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Richard Koo, Chief Economist, Nomura Research Institute explains how this "Balance Sheet Recession" is different
|Mr. Richard C. Koo is the Chief Economist of Nomura Research Institute, the research arm of Nomura Securities, Tokyo. He has recently released a book titled “Balance Sheet Recession - Japan's Struggle with Uncharted Economics and its Global Implications”. In this interview he explains how the recession in 2008 was different and what should be the role of the Government.|
Mr. Richard C. Koo is the Chief Economist of Nomura Research Institute, with responsibilities to provide independent economic and market analysis to Nomura Securities, the leading securities house in Japan, and its clients. Before joining Nomura in 1984, Mr. Koo, a US citizen, was an economist with the Federal Reserve Bank of New York (1981-84). Prior to that, he was a Doctoral Fellow of the Board of Governors of the Federal Reserve System (1979-81). In addition to conducting financial market research, he has also advised several Japanese prime ministers on how best to deal with Japan's economic and banking problems.
In your latest book “Balance Sheet Recession: Japan's Struggle with Uncharted Economics and its Global Implications”, you have written about “balance sheet recession”. Could you please explain how a “balance sheet recession” is different from the other recessions?
Other recessions are typically due to excess production, inventory buildup and then you have to work through the inventory. Sometimes the central banks raise interest rates to slow down growth etc. Those are the typical garden-variety recessions.
But once in several decades, the private sector goes crazy and borrows tons of money to invest in all sorts of assets. Thus the bubble is formed. When that bubble bursts, especially when it is a nationwide asset price bubble financed with debt, asset prices collapse but the liabilities remain. Then a huge portion of the private sector realizes that their balance sheets are under water. When that happens, they all have to repair their balance sheets. So how do you repair your balance sheet? You use your cash flow to pay down the debt. If everybody does that at the same time and tries to pull themselves out of negative equity, then there is no demand for saved funds. Hence there will be excess savings in the private sector because these people with balance sheets under water will not be interested to borrow money at any interest rate. Also they are already in high debt and almost bankrupt, so no one wants to lend them money either. With no borrowers and no lenders, monetary policy does not work in this situation.
I am afraid that when people are minimizing debt instead of maximizing profit, we enter a very different world. That’s the world were monetary policy is largely ineffective, whereas fiscal policy, even though most modern economics text books give it a bad name, becomes very effective. In fact it is the only cure for this disease. It is the only cure because the government can’t tell the private sector not to repair their balance sheets. The private sector must repair their balance sheets. If they continue to repair their balance sheets, everybody is paying down the debt and no one is borrowing money. So all the debt repayment comes into the banking system but with no other borrowers and those funds get stuck in the banks. That becomes the deflation gap for the economy. But if government borrows that money and spends it, then this excess saving in the private sector will re-enter into the income stream of the economy and GDP can be kept.
You mentioned that government should start borrowing and spending money. Will the current actions of the US government create any balance sheet problems for the government?
Well, by borrowing and spending the debt level goes up. But, I can assure you that if the government didn’t take this action, then the situation could be worse. In 1997, Hashimoto, the Prime Minister of Japan, was worried about the budget deficit just like those people who are worried about the budget deficits in US, UK today. So, Prime Minister Hashimoto decided to cut the budget deficit listening to the IMF, OECD etc. who didn’t understand anything about balance sheet recessions at that time. And what happened was the Japanese economy collapsed first. The budget deficit actually increased dramatically. So, definitely budget deficit is a problem, but whether you can do anything about it is a different issue. People can talk about reducing budget deficit all they want. But whether it’s possible to reduce it or not is a completely different issue.
As you mention Japan had lost its decade. So some people are suggesting that it’s going to be the lost decade for US. Do you think so?
Well, it was lost decade in the sense that we had very slow growth. But it was very successful economic policy because if those actions were not taken by the government, Japan would have fallen into great depression. And if you measure what the Japanese economy might have been in the absence of government policies and then measure the effectiveness of fiscal policy from that point to where the actual numbers are, then you will realize how effective the policy was. The budget deficit or the cumulative government debt from 1990-2005 was about ¥460 trillion, that’s 92% of Japan’s GDP. It’s a huge increase in government debt. But the amount of GDP that this ¥460 trillion supported was over ¥2000 trillion. If no actions were taken the economy would have collapsed. If you measure from there to where it is now, then it would be ¥2000 trillion over a 15 year period. So 460/2000 was a very good deal.
What are the lessons that US can learn from Japan’s great recession?
When a country falls into this type of recession, which happens may be once every 70 years or so, because the last time US fell into something like this was during the Great Depression 70 years ago, you not only need fiscal stimulus but the fiscal stimulus has to remain in place until private sector deleveraging is over. We didn’t know that in Japan. So at first, in recession we provided fiscal stimulus and then when the economy improved and budget deficit increased, we cut the stimulus. The economy again goes down and we repeat the process. So we had this zig zag and it took us 15years. There is no reason to have taken 15years, if we knew in advance that this is a different disease. So, my message to the US and UK is that if you see private sector deleveraging, then maintain the stimulus until the private sector balance sheets are repaired. And once these companies start coming to borrow money, then that’s the time to cut the budget deficit. But not before that. If you try to cut the stimulus prematurely, then the whole thing will come crashing down and the recovery process will take longer.
Some economists have blamed low interest rates kept by the Federal Reserve for the crisis in 2008. Do you agree that low interest rates led to the crisis?
It had a little bit, I suppose. The part of the Federal Reserve that I was not happy about was that Alan Greenspan, the former Chairman, refused to acknowledge that there was a bubble. All the way until the very end, he never used the term “bubble”. When the central bank Chairman says that there is no bubble whereas everyone is convinced that there is a bubble, we are in for massive disaster. Lots of staffers of the Federal Reserve Board were worried about the bubble. But if the Chairman is not convinced, then they can’t do anything either, which was very unfortunate
And the other part, which is very specific to this crisis, is that the rating agencies gave AAA-ratings to subprime mortgages. If they didn’t do that, a lot of what we are experiencing now would not have happened. So, the two pieces that are very peculiar to this episode is that Alan Greenspan was not issuing sufficient warnings about the bubble. It’s his job to inform the public about the bubble. The other is the rating agencies which are supposed to be private sector watchdogs to maintain quality of financial transactions in the market. They failed absolutely in their jobs.
And how do you think the Federal Reserve performed after the crisis. Did they manage the crisis in the best possible way?
Until Lehman Brothers collapsed, I am afraid their actions were very poor. There is no indication that Ben Bernanke warned Hank Paulson that if Lehman fails, then the whole system will come crashing down. Many in the private sector knew that was the case, only the Federal Reserve Chairman didn’t know that. And when Paulson decided to let Lehman go, the whole thing came crashing down as expected. So, in that sense all the way until the collapse of Lehman, they did a very poor job. But after Lehman went bankrupt, from that point, the Fed’s actions were very good. Bernanke realized that he had dropped the ball. So he did everything in his power to fix the situation and I thought that part was very good.
Now the interest rates are already too low. The Fed can’t lower the interest rates further. What are the other monetary tools that the Fed can use?
Virtually nothing. As I said, in this type of recession monetary policy is largely useless. You have to rely on fiscal policy.
You said that US needs to have fiscal deficit and government should borrow and spend. At what level of debt-to-GDP ratio will this become unsustainable?
Not that I am aware of. During a balance sheet recession, the amount of money government has to borrow and spent to keep the GDP from falling is exactly equal to the excess savings in the private sector (of all these people who are paying down their debt). So the money is available inside the country to finance the government budget deficit. US doesn’t have to rely on the Chinese, Arabs or Japanese to buy US bonds or US Treasury securities. Stock of debt is a different question. Americans have sold a huge amount of Treasury bonds to foreigners in the last 20 years. If the foreigners dump their holdings and push US interest rates sky high, then that will be dangerous. But that’s a stock of debt issue. The flow part is different. The reason US government has to run large deficits is because excess savings that have been generated in the private sector have not been borrowed by the private sector.
Do the unfunded liabilities like healthcare, social security etc. pose a problem?
Those should be separated from this balance sheet recession issue. Those are other structural issues of the US economy and they have to be dealt on their own merit.
Japan had a problem of deflation whereas in US some economists fear high inflation. What is your option?
Those people in US who are arguing for inflation are looking at Federal Reserve’s balance sheet. And as you know it grew very substantially after Lehman Brother’s collapse. But what they should look at is not just the size of the Federal Reserve’s balance sheet but what is actually happening to the money supply. And if you look at that number, they hardly grew during this period. Furthermore for private sector to get excited about inflation, there must be credit creation. And when you look at credit available to the private sector, this number is actually falling. Bernanke often mentions that the bank lending to the household and corporate sector have been falling. With the credit available to the private sector falling, how are you going to get inflation? So I think those people who are worried about inflation will be disappointed.
People are buying gold to protect against the expected inflation. Do you think gold prices will fall?
There is always a possibility that the central bank will do something crazy and stupid like dropping money from a helicopter. I think people are worried because Mr. Bernanke has this nickname “Helicopter Ben”. And at least until 2 years ago, he has said a few things suggesting that one day he might do that. That really got me worried. Even I wanted to buy gold when I heard Mr. Bernanke talk like that. In these days, I don’t see that type of talk coming from Mr. Bernanke. So the possibility of hyperinflation, the central bank losing its credibility and control, is not as high as it seemed 2 years ago.
In your book you have written about the “fallacy of composition”. Can you please explain the concept with respect to the US economy?
The “fallacy of composition” means everybody at the individual level is doing the right thing, but because everybody does the right thing at the same time, we get the wrong result. That’s the “fallacy of composition”. Suppose that I am a farmer, I decide to grow crops and work really hard to have a good harvest and get good income. But if all the farmers did the same thing, there will be an excess supply of the crop. So the prices will fall and everybody is in a worse shape. That’s the “fallacy of composition”.
Some of the Asian countries, especially India, didn’t get that much affected by this major financial crisis. What do you think are the Asian countries doing right which the developed countries are getting wrong?
First of all, in this crisis the aggregate demand collapsed, but the demand that collapsed was almost exclusively on durable goods and big tickets items like cars. Japan and a few other Asian countries were affected very badly, even though we are not at the epicenter of the crisis. We have nothing to do with any of the subprime crisis. But Japan’s industrial production fell to a low of the 1983 level, the level 25 years ago. This was because Japan was concentrating on building durable goods. All the capital invested was mainly to produce durable goods. So we were affected proportionately more than others.
In India, you don’t have a huge emphasis on durable goods. You have a very good service sector producing software etc. That part was affected less than durable goods producers. In that case, India was spared. China was affected by the collapse in durable goods demand. But China put a massive fiscal stimulus. China was actually headed towards a perfect balance recession in November 2008. The stock market and the housing market were collapsing in China. But with the very appropriate policy response, they were able to avoid it.
The US dollar’s position as the reserve currency could have been challenged by the Euro in the next decade. But right now, Euro is weak and there are severe problems in the European region. Is there any alternative to the dollar as the reserve currency?
The Eurozone is an artificially put together currency zone. It’s not a natural currency zone like people pegging to the US dollar because US economy is so large. In the case of Euro, it was completely man made. And in order to make this work, they came up with all sorts of ideas. I am afraid some of those ideas were far from sufficient. Especially this 3% limit on budget deficit.
If the problem is within 3%, it’s not so bad. But when the problem goes beyond 3%, like in the case with Greece and Portugal, then what do you do? There is no corrective mechanism anywhere in the system. And that’s why Euro is suffering its problems. We have to come up with a completely different scheme to make this artificial currency area work.
I have my suggestions. My suggestion is that none of these Eurozone countries will sell its government bonds to foreigners. So, German government can only sell German government bonds to German people. Similarly, French government can only sell French government bonds to French people. I think that should have been the key ingredient necessary to make this currency area work. Because by doing that, the government budget deficit problem of each country will become entirely self-contained. If German government defaults, only Germans are hurt. If French government defaults, only French people are hurt. By doing that, this issue is completely removed from the Euro. The ECB can run the Euro without worrying about which economy is going crazy on budget deficit. This week is Greece, next week is Hungary, and the following week is Ireland. That’s stupid!
In order the free ECB from these worries, all the budget issues should be made internal to those countries. And if that can be done, there is no reason why Eurozone concept should not work. Of course, we are long way from that.
Nomura Research Institute Chief Economist Richard Koo was interviewed during the CFA Institute 2010 Annual Conference by Bloomberg TV.