What it expresses amazingly well is the degree to which 2008 compromised the transmission mechanism for central banks. The standing relationship between the monetary base and the overall money supply effectively came to a halt in the days after Lehman.
From then on central banks were forced to throw increasingly gargantuan sums of base money at the economy just to keep the overall money supply in a steady state, i.e. to prevent a Depression-era money supply contraction.
As the chart also shows, however, the Eurozone has thus far been the most modest, meaning it still has more room for base money expansion.
Indeed, as Koo notes:
Compared with Japan, the US, and the UK, the ECB has supplied only two-thirds the liquidity that its counterparts did, even after both LTROs. Taking pre-Lehman liquidity levels to be 100, the Fed increased its monetary base to 321 and the Bank of England expanded its monetary base to 297, while the ECB’s monetary base stands at just 196 even after the two LTROs. The Bank of Japan increased its own monetary base to 313, although the timeframe is substantially longer. Given that the US and the UK were able to triple their monetary bases without generating inflation, I estimate the ECB could supply an additional €945.5bn in funds—enough to bring the liquidity index up to 300—without having to worry about inflation (Figure 1).
However, as Koo also notes, the lesson from Japan is that liquidity does not always translate to increased bank lending. For example, the monetary base in Japan currently stands at 313 on the same index, while bank lending remains stuck at 1990 levels.
In Europe the situation is arguably worse because the bank lending problem is also being compounded by the EBA’s new capital rules:
With so many European banks having the same problem at the same time, it is difficult for individual banks to raise capital in the current environment. The limited availability of capital means the new rule effectively limits the amount of risk assets that European banks can hold. Regardless of how much liquidity the ECB supplies, banks will be forced to scale back their loans to the private sector, which are treated as risk assets. The only assets banks can buy with funds borrowed from the ECB are those that are not treated as risk assets, ie, government bonds. That is one reason why European banks’ purchases of European government debt increased after the ECB’s first three year funding operation last December.
That’s to say additional liquidity in Europe is currently translating into additional government bond buying rather than real-world lending.
For recovery to take hold, Koo says, capital rules would either have to be relaxed or public funds would have to be injected into banks.
Lacking that sort of action, liquidity will otherwise continue to head into government bond markets. In fact, as long as private borrowers remain scarce, Koo believes government bond yields will continue to stay compressed.
As he sums up:
Government bonds are trading at prices that could never be justified if we were not in a balance sheet recession. I suspect many western bond investors experiencing such prices for the first time are far from comfortable and would sell their positions at the first hint of trouble. Hence there is still the possibility that some seemingly inconsequential piece of news could trigger a plunge in bonds, as happened quite frequently in Japan a decade ago. As long as the private sector remains a large net saver, however, I expect such mini-crashes to be only temporary.
The short term may bring sharp increases in government bond yields, but a fundamental shift in the market’s mood will require the private sector to overcome its aversion to debt, and that is likely to take a long time.
We guess that means he’s bullish government bonds. (Even European periphery ones.)