I said the eurozone was currently suffering from two diseases-pneumonia and diabetes-an analogy I drew on frequently in Japan more than a decade ago.

Structural reforms are akin to a treatment for diabetes patients, who must eat carefully and exercise more to improve their longterm physical condition.

A balance sheet recession, on the other hand, is more like pneumonia. If it is left untreated, the patient's condition can
deteriorate rapidly. The patient can even die if proper treatment is not administered in the first three days.

These two illnesses sometimes occur simultaneously, which complicates matters because the treatments are in a sense contradictory.

Diabetes sufferers must restrain their intake of food, while pneumonia patients can die without ample nourishment.

Eurozone should treat pneumonia first

When the two diseases occur together, the physician must give precedence to the pneumonia, which demands immediate treatment. The diabetes can be left for later.

I added that regardless of what may be appropriate for Greece, where problems are due to previous governments' fiscal profligacy, insisting on austerity for Spain, Portugal, and Ireland is the wrong answer. It will only cause conditions to worsen.

This conclusion was utterly different from what my hosts had in mind, but I added two examples from Japan and the US: the austerity policies implemented by the Hashimoto government in 1997 and Federal Reserve Chairman Ben Bernanke's recent warnings about the so-called fiscal cliff.

In the former case, the Hashimoto government chose to increase taxes and cut spending at a time when the private sector was minimizing debt in spite of zero interest rates. The economy duly collapsed, sending the fiscal deficit from ¥22trn in 1996 to ¥38trn in 1999, an increase of 68%. It took Japan nearly a decade to bring the deficit back to its starting level.

In the latter case, the Fed chairman, who has demonstrated an understanding of the dangers of a balance sheet recession, used the powerful metaphor of a "cliff" to warn Congress about the dangers of engaging in premature fiscal consolidation.

Finally, I noted that the Cameron government, which came to power in the UK on a platform of bold fiscal retrenchment, is now seeking to change direction after watching the local economy behave in an entirely unexpected fashion.

Germans understand need to ease southern Europe's pain

The German politicians-perhaps because they have been focusing exclusively on domestic and euro-related issues for the last few months-listened carefully to what I had to say about the situations in the US, Japan, and the UK.

I ultimately recommended that Germany support fiscal stimulus, not fiscal consolidation, in Spain, Portugal, and Ireland, which face both balance sheet recessions and structural issues. Only after these patients recover from the first disease should they be treated for the second.

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.

In other words, if extreme pain prevents the patient from undergoing further treatment, the pain must be managed so that treatment can continue.

German competitiveness gains not due solely to structural reforms

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.

But as I noted in my previous report, much of Germany's newfound competitiveness can be explained by differences in money supply growth with the rest of the eurozone. The domestic labor market reforms were also a major factor, but not the only one.

Evidence of this is offered by a breakdown of Germany's trade balance by region, which shows little change in the balance of trade with North America or Asia from 2000 to 2008 while the trade surplus with other eurozone nations rose sharply (Exhibit 1).

If Germany's enhanced competitiveness were in fact the result of domestic structural reforms, the trade surplus should have increased with respect to Asia and North America as well as the eurozone. But that did not happen.

David Fuller's view Interesting analogies and Richard Koo is a superb communicator, able to make complex matters comprehendible.