, and with policy interest rates at or near zero, post-bubble economies have been mired in a classic “liquidity trap.” They are more focused on paying down massive debt overhangs built up before the crisis than on assuming new debt and boosting aggregate demand.

The sad case of the American consumer is a classic example of how this plays out. In the years leading up to the crisis, two bubbles – property and credit – fueled a record-high personal-consumption binge. When the bubbles burst, households understandably became fixated on balance-sheet repair – namely, paying down debt and rebuilding personal savings, rather than resuming excessive spending habits.CommentsView/Create comment on this paragraph

US consumers have pulled back as never before.

t’s the math: In fiscal 2012, Social Security, Medicare, Medicaid and civil service and military retirement cost $1.7 trillion, about half the budget.

As a share of national income, defense spending ($670 billion in 2012) is headed toward its lowest level since 1940.

Expansion was, for lack of other options, financed largely through short-term loans.

since the onset of the global financial crisis, eurozone-based banks’ subsidiaries in emerging Europe have been reducing their exposure to the region. In 2009-2010, the European Bank Coordination Initiative – known informally as the “Vienna Initiative” – helped to avert a systemic crisis in developing Europe by stopping foreign-owned parent banks from staging a catastrophic stampede to the exits.CommentsView/Create comment on this paragraphBut, in the second half of 2011, the eurozone-based parent banks that dominate emerging Europe’s banking sector came under renewed pressure to deleverage. Many are now radically changing their business models to reduce risk.

Recent research indicates that electric cars may reach break-even price with hybrids only in 2026, and with conventional cars in 2032, after governments spend €100-150 billion in subsidies.

A life-cycle analysis shows that almost half of an electric car’s entire CO2 emissions result from its production, more than double the emissions resulting from the production of a gasoline-powered car.

Proponents proudly proclaim that if an electric car is driven about 300,000 kilometers (180,000 miles), it will have emitted less than half the CO2 of a gasoline-powered car. But its battery will likely need to be replaced long before it reaches this target, implying many more tons of CO2 emissions.

The strategic technologies that have repeatedly transformed the market economy – from railroads to the Internet – required the construction of networks whose value in use could not be known when they were first deployed.

Consequently, innovation at the frontier depends on funding sources that are decoupled from concern for economic value;

Financial speculation has been, and remains, one required source of funding. Financial bubbles emerge wherever liquid asset markets exist. Indeed, the objects of such speculation astound the imagination: tulip bulbs, gold and silver mines, real estate, the debt of new nations, corporate securities.

As King struggled with the crisis, he concluded that the biggest vulnerability was the solvency of the banking system itself. The crash wasn’t just a liquidity squeeze caused by toxic assets; the problem was that big banks around the world were undercapitalized and, in many cases, insolvent.

King pushed the banks to recapitalize and, later, to accept more regulation. This upset a financial elite that, as King says, was the only sector of the British economy that had escaped the market revolution of the Margaret Thatcher years.

As for equity levels, in many cases a foreign bank might simply have to convert loans it had made to the American operation into equity investments. Suddenly the American operation would appear to be better capitalized.

European regulators who trusted Iceland to regulate its own banks wound up paying off depositors even though there is little hope Iceland will ever reimburse those payments.

It turns out that in the financial crisis, big banks with high leverage ratios — that is, more capital relative to assets — were significantly more likely to survive without needing bailouts.

Like an inmate on death row, the euro has received another last-minute stay of execution. It will survive a little longer. The markets are celebrating, as they have after each of the four previous “euro crisis” summits – until they come to understand that the fundamental problems have yet to be addressed.

Likewise, they now recognize that bailout loans that give the new lender seniority over other creditors worsen the position of private investors, who will simply demand even higher interest rates.CommentsView/Create comment on this paragraph

Its full name is more than a mouthful. Trans-European Automated Real-time Gross Settlement System is better known as TARGET2 for short. It is the behind-the-scene payments system that conveniently enables citizens across the euro area to settle electronic transactions in euro. And at just over €500 billion, its TARGET2 claim on the Eurosystem is also the largest and fastest growing item on the Bundesbank’s balance sheet, as well as a source of much misunderstanding and debate.

The allocation of TARGET2 balances among the seventeen national central banks, which together with the ECB make up the Eurosystem, reflects where the market allocates the money created by the ECB. The fact that the Bundesbank has a large TARGET2 claim (asset) on the Eurosystem, while national central banks in southern Europe and Ireland together have an equally large TARGET2 liability, simply reflects that a lot of the ECB’s newly created money has ended up in Germany. Why? Because of capital flight.

Since the euro eliminated exchange rate risk among its member states, Germany has invested a substantial portion of its savings in Europe’s current account deficit countries. Some of those savings are now returning home. That’s the capital flight.