April 2010 King's college Richard Koo - Explaining a balance sheet recession and Japan’s lost 15 years

This article was from  an Interview of Richard Koo  by Daniel Erasmus at King's College, April 2010

It was transcribed from https://www.youtube.com/watch?v=HaNxAzLKegU&t=317sI do not own the rights, and should the owner want this article removed, please contact me. 

There is a great deal of confusion in both US and the UK about what is the right approach to this current crisis—a lot of things have been tried— zero interest rates, quantitative easing, massive fiscal stimulus— when this comes on top of a budget deficit, we tried guaranteeing bank liabilities, with additional capital injections to the banks. We went through all these highly unusual measures.

Well, in Japan—every one of those things were put in place— we had to this 5 to 10 years ago sometimes 15 years ago; and so for those of us in Japan looking at what's happening— what's unfolding abroad— it's like a replay of what we just went through.

All the confusion in the policy debate, whether there should be more fiscal stimulus or less— whether monetary easing can compensate for less fiscal stimulus. These are things we discussed in Japan 10 years ago and at first when we were going through it; it seemed like there were no other options to look at. Because anything that resembled Japan in the past— you have to go back all the way to the Great Depression in the United States and it was a different country, in a different era.

So there was a great deal of trial and error, not knowing what is the right thing to do and it took us about 7 to 8 years into the recession, before we realized that this is actually a different disease; this is no ordinary recession.

Ordinary recessions happen because there's over production of some sort—

Inventory buildup, always some inflationary pressures—central bank is tightening monetary policy— those are the typical reasons we fall into a recession.

But the one we fell into people were no longer maximizing profits, they were minimizing debt. And even with zero interest rates companies were paying down debt.

In no business schools or economics departments anywhere in the world have suggested that such things should take place. These things are not supposed to take place because if companies are paying down debt in zero percent interest rates environments, that suggests under ordinary theories that corporate executives are so stupid they can't find good use for the money even with zero interest rates.

Then why should these companies be around? Companies should just give the money back to the shareholders and let the shareholders find something better to do with their money. That's the usual interpretation and something like that was not supposed to happen.

But it happened in Japan, for ten years— rates were almost 0 in 1995, short-term interest rates were 0 in 1995, and corporate debt repayment continued until 2005—a full 10 years, in some of the bigger years the net debt repayment was over 30 trillion a year— 6% of Japan's GDP was net debt repayment.

Some companies are borrowing, but so many more others are paying down debt, so the net was 6% of GDP going backwards. Why is that so bad?

Well, first of all why did it happen? It's not the Japanese corporate executives suddenly went berserk; they were doing it because they faced a balancing problem.

During the bubble days, they bought tons of money to invest in all sorts of asset thinking that they're going make more money. As the price bubble collapsed, liabilities remained, so they realized you have more debt than what you can show on the asset side.

If you your balance sheets out of order, then you're actually bankrupt right?

But there are actually two kinds of bankruptcies— the bankruptcies with cash flow or without cash flow— if you have no cash flow and you are bankrupt that's the end of the business— you have to raise your white flag and you have to surrender.

If you have cash flow and balance sheets on the water— that corporate executive will do one thing— use the cash flow to pay down debt for sake of shareholders. That's the best possible solution—stakeholders of the firm don't want to be told that the company's bankrupt— your shares are just piece of paper. Bankers don't want to be told that their lending to the company became non-performing loans. Workers don't want to be told that there are no more jobs tomorrow because the company is bankrupt.

So for all the stakeholders involved the right thing to do at the corporate level is to use the cash flow to pay down debt because asset prices never go negative. So if you continue to pay down there at some point your balance needs to be balanced again you say I'm out of this problem now we're going to start making money and so forth.

So it's just a couple of years. Well, at least that's what people think that's the right thing to do at the micro level. When everybody does it at the same time what happens to the macro economy?

In a national economy, if someone is saving money, you better have someone on the other side borrowing and spending money to keep the economy going. In a usual economy that when we assume implicitly in all economics, is that if someone saves money the money comes into the financial sector the financial sector will find some other potential borrowers and the financial sector will give that money to the to whoever can use it. That person will spend the money against the original income.

So if I have a 1000 of income, and I spent 900 myself, 100 is saved, but this 100 goes through to the financial sector— someone borrows it, spends it, and then so 900 plus 100 against the original income—$1000.

If there are too many borrowers you raise interest rates. If there are too few borrowers, you bring rates down. Someone raises his hands, pick up the remaining sum and you go forward. That's basically the economy as we know. What happens when you bring rates down to zero and you still don't see anybody borrowing money?

Because if you are actually bankrupt, your balance sheets is under water— you're not going borrow money at any interest rates and no one's going lend you money either if they know you actually bankrupt right?

So you bring interest rates down to zero the $100 this household saved gets stuck in the financial system— since no one is borrowing money and everybody's paying down debt, so only $900 is spent.

The economy shrinks from $1,000 to 900. The $900 is someone's income and if that person also decides to save 10%, $810 is spent, and $90 going to the financial sector. It is a vicious cycle that one gets stuck in, as I said, the whole process took ten years—so if you leave this system unattended and everyone decides to save 10%--

you go from 1000 to 900, 900 to 810, 810 to 730, and in no time!

And you might wonder how did anything like this happen? Well as I said earlier in the Great Depression in the United States was exactly this pattern U.S. lost half of its GDP in just four years from 1929 to 1933 because everybody was paying down debt and no one was borrowing money.

In this type of situation, monetary policy is largely dead in the water, because you bring rates down to zero nothing happens— so if the government wants to keep the economy from falling into this deflationary spiral.

The government cannot tell the private sector— please don't repair your balance sheets, right? The private sector has no choice; the private sector must repay its balance sheets. The only thing the government can do is opposite of the private sector. That is, the government borrows the $100 and spends it. Then, with $900 plus $100 against the original income $1000— the economy moves forward

That's basically what we realized was happening in Japan and at first we didn't realize that was the case, so we put in the fiscal stimulus and the economy improves and then we say, the budget deficit is too large, we cut it, and the economy weakens again because private sectors deleveraging. Then we put in another fiscal stimulus economy proves and these people have nothing better to do that other budget deficit is too much so we got it again we felt so we had this zigzag for full 15 years.

This is not taught in economic textbooks because something like this not supposed to happen. As I told you earlier, no one gives a direction of what is the right thing to do until we discovered it ourselves that this is a different disease— completely different –it's not a common cold anymore— this is pneumonia.

Once that point was understood, we were able to have little more stability to the fiscal stimulus, especially after we made another mistake in 2001, and after that more or less fiscal stimulus was maintained and we finally climbed out in 2005; the whole thing took 15 years.