Sunday, 28 April 2013

Richard Koo's "balance sheet recession"

On Thursday last week I participated at the ZSEM and Bloomberg Investment Conference, entitled "Redesigning Global and Regional Finance". In addition to a series of interesting speakers, the keynote address was done by Richard Koo, Chief Economist at Nomura Research Institute, and the main advocate of the "balance-sheet recession" argument. This is, after all, the argument he is presenting in his 2008 book "The Holy Grail of Macroeconomics" (the idea has received a lot of attention in mainstream economics). 

The presentation itself was excellent. He has managed to keep my undivided attention for the whole two hours, which is even more surprising since I didn't agree with some of his major points. Not since Arthur Laffer at the IEA last year has a speaker caught me with so much enthusiasm. 

Anyway, his major argument is that the current crisis is a "balance-sheet" recession, a term relatively new to the economic science, primarily because Mr Koo himself came up with it (he was observing a bunch of graphs on borrowing and spending and reached, in his own words, paradigm-altering conclusions). The presentation he did a couple of days ago in Zagreb is more or less similar to the one you can find here (which he presented in the Berlin conference last year). Or in pdf form, his standard argument can be found here.

Balance-sheet recession explained

A balance-sheet recession is characterized by an initial AD shock (such as the housing bubble burst in Japan in 1992 or in the US in 2007), after which the consequential effects of rapidly declining housing prices are causing massive private sector deleveraging. Both households and the corporate sector start saving, while on the other hand there is no one left to borrow and spend. So the idea is for the government to step in and provide the necessary liquidity in the system on the borrowing and spending side in order to prevent output from dropping down even further. And this is, in Mr Koo's words, exactly what Japan did to ease the effects of the bubble-induced financial crisis in the 90-ies.

To support this story Mr Koo provided a series of graphs verifying his position, first on the Japanese problems in the past few decades, and then in the US and some Eurozone economies as well (all these graphs can be found in an earlier presentation of his).

After stressing the ineffectiveness of monetary policy in initiating the recovery (he has shown rapid expansion of monetary base in the US, UK, ECB and Japan and concluded that due to the ZLB, a low multiplier, and the fact that no one was borrowing, this money was being stuck in the banking system), he went on further to describe the shock in Japan that translated itself into a balance-sheet recession: 
The first graph shows this story which has occurred in Japan from 1990 to 2006. Since the burst of the Japanese housing bubble firms started with massive deleveraging and the effect was a substantial decrease of borrowings from financial institutions and funds raised in markets. Firms were basically using their positive cash flows (which they still had due to good business results from exports) to cut down their debt. Since everyone was deleveraging, no one was left to borrow. The reason this is called a balance-sheet recession is because firms balance sheets were bad ("under water", as Koo calls them), while their cash flows were good, so they needed to use the cash flows to pay down their debts. Since there were no borrowers left on the market (households saving, businesses not borrowing - this is visible by looking at the aggregate balance sheets of banks in Japan), someone had to step in to provide the liquidity - the government. 

Koo pointed out that Japan's government has never allowed nor real nor nominal GDP to fall below the pre-crisis peak (as can be seen from the graph above). This was a big mistake in my opinion. The housing bubble implied that Japan needed a correction, and by keeping GDP at artificially high levels was a wrong signal to the real economy. Japan needed a correction after its economy overheated and after its previous growth model ran out of steam. It needed to switch to a new, more sustainable growth path. The effect of its high levels of government spending is record high peacetime debt, bringing to question its sustainability.

The Japanese government underwent a huge decade long stimulus to provide the liquidity in the system, which has resulted in a cumulative deficit from 1990 to 2005 of 315 trillion Yen, which is about 3 trillion dollars, and has resulted in Japanese public debt to rise above 200% of GDP. Mr Koo didn't see any negative implications of these highly unsustainable debt levels (regardless of the Reinhart-Rogoff argument - I asked him later). He is after all a proponent of the approach that it's slow growth that causes high debt since the government must intervene during AD shocks. In my opinion this is a self-defeating negative spiral of ineffective government stimuli, consequential rising public debt, and slow growth (after all, Japan has usually been the counter-example of stimuli policies, particularly with respect to local effects).

The stimulus might have been helpful in not allowing Japanese GDP to plummet, however its effects were so slow that even after 20 years the Japanese private sector is still risk-averse and is not lending or borrowing as it did before. Koo points out to a reversal of the trend in 2005/06 which was unfortunately stopped by the global crisis, but I don't see the big shift at all. Japanese government in 15-20 years of stimulus has done very little on the financial market, and even less in the psychological aspect to induce people to spend. This is why, in my opinion, the Japanese example remains to be a failed approach to starting a recovery. They have failed to reignite their economy despite years of similar approaches (and some unsuccessful patches and reforms attempts on the way - he made the point that premature fiscal reforms in Japan only worsened the deficit in 1997 and 2001).

Anyway, Koo's implication for the reemergence of the balance sheet recession in current times in Japan is to support new PM Abe's economic policies focused on stronger stimuli (fiscal and monetary) to once again provide the necessary liquidity in the economy and encourage people to borrow and spend. So more of the same approach. 

The US and EU balance sheet recessions

In the US case he draws similar conclusions: 
As he does for the Eurozone and the UK (click to enlarge; first graph is Eurozone, second UK): 

The story is the same, everyone is deleveraging (corporates cutting debt - blue line, households saving - red line), no one is borrowing so the government has to step in to provide the excess liquidity. As we can see  this is happening in all three examples (notice the particularly sharp reaction of both households and businesses in the US in 2008, after which the budget deficit, thanks to bank bailouts and stimuli, increased rapidly). The same thing is true for individual country examples (he mentions Ireland, Portugal and Spain). Along with this he also provides the bar graph of both the households and the corporate sectors in each country to show the deleveraging process. But by looking at these graphs, while no one is disputing that deleveraging is occurring, one can't help at notice that in every example government deficits immediately increase (the green dashed line). So in each case the government does react via excess liquidity. I would in fact argue that after the initial shock which causes the private sector to panic, the government announces bailouts to which the private sector reacts with even more caution and increases savings even higher. This can slightly be visible from this graph. Bottom line is that governments in all these cases reacted with immediate greater liquidity into the system.

Has this been a successful strategy so far? Not really. The only effect it has caused was a substantial increase of public debt and rising budget deficits (just as it did in Japan), which has forced the politicians into austerity measures to cut these deficits. This is why Koo emphasizes that it's hard to maintain the stimulus for too long in a peacetime economy. But this is far from an excuse. What those graphs rather remind me of is the "World's most important chart" from Goldman Sachs which epitomizes the clear-cut relationship between government deficits and private sector savings. They move perfectly opposite one to another. 

Concluding points - is the balance sheet recession a phenomenon, or is it just a clear market signal?

Koo mentioned a recovery in Japan after 15 years of government stimuli (albeit some fiscal reform episodes imposed by the IMF) that started giving effects around 2005/06, when credit activity once again started in the private sector. However, I wouldn't call that a recovery. There is something seriously wrong when a mountain of funds from before the 1990s gets blown apart so strongly during the next 20 years. To me this is a typical example that something structural was wrong with Japan's economy. The AD bubble shock was a trigger for bringing the systemic instabilities of an overheated economy on to the surface. The firms balance sheet deleveraging is a normal reaction in an uncertain environment. It's not a big puzzle why this is happening - huge uncertainty and lack of confidence in the economy, just as we have now. Naturally, both households and corporates (and banks) are being careful and risk-averse. Koo made a good point of how this is purely a psychological issue of recovering from a traumatic event. And I agree. However, he thinks that more government borrowing and spending will be enough to help the households and businesses forget about the trauma. Not likely. The reason the Japanese started borrowing again (even slightly) is not due to persistent government stimuli, but simply because enough time has elapsed. When the problem is structural, when one engages into a rapid productivity decline and an inability to adapt to a new technological shock, then the standard answer isn't a fiscal stimulus, it's institutional reforms that enable new patterns of specialization and trade and new jobs emerging, which guides the economy towards a new sustainable growth model. 


  1. Interesting, but Im not really buying the balance sheet recession view, and even if I found it plausible, I dont really see it as a call for fiscal intervention. If that was the solution than governments could be targeting certain total debt ratio they thought was consistent with sustainable growth - which is obviously idiotic, but the point was to illustrate that government involvement is not necessary or a better solution. I do think japanese government involvement actually delayed the restructuring of the economy as they tried to support problematic sectors. The fact that NGDP didnt move only shows that BoJ didnt allow it to. In that situation they would especially be better of if the government didnt do anything. Btw, dont forget that BoJ was doing QE from 2001-2006, that may have helped with borrowing, even though QE pace was pretty timid.

    1. Naturally, I agree. As for monetary policy, Koo was pretty restrictive on the idea that BOJ's actions had anything to do with the slight recovery and increased borrowing. He emphasized this graph on pg 21 (exhibit 4) in that monetary policy hasn't been effective to initiate bank lending (green line) He is stressing it all on the fiscal policy approach (it's understandable that he supports this approach since he was the economic adviser to the government at the time)

  2. The balance sheet argument surely makes a lot of sense. Both firms and households tend to deleverage significantly, particularly following such a strong wealth shock as were the Japanese or US bubbles. But the claim that it can be solved by initiating more borrowing from the government in such a situation is only one part of the story, and in my opinion a short-sighted part of the story.
    Higher government spending will temporarily provide liquidity to the system but will in addition to that create a crowding out effect of investments and make the system dependent on more government spending – as it coincidentally happened in Japan.

  3. With respect to your text on China, do you think this argument could extend to China today and it's ever expanding bubble?

    1. Absolutely. The Chinese bubble will inevitable burst just like the Japanese one, and China's authorities will probably apply the same effort in trying to overcome it, which will also lead them to a lost decade, or even a few lost decades.

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