8 Jun 2010 INETeconomics
[Richard C. Koo is the Chief Economist of Nomura Research Institute]
There is a great deal of confusion about what is the right approach. A lot of things were tried: Zero interest rates, quantitative easing, massive fiscal stimulus, guaranteed bank liabilities, capital injections to the banks.
We in Japan went through all of it! We had to do it 5, 10, even 15 years ago.
When we were going through it there was nothing else to look at. Anything that resembled Japan in the past, you had to go all the way back to the Great Depression in the United States, and that's a different country in a different era [but see what he says below]
It took us about 7 or 8 years before we realized this is actually a different disease. This is no ordinary recession. Ordinary recessions happen because there is overproduction of some sort, inventory build-up or some inflationary pressures, central bank tightening. But the recession we fell into, people were no longer maximizing profits, they were minimizing debt!
Even with zero interest rates companies were paying off debt.
No business schools or economics departments have suggested that such things should take place. Because if companies are paying down debt in the environment of zero interest rates, that suggests under ordinary theories that corporate executives are so stupid they can't even find a use for the money with zero interest rates! Companies should just give the money back to the shareholders.
But it happened in Japan for a full 10 years. Rates went to zero for 10 years and net repayment of debt was 6% of Japan's GDP per year. They were doing it because they faced a balance sheet problem. The asset price bubble collapsed, liabilities remained.
Now you can be bankrupt with no cash flow or with cash flow. In the former you die. But in the latter, that corporate executive will use the cash flow to pay down debt, because for all the stakeholders of the firm that's the best possible solution. Shareholders don't want to be told that you're bankrupt your shares are just a piece of paper. Bankers don't want to be told that they're lending to the company with all non-performing loans. Workers don't want to be told that there's no more jobs tomorrow because the company is bankrupt. So 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, if you continue to pay down debt at some point your balance sheet is balanced again and you say phew I'm out of this problem. Now I can keep making money again. That's the right thing to do at the micro level, but when everyone does it at the macro level what happens? [Amazing] If someone is saving money you better have somebody on the other side spending money [!]. Now let's assume if there is saving that it goes to the financial system. It gets intermediated and goes to borrowers and lenders. If there are too many borrowers you raise rates, if there are less borrowers you reduce rates.
But what happens when you bring rates down to zero and no one is borrowing money?
If you're bankrupt you're not going to borrow money at any interest rates and no one is going to lend you money as well if they know you're actually bankrupt. So the savings get stuck in the financial system. The economy shrinks. When you bring interest rates down to zero, the $100 that the economy saves gets stuck in the financial system. The cycle keeps repeating downward. No one is borrowing money and everybody is paying down debt.
Out of $1000, assume $900 is spent and 10% is saved. $100 goes to the financial system (which doesn't get spent, it just stays there). That $900 becomes somebody's income.
Out of that $900, $810 is spent again and 10% is saved. $90 goes to the financial system (which doesn't get spent, it just stays there). That $810 becomes somebody's income.
Out of $810, etc.... to $730....
If unchecked you go down all the way to half the income in no time.
Did anything like this every happen?
The Great Depression of the 1930s! The US lost half of its GDP in 4 years.
The only thing that the government can do is to do the opposite of the private sector.
That is it still borrows the $100, and you get back to $1000. The economy moves forward.
That's basically what was happening in Japan. We didn't realize it immediately. So we put in a fiscal stimulus, the economy improves, then we said 'oh no the budget deficit is too large' so we cut it again. Then expanded it again etc. The private sector was still de-leveraging throughout. We had this zig-zag for a full 15 years.
This is not in economics textbooks. No one could give us direction on what to do until we discovered it ourselves. This is a completely different disease. We finally understood that you need to maintain stimulus. We finally climbed out in 2005.
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Richard Koo: How the West is Repeating Japan's Mistakesby INETeconomics12,911 views
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