The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession

A Guest Review by Lindsay Fraser

At a time of economic crisis,  parallels from elsewhere become of the utmost interest. Take, for example, the experience of Japan in the 1990s, the subject of Richard Koo's book, The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession.

Japan’s
recession has been blamed variously on structural problems, on the banks (via a
standard credit crunch), or on a failure in monetary policy.  Koo, the chief economist at the Nomura Research Institute, sets out why economic evidence
supports none of these – for example, the strength of exports during this
period suggests that Japanese companies were not just structurally sound but
remained highly competitive.  Rather,
he suggests that the collapse in the 1980s asset bubble triggered a balance
sheet recession.  Faced with the
fall in property prices (real estate fell 
87% in
three years from its peak to its trough in 2003/4), companies were left with a
huge hole in their balance sheets, which they set about repairing in the only
way open to them – the repayment of debt. 
This was not obvious at the time because companies, understandably, were
keen not to publicise this and, because their core operations remained healthy,
they believed (correctly) that given time they could rebalance their balance
sheets without frightening their investors. 

The key point
here, according to Koo, and the reason for the reference to the “Holy Grail” in
the title, is that, whereas traditional economics assumes that every firm’s
priority is always to maximise profits, Japanese companies instead
adopted the goal of debt minimisation. 
While this was utterly rational for each company to do individually,
collectively it led to a vast shrinkage in aggregate demand, and a deflationary
cycle.  This explains why
traditional monetary policy did not work on this occasion:  monetary policy assumes the existence
of willing borrowers in the private sector, and it is simply a question of
setting the right “price” in order to stimulate demand for debt. Instead, the
private sector continued to repay debt even when interest rates were nearly zero. 

The BOJ also tried quantitative easing,
putting ¥25tn into the system between 2001-2006.  This was ineffective as the system was already awash in
excess reserves, but also explains why inflation did not take off as a
result.  The main policy that did succeed,
and prevented total collapse, was the huge fiscal stimulus via bond issuance
and expenditure on public works (plus a blanket deposit guarantee for the
banks).  This helped to replace the
lost demand from the private sector, allowing the economy to continue to
operate.  Koo explains the current
incipient recovery in Japan as evidence that balance sheets may now be
repaired, allowing companies to invest in growing their businesses again.   He regards the 1990s as a success rather than failure, thanks
to the government’s actions – the fall in GDP would have been far more painful
without it. 

He believes the
US depression in the 1930s had similar causes, and examines some of
the other policy options available. 
He dismisses the idea that central banks should buy up “risky” assets,
partly because of the volume required to make a significant impact and partly
because of the risk to the bank’s own credibility.  Similarly, he rejects the idea of “helicopter money” –  Milton Friedman’s (and Fed Chairman Ben Bernanke’s) suggestion
that monetary policy will always work because, if all else fails, you can
scatter money over cities and thus increase the money supply – because of the
impact of such a policy on the integrity of the currency itself.  (Tax rebates do not come into the same
category, because they are part of fiscal policy.)  The other effective option available to countries running a
current account deficit is to devalue the currency, so as to tap into external
demand (this wasn’t available to Japan in the 1990s, of course, with its large
surplus). 

Koo describes the typical economic cycle, dividing it in two phases.  In the expansionary (“yang”) phase, the
economy is behaving along traditional macroeconomic lines, with companies
seeking to maximise profit, with monetary policy effective in controlling
demand, until overconfidence leads to bubbles appearing.  At this stage, tighter monetary policy
pricks the bubble leading to the deflationary (“yin”) phase, when companies
shift to debt minimisation in response to asset price falls and forcing
governments to rely on fiscal policy until balance sheets are repaired and
confidence returns, starting the expansionary phase again.

Koo argues that
Japan’s experience shows up the flaws in both monetarism and in Keynesian
economics as both assume that firms continue to seek to maximise profits and
neither succeeds in explaining why monetary policy fails to work in a balance
sheet recession.  While Keynes was
right in recommending fiscal stimulus, he did so for the wrong reason, arguing
in terms of the multiplier effect of government expenditure and the marginal
disutility of labour for long-term unemployed, rather than seeing it as
offsetting the effect of debt repayment by the private sector.  As a result, Keynesians have tried to
explain economic cycles using “sticky” wages and other price rigidities.   If we incorporate the idea of a
balance sheet recession into the Keynesian model, then it’s easier to
understand why a robust economy can suddenly stall following a fall in asset
prices. 

Drawing all
these threads together, Koo argues that Japan’s experience should reassure
Western economies as they struggle with a balance sheet recession.  He explains deflation by the example of
someone earning $1,000, spending $900 (which then becomes income for someone
else) and saving $100.  Someone
must borrow (and spend) that $100 for it not to be lost to the economy,
otherwise effectively income has been reduced to $900, of which $90 is saved
and so on, into a deflationary spiral. 
 In a balance sheet
recession there is a shortage of borrowers wanting to borrow (then spend) the
initial $100.  He therefore
justifies the government increasing its spending to offset that unwanted $100,
without fear of crowding out private demand – indeed the increase in government
spending is simply financed by the increased private savings.  (This is exactly what happened in
Japan, where most of the government debt is held by domestic investors.)

His
recommendation for the US is for the Administration not to worry too much about
the fiscal deficit:  Obama should
declare a balance sheet recession and that he will do all he can to support GDP
for five years or longer.  Neither
monetary policy nor tax cuts will work while the private sector is
deleveraging.  The Fed should adopt
a new role as “borrower of last resort”. 
He also has lessons for Asia in this new era of globalisation:  they can no longer rely on exporting to
America being the solution to their problems.   And advises against allowing bubbles to develop in the
first place!