Say ‘balance sheet recession.’ The one book everyone should read to understand the present predicament. Only by actually understanding what’s going on can proper policies be evaluated.
It’s not the first time we’ve mentioned it here. Koo is every bit as relevant for the US today as it has been for understanding Japan’s lost decades.
Book Review: Koo’s ‘Holy Grail of Macroeconomics’ Thorough but Fails to Consider Post-Recovery Debt
By Chain Bridge Investing
From the start of his book, “The Holy Grail of Macro Economics: Lessons from Japan’s Great Recession,” Richard Koo immediately begins attacking the many policy treatments that were believed to be necessary to bring Japan out of its Great Recession, but – in his opinion – failed. He believes that many of these misconceptions resulted from treating Japan’s Great Recession as the typical supply-side shock recession. Yet Japan did not experience a supply-side shock recession; instead, it experienced a balance sheet recession, which has been generally ignored in economics and thus why many economists missed it. Consequently, many of the policy treatments such as monetary policy, structural reforms, and bank reforms failed to fix the Great Recession since they are primarily tools used against a supply-side shock recession and not a balance sheet recession. Throughout the book Koo consistently reiterates that monetary policy is impotent during a balance sheet recession, but fiscal stimulus is a must and the correct policy to implement.
According to Koo, a balance sheet recession occurs when asset prices drop significantly below the value of their corresponding liabilities and thus alter the behavior of the owners of the affected balance sheets. In these situations, the balance sheet owners, whether they be individuals or corporations, seek to pay down their debt with their incoming cash flows and forgo future investment and spending. Consequently, such actions lead to a reduction of aggregate demand. With little desire to focus on growth and spending, the private sector, defined as individual households and corporations, reduces its demand for credit.
As a result, since the private sector is busy paying down debt, monetary policy is impotent. Monetary policy as implemented lower interest rates, inflation targets, and increases in reserves cannot increase the money supply due to the fact that there is very little demand for loans or other methods of credit creation. Without credit creation, money supply cannot increase and aggregate demand cannot recover as it would during a supply-side shock recession.
In order for aggregate demand to recover in a balance sheet recession, the government needs to step in to shoulder the burden of spending and borrowing that is being neglected by the private sector. Koo believes that Japan and any country in a balance sheet recession needs to rely on fiscal stimulus until the time when balance sheets are again stable and the private sector begins to actively seek additional credit. When the private sector’s demand for credit returns, the government should then implement a policy of fiscal consolidation – but no sooner. He cites examples of fiscal consolidation that occurred in Japan during 1997 and in the U.S. in 1937. In both instances, the result was another contraction in the economy and gross domestic product, thus delaying a significant recovery.
During the course of the book, Koo thoroughly analyzes the causes, the effects, and the life cycle of a balance sheet recession. His analysis not only takes the reader through the details of Japan’s Great Recession, but also re-examines the Great Depression in the U.S. during the 1930s. He successfully argues on the back of substantial data that both instances were balance sheet recessions where monetary policy was useless due to the lack of demand for credit.
With regards to the Great Depression, he illustrates that contrary to popular opinion the U.S. banking system had ample reserves during the Great Depression and that bank failures and withdrawals of deposits accounted for approximately 15% of the decline in total deposits. The other 85% of the decline resulted from the private sector paying down their outstanding debt to evade bankruptcy, thus causing bank deposits and money supply to contract. Since the private sector was so focused on paying off its debt, the demand for addition credit was minimal.
In Japan’s situation, it was the country’s corporations that were heavily leveraged and helped cause the balance sheet recession in the 1990s. Even though many of these companies managed to stay afloat due to the great demand for their products by the rest of the world, most of their cash flow from operations went towards paying down extremely high debt levels. It should be noted that due to the global demand for Japanese products, output prices experienced little to no downward price pressure, which cannot be said about asset prices. The stability in output prices helped Japanese firms immensely during Japan’s Great Recession.
Meanwhile, the Japanese households that experienced unemployment, reduced salaries, and reduced bonuses could no longer save their money at previously established rates. As a result, individual deposits declined as more of that money was spent on necessities and removed from the banking system.
Although the central bank in Japan lowered interest rates and conducted its own version of quantitative easing by purchasing short-term government debt, these factors were not able to stimulate borrowing demand and thus did not increase aggregate demand. Japan’s saving grace was its fiscal stimulus policies, which used the government’s spending and balance sheet to replace the spending of the whole private sector. While fiscal spending is usually less efficient and effective than private sector spending, there was little to no private sector spending during this time and fiscal spending was better than no spending. It was the fiscal spending, funded by government debt, which allowed Japan’s gross domestic product, money supply, and wealth to avoid tremendous drops.
After thoroughly examining the balance sheet recessions in the U.S. and Japan, Koo states that balance sheet recessions are rare and usually take decades or even centuries to reoccur. His primary argument for such a belief is that when people experience a balance sheet recession they develop a deep aversion towards debt, thus allowing the government sufficient time to pay down its fiscal debt.
While Koo does a thorough – and sometimes redundant – job of explaining a balance sheet recession and connecting it to the economic situations of Japan and the U.S. Great Depression, his coverage of topics is uneven. He does not cover other areas such as the life cycle of the balance sheet recession or the consequences of fiscal stimulus after a recovery with nearly as much thoroughness. Consequently, he leaves the reader with many questions unanswered.
According to Koo, balance sheet recessions do not occur frequently since debt aversion tends to last for at least a couple of generations. Although Koo seemed to rely on a plethora of data to make many of his arguments regarding the balance sheet recession, he fails to provide sufficient data to support his claim that balance sheet recessions are rare due to debt aversion. In the book he bases most of his support for such a claim on Japan’s experience, yet the Japan experience still has yet to be fully resolved.
Furthermore, it is important to note that the corporations were the highly leveraged group in Japan’s Great Recession, not the individual households. Meanwhile, in the current crisis with the U.S., it is the individual households that are highly leveraged and not necessarily the corporations. One wonders if debt aversion may only be applicable to the offending party of each balance sheet recession and not to the whole private sector. If debt aversion does not take hold over the whole private sector, then there is a risk that balance sheet recessions could occur more frequently than Koo believes. Moreover, considering how many boom and bust cycles have occurred in the last 100 years, it seems possible that debt aversion could be overcome in less than two generations’ time.
When considering the fiscal debt burden that remains after an economy recovers from a balance sheet recession, Koo simply dismisses the large fiscal debt by stating that countries can handle a large debt burden like Great Britain did after World War II. Moreover, due to his theory that balance sheet recessions do not occur often, he believes that there will be plenty of time to pay off the debt. First, as stated above, there is some doubt as to exactly how much time there is to pay it off before the next recession. If you are a U.S. citizen, consider that since 1980 there have been less than five years where public debt has declined. How realistic is it that a country’s public debt will be paid down before signs of future trouble? It does not seem that likely, especially in an environment of slowing growth.
Second, Koo fails to give adequate consideration to the portion of the debt burden that is represented by short-term treasury bonds, which will have to be refinanced frequently. This puts any government, especially the U.S., at risk of increased interest costs and possibly additional debt as interests rates increase in a recovering economy. As one can see, Koo should have spent some additional time examining the possible consequences of fiscal policy after the recession is resolved. Instead, he presents fiscal policy as a solution with little repercussions when there are some serious concerns.
At present, the reader should note that the magnitude of Japan’s public debt remains an issue of concern amongst investors and economists. Whether it will hinder Japan’s future growth remains unknown, but such high debt levels do continue to put a Japanese recovery at risk.
Is Koo’s theory the “holy grail” of macroeconomics? No, it is an incomplete work. For this work to be considered the solution to balance sheet recessions, Koo would have to more adequately address the consequences of large fiscal stimulus and the result debt burden once an economy is recovered. Nevertheless, the book is very informative and educational. Koo does an excellent job explaining not only balance sheet recessions, but also basic macroeconomic concepts. He provides a fresh and easy to follow perspective on both Japan and the United States. Although littered with redundancy, his argument and logic are clearly made to the reader. As a result, readers of various levels of economics background will most likely benefit greatly from this book.
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The criticism of Koo about the frequency of balance sheet recession seems fair to us, but hardly central. In our view, no firm conclusions can be drawn about the frequency of such crisis, they way are too dependent on circumstance for that.
We’ve frequently stated that there is no alternative to fiscal stimulus in a balance sheet recession. Yes, we fully acknowledge that this will whack government finance out of kilter. In an ideal world, governments should run surpluses (or at least not large deficits) during boom times (that is true countercyclical policy). That’s why this policy worked so well in China. China had a much larger stimulus, proportionally to the size of the economy, than the US without this bringing government finances into danger.
As a result, not only did China experience a very short recession, they now have killer infrastructure in place that fosters future economic growth as well.
People who argue that the US government cannot borrow money at 3% (for 10 years) and put it in productive projects that stimulate today’s demand and future growth and generate a return in excess of that 3% have forgotten how the internet came into being, have forgotten the GI bill, the technical colleges which propelled the US into a leading role in the second industrial revolution at the end of the 19th century, things like that.
Tax cuts? Simply less efficient. A lot less efficient. Exactly because we’re in a balance sheet recession most of these will be saved. If you want any proof, look at the Netherlands (our home country), which has weathered the recession surprisingly well (unemployment has only increased a little and is already falling again, house prices are off their highs a little, but not much).
There exists a scheme of tax-free savings (called the ‘spaarloon’). As a way to get demand going into the economy, the government has recently chosen to free the complete balance of savings to the participants in the scheme (which is rather popular). This is effectively the same as a one-off tax cut. The result? Less than 20% of the freed-up balances are actually spend, the rest is saved again.
And this happened in a country which has experienced only a very mild balance sheet recession (if at all), countries (like the US) which experiencing a much more severe version will see people much more eager to save (or pay-off debt) any possible windfall coming from a tax cut.
The only people, of course, who wouldn’t save or pay-off debt are those that need all they can get just to make ends meet and get food on the table, you know, the unemployed. They will spend near 100% of any income (like unemployment benefits) they get, which is why this is one of the most effective ways to get spending in the economy.
Which is why it is a complete mystery to us why there is a party proposing not to prolong unemployment benefits (out of budgetary considerations, we understand) but at the same time proposes prolonging tax cuts for the wealthy (suddenly, those budgetary worries disappear..).
In general, the richer people are, the more they are inclined to save any windfall from any tax cut, which makes this one of the least effective ways to stimulate demand in the economy.