 My name is John Hamery and my role here is entirely ornamental. I'm just going to get us started I'll turn the program over to Steve Schragi real soon and Wanted to say a word of welcome to all of you and a word of welcome again to Richard Koo You know my my personal hobby is whitewater canoeing and I've gone up in a main a number of times the last time I was up there Several of my buddies fell away and there were only two of us and I'm not that strong I could or in the past I'd always had somebody else kind of guide us down the rivers We're we're going down the east branch of the Penobscot and I'm looking at the guidebook We're kind of drifting down and it says be careful to see the approaching narrowing of the river You'll see two large boulders. It's completely impassable Lethal beyond this point and I look I'm here two boulders and Weep back paddle like crazy and pull off and you know It's right over the edge of the thing called the hulling machine They used to run logs down this and they get caught in that and just stripped the bark right off of him We would never have made it Well, I thought of that last night when I was thinking about Richard Koo Richard has written some guidebooks for how to survive treacherous waters and We first had a chance to hear him last fall Richard's he comes to this with a Remarkable personal history. He has he of course is the chief economist for Nomura and in his time in Japan has become one of the lead intellects in in Japanese economic and business circles to think through the remarkable problems and challenges that Japan has been experiencing and when when I first met Richard he said you all don't know what you're Living through right now. You're in the front end of something very different. This is not a typical recession You know and this is as he said this is you you don't have the flu You've got you've got double walk of pneumonia here, you know, and you you gotta realize this is a very profoundly different era and Richard is in his work pioneered the concept of a balanced sheet recession. I have to be careful how I say that and that it is a it's a psychology that grips the entire country and Everybody at the micro level is doing the right thing and at the macro level. It's turns out to be astoundingly difficult to manage so Richard is like the the the guy who went down that river first I don't know who I don't know who wrote to says pull off now or otherwise you get killed because they obviously didn't go down the river the first time But but Richard is has been down this path. He has experienced very dangerous waters and he has He's helped many administrations kind of survived to help think it through and he's gonna help us today So Do you want to say a word Steve before you start so we turn to why don't I turn to to to Steve just for a second? And then we'll turn it to you Just quickly because I think dr. Hamry covered it so well, but I think you're gonna see from this presentation Got it. No no problem, and I think as John and capsule so well Richard just has such a phenomenal background and he's been praised from Leading economic thinkers and speakers ranging from Martin Wolf to Larry Summers I think we're gonna see why today One of the things I was struck by and rereading many of his pieces Over the last several days was a real sense of deja vu not only in the sense of the economic situation But also in the sense of the political situation and how we've failed to really confront this and deal with this Sure, it deal with this head-on And and I was at a lunch actually yesterday with Paul Krugman and And professor Krugman said that you know after all the criticism that Americans had heaped on the Japanese in the 1990s We all old them a sincere apology as we struggle to deal with many of these same issues So I don't know if I'm in a position to apologize for all Americans But I can really thank Richard Cooke for coming here and sharing his wisdom and we really look forward to this presentation Thank you very much. Thank you all for coming I'm Richard Cooke and chief economist of Nomura and I've been stuck in the island for the last 25 years I'm actually an American citizen started my career at the New York Fed and I was in charge of syndicated loan this syndicated loans at the time almost More more than 25 years ago and when Latin America debt crisis happened I was in charge of that and for those of you who are old enough to remember how bad the Latin American debt crisis was I can't I have to use my hands This can come down I was in the middle of this massive banking crisis where it was said that seven out of eight US banks Were actually underwater because if you remember what that number can take crisis was like everybody from Latin America Mexico down to the southern tip of Chile were all underwater all when bankrupt couldn't pay and That's how bad the situation was then I moved to Japan and then Japan has a huge banking crisis and I use a lot of my experience as a New York Fed economist handling Latin America debt to help Japanese Go through its banking crisis and then I see something similar happening in the United States now So I'm coming from this this crazy background With a Taiwanese name Japanese background the US citizen and New York Fed person woman You're that person and I see there's so much similarities between what's happening around the world today Compute to what happened to Japan over the 15-year period Now we know how bad the economy is all around the world This is the United States fashion utilization and unemployment down very sharply This is Europe It's going down also very very sharply even beyond the 9-11 the bursting of the ID bubble that incident and This is China where the house prices are also falling This is Shenzhen the most exposed part of China as it were And exports are also falling very sharply as well and a lot of people Called the current situation The return of great depression in some ways what we are faced with is worse than the Great Depression because during the Great Depression All there was a very clear cut epicenter. That was the United States But this time the same problems are happening all over the world all at the same time that all of them have real estate bubbles that are bursting and It ranges from United States China Spain Ireland South Korea parts of Australia parts of France and It's all going at the same time And so I find this situation very very disturbing And as a result even though Japan has no bubble inside the country Japanese economy is collapsing very rapidly as well and the reason behind that is that If you look at which part of consumption is falling all around the world. It's the durable goods Then the regular goods and in the services. There's almost no declining services But huge declining durable goods because Japan makes so many good durable goods People say well, I can keep the state of another year two years. No big problem. And as a result, we are suffering very very badly Against this Problem central banks all around the world have lowered the interest rates very very sharply United States in particular started from September of nineteen eight September of 2007 And brought rates down the fastest rate in feds history down to the same level of Japanese almost zero and other central banks also follow suit but Nothing has happened economy continued to weaken as the prices kept on falling and This is very different from what we learn in schools But there is an example of this before and that is Japan Fifteen years ago, the Bank of Japan was cutting rates from 8% to 0 Nothing happened economy continued to weaken house prices kept on falling and this kind of recession I Called it balance sheet recession as Dr. Henry mentioned a little earlier Because I think we are faced with a situation where private sector people are no longer maximizing profits as we learn in schools They actually minimize in debt They are minimizing debt because asset prices collapsed Liabilities remain Everybody realized that their balance sheets are underwater Or some are some are significantly underwater was some may not be so under the water but they are feeling extremely uncomfortable with the state of their balance sheets and If you if your main line of business is already bad and then you have this problem Then of course you have no choice. You have to raise your white flag and walk off the stage But suppose your main line of business is still good. You're generating cash flow, but your balance sheets underwater Once you're in that situation What would you do or you use the cash flow to pay down debt? Because that's in the interest of all the stakeholders of the firm in that if you are If your shareholders, you don't want to be told that your shares are just worth piece of paper If you're a banker if a creditor you don't want to be told that all your loans the company is now Non-performing loans, you know if you're a worker you don't want to be told that You are you no longer have jobs And so for all the stakeholders in the firm Idea of using the cash flow to pay down debt is the right thing to do And as long as you have a cash flow you continue to pay down debt at some point your balance sheet will be balanced again And at that point you can say to yourself. I'm out of this problem now I'm gonna maximize profits are gonna go forward, but during this period Where you're paying down debt you keep your mouth shut make sure people from outside Don't pay too much attention to your balance sheets Tell all the outside investors whatever they wanted to hear and you quietly pay down debt If I'm running one of those companies, I'm sure I'll be doing that and if you're any one of those companies yourself I'm sure you'll be doing that because As long as you have cash flow the time should solve this problem. There's nothing wrong with the technology Nothing wrong with your management. It's just that you have this balance sheet problem But when everybody does this all at the same time We fall into a fallacy of composition problems in that in the national economy when you have a household someone saving money Usually household sector but not necessarily household if someone's saving money Someone out there the other side better be borrowing and spending the money or else the income flow will stop Suppose I'm a member of the household sector. I spent I get thousand dollars of income. I spent nine hundred myself $100 we say In the usual economy this hundred dollars will go through a financial sector and Given is in given to someone who can borrow and spend this money and with that $900 plus $100 $1,000 against the original income of $1,000 the economy moves forward If there are too many borrowers you raise interest rates you feel the potential borrowers drop out To feel borrowers you bring rates down and the people of some people will raise hands take up the money and economy will Forward that's the usual account But in this recession what I call Balancing recession even with interest rates down to zero No one's out there borrowing money. Everybody's paying down debt Then what happens? But the thousand dollars of income I received 900 I spent hundred dollars comes into the banking system It just gets stuck there No borrowers even with zero interest rates So only nine hundred dollars is spent and that becomes someone else's income those who receive the nine hundred Let's say, okay. Let's say 10% so eight hundred ten dollars is spent $90 going to banking system that $90 gets stuck So if very quickly you go from one thousand nine hundred eight hundred ten seven hundred thirty in this very rapid collapse of economic activity even under zero interest rate and No matter how much central bank trying to inject our liquidity to the system This is everybody's trying to repair their balance sheets. It just gets stuck in a banking system also and In this type of recession if you do nothing about the situation economy will collapse until People are too poor to save any money. Then there won't be no there at that point There won't be any more leakage the situation will stabilize, but it could be half of the income you had earlier Then you have to spend all of it. That's why there won't be any more leakage The last time this thing actually happened was the Great Depression in the United States from 1929 to 1933 Where US lost 46% of its GDP in just four years And when you go back and look at all the numbers it fits this pattern exactly that everybody's paying down debt no one's borrowing money and economy collapse in very very sharp play in this type of recession Government can do a lot of things to prop they can't prop the economy up, but you economy never enters a real self-sustaining growth Until private sector balance sheets are actually repaired And so this is going to be a long process Especially in view of the fact that when everybody tries to repair the balance sheets all at the same time Naturally economy weakens when economy weakens as the prices fall even further and the goal moves away from the private sector Trying to reach that goal and the harder they work Further the goal would be and that's why these process typically takes a long time Now how similar I mean how similar is United States to the Japanese situation this chart shows the demand for funds as viewed from federal reserve senior loan officers opinion survey and Even though there's so much attention paid to the credit crunch the fact that American banks are not Providing sufficient credit when you look at the demand side You also see a very sharp drop and we often miss this part because Bankers not lending is a front-page news Borrowers not borrowing is never a news Then if you are and so this part of the development Usually is missed by the press during the Great Depression also you go back and check a lot of people are saying Bank banks are not lending money but actually the borrowers were disappearing even faster and In Japan too. There was a lot of argument about the credit crunch in Japan We actually never had credit crunch except for a very short period of time It was actually the borrowers disappearing faster than the lenders and that's why the economy could move for such a long time Comparing the US with Japan this chart shows what happened to US house prices since 1992 and what happened to Japanese house prices exactly 15 years apart and you can see that Tokyo Osaka house prices going up was exactly the same amount as the US house prices and going down almost exactly the same way So even though a lot of people say all Japanese and Americans are totally different society different culture different this and that When it comes to greed exactly the same And we are here at the moment, but there's a house price futures listed in Chicago Board of Trade and That shows that house prices will continue to fall until something November of 2010, which is another 18 months or so and The fact that it may continue to fall suggests that It's going to be very difficult to achieve a true stability in American banking system because house prices or the real estate prices will be still falling Now how much credence shall we add to this this particular point? Well Because futures isn't what futures market says is not always what happens in the future for those of you who played in the futures market You know this very well Well, if you go back on this one the futures market is saying that house prices have to fall to the level of 2002 or 2003 Then when you look at this other chart, this is actually a work done by the Federal Reserve Where they looked at the relationship between house prices and rents for this very long period of time There was a remarkable stability rents and house prices for many decades all the way to 1997 and 1997 to begin to diverge. That's the beginning of the housing bubble and What we are seeing now is house prices going back to where the rents are Kind of a historical Discounted cash flow value of the house you have to fall 21% from where we are now Based on this this data this data is different from the one you saw earlier But it goes back much further. So for this purpose, we have to use this or of your house price index And on this of your house price index house prices will have to fall another 21% And then you go back to what that would mean Right house prices will have to fall to the level of 2003 So what the futures market is telling us is that yeah house prices will have to return to the historical cash Discounted cash flow values. So there is some credence to what the futures market is saying But what that means is that we are just an entry level of the problem We are far from the exit because prices will continue to fall and This is just an estimate of how much savings American households will have to recreate because of the loss of savings they thought they had in their housing houses and this this line is Assuming that House whole savings rate is 4% 4% happens to be the savings rate at 1997 when the two began to diverge. So I just use a 4% If they actually saved 4% throughout this period, this is how much they would have saved This is how much American households actually saved So the gap between the two is how much they will have to rebuild their savings This amount is 1.5 trillion and it's it doesn't seem like much Well, it is a huge sum of money, but compared to the kind of numbers we are hearing these days It doesn't seem like much, but the problem is that this will have to be added on top of Saving straight going back to to the normal level And as you can see a savings rate increasing very sharply now and that's what's killing Exports of so many countries all around the world. So suddenly people are Deciding that they should increase their savings because the savings they thought they had here Disappearing very very quickly This is all very very depressing because it's not this is not just the story in the United States This is happening all over the world all at the same time in Spain in Ireland in parts of China France South Korea Australia all facing the same problem where people trying to rebuild their balance sheets as quickly as possible and financial institutions trying to rebuild their balance sheets has a very Devastating consequences because if financial institutions lack capital due to Their losses There's a leverage factor working in reverse So if the financial institution loses $1 of capital be below the the required level They have to cut their lending by $12.5. And so that then adds even more problems to to this whole thing and That's where we are now Now this is all extremely depressing because Everybody's in this problem all at the same time, but I think there is one ray of hope and that ray of hope is that those of us in Japan went through this 15 years earlier and we managed to find out what kind of problem this actually is and how to deal with it This is what happened to Japan's bubble In the 1980s the Japanese case it was the commercial real estate that led the bubble And as you can see commercial real estate prices went up very sharply and a lot of people that made a lot of people Very rich and they spend a lot of money because as you can see Japanese GDP both in nominal and real terms are moved up very sharply that part. I'm sure anyone can understand But what's remarkable is what happened afterwards? The commercial real estate prices collapsed and it fell to the level of love level last see in 1973 Nationwide basis it fell 87% from the peak Just imagine Washington DC down 87% Manhattan down 87% San Francisco down 87% what kind of economy do you think you have left in the United States? Probably not much right Look what happened to Japan's GDP it never went below the peak of the bubble It was always above the peak of the bubble even though our growth was very slow And we had some bout of negative growth for this one is the most recent externally driven factors, but we had Even though we have some negative growth overall we managed to keep our GDP from falling And our unemployment rate never went over 5.5% and it came down afterwards Given that we lost wealth as a result of the volume asset prices Equivalent to three years worth of Japan's GDP. We lost just on land and shares real estate and shares We lost wealth equivalent to 1500 trillion yen. That's a three years worth of Japan's GDP the largest loss of wealth in human history during peacetime Because when you go back to the Great Depression and see how much wealth was lost When US share prices went to 1.6 during the Great Depression Latest estimates suggest that it was the loss that Americans suffer was equivalent to one year's worth of 1929 GDP This is well over three years worth of 1989 GDP the last year before the bubble And this is just land and shares if you add gold club memberships Porsches Ferraris another painting that the Japanese bought during the bubble days you'd be well beyond 1500 and 1500 trillion in Japan 45 trillion in the United States Just imagine the United States losing 45 trillion dollars of wealth What kind of economy would you have left at the end of the day? And in terms of debt repayment, it's debt repayment that causes the GDP to shrink During the bubble days Japanese companies borrowed and spent a huge sum of money and then once the bubble burst Japanese corporate fund for human drops very sharply Bank of Japan also brought short-term rates interest rate short-term interest rate from over 8% to almost zero by 1995 But to no effect whatsoever more than that Even though rates were zero almost zero from 1995 Japanese companies stopped paying down debt because you can see that's going into negative range It's the whole corporate sector is paying down that and On some of the bigger years. This is over 30 trillion yen a year that's 6% of Japan's GDP going backwards So the blood is then circulating backwards now if you add Household savings, let's say was household savings 4% of GDP and 6% of debt repayment coming into the banking system Japan wouldn't be losing 10% of GDP every year and that would be exactly the great differential situation And Japan would have lost 46% of its GDP in four years that could have easily happened But we managed to stay away from that scenario, how did we do that? Well, we did it because Government came in and borrowed that money If the government came in and borrowed a hundred dollars and put that back into the income stream of 900 plus hundred thousand dollars a game So there's no reason to GDP for there's no reason for GDP to fall Next year same thing happens Household saving money corporate sector paying down debt. Why same thing happens year after year after year? Well, if asset prices for 80 80 some percent from the peak one or two years of debt repayment It's not gonna be not might take 10 years 20 years Some people shaking hands may take take 30 years before about corporate balance sheets are clean But as long as you have cash flow, they'll be paying down debt So same thing happens year after year after year and the Japanese government Run by liberal Democrats those days. They were highly liberal with public spending They put in they'll build bridges and roads and Basically kept economy from falling as you can see after the bubble burst government spending was actually increased in Japan even though tax revenue fell and The gap between the two is of course the budget deficit and this additional spending during this period from 1990 to 2005 as up to something like 300 trillion up to 300 trillion yen Now 300 trillion yen is no peanuts 60% of Japan GDP but when you consider how much this 300 trillion Supported how much GDP this 300 trillion supported? You realize that this is probably the most successful fiscal spending in history of mankind Because when you look at this chart If GDP was allowed to fall if the government did nothing Chances are high that this thing would have come come down something like this to perhaps the level of GDP in 1985 if that happened We would have lost GDP during this period close to maybe 2000 trillion yen the 2000 trillion yen of GDP was supported by 300 trillion of government spending the multiplier effect is something like seven Not one or less than one as you are many of you might have believed or heard from other sources and The reason you hear this comments that our Japanese spend so much money on roads Roads to nowhere bridges to nowhere and they still have very slow growth All that argument that you have been hearing of the last 18 years is based on one assumption, right? That assumption is that even if you did nothing even if the government did nothing Japanese GDP would have been flat and Then the Japan did 300 trillion. It was still close to flat So they must have wasted this money on some of the most useless project on earth You know, that's how the argument is put together And when some of these journalists took up the on the microscope and looked and there were some bridges to know where some roads to know where and then that Become a big scandal But my argument here is that this country Japan lost 1500 trillion yen of wealth three years worth of Japan's GDP asset prices down 87 This is nationwide not just our spot, but the whole country commercial real estate prices were 87% from the peaks of South Marias. They fell even further If nothing was done, we would our GDP would have collapsed if you measure the effectiveness of fiscal policy from that point It looks far better but unfortunately econometric models are not designed to capture this kind of problems because econometric models Assumes that with with no input economy is an equilibrium Then you add this Changes and see how much it added to it But what the situation we face was that without the economic stimulus we would have at 30 or 40 percent decline in GDP and so Once you understand what was behind it. I think you would agree that fiscal stimulus was useful Now if people in the United States or in Europe or in China or in Australia Realize that there is a way out of this kind of a crisis after all That it is possible to keep the GDP from falling with proper government actions Wouldn't that make people feel a few lot better? Because if Japanese if Japanese can do it Why not the Americans? Why not the Brits? Why not the Australians? and if I mean none of the countries have faced anything close to decline in asset values 87% from the peak But even with the 87% decline it is possible the fact that it is possible to keep the GDP from Falling with the proper fiscal stimulus I think will make so many people feel so much better that there is a way out of this kind of recession And that is government spending and I very much like to see for example President Obama come out and say this is no ordinary recession This is a balance sheet recession and this kind of recession happens once every many decades because this kind of recession happens only after a burst thing of a nationwide asset price bubble and Usually you don't get this kind of bubble because usually people are more careful with their affairs and don't go crazy but after very many decades People do go crazy and when that happens you get into this kind of situation And when it happens and when people suddenly realize that they made a mistake They were chasing wrong asset prices and move away from profit maximization to debt minimization It's only in those instances that we need a big Proactive government because the government cannot tell the private sector. Please don't repair your balance sheets The private sector has no choice. They have to repair the balance sheets And so the then if you if you just let the private sector repair the balance sheets and let the economy go down in a drain We'll be all dead So the government has to do the opposite of the private sector borrow and spend the money that Private sectors also saving or paying down debt and put that back into the income stream So only in these instances when I go balancing recession, we need a big government Proactive government in all other recessions I am against government spending as a former central bank and myself I can monitor policy can handle it But in this type of recession, I'm afraid that's not the case because people no longer maximizing profits as we all assume in our economics They are minimizing debt Now if there's any mistake that Japanese made throughout this process It is that at the beginning no one had a concept of balance sheet recession I didn't have it no one else did and it's not part of the economics either in any of the universities And so we thought oh, it's just let's simply go downtown We put in a fiscal stimulus and then it worked once you put in a fiscal stimulus economy began to improve I said oh, I'm priming worked and then you look at the budget deficit. It's huge. Oh, let's cut it We cut the spending economy collapse properly and employee another fiscal stimulus economy improved and then people saw the budget deficit We cut it down That's why we had this huge zigzag throughout this period and That lengthened the period of recession in my view unnecessarily At least by five years if not more if we had known in advance that it's this kind of recession where It's not just the inventory build-up But private sector souls actually minimizing debt because of their balance sheet problems and that we are gonna be in this for a long term Then we would have come up with a better project to for to prepare Japan for the 21st century all of that because Government will have to be in there for the for this medium term and I very much like to see President Obama come out and tell the American people that It's this type of recession not the ordinary round-on-the-mill recessions We're gonna be in this for a long for at least a few years And so let's come up with those good projects that will prepare the Prepare America for the 21st century or something. You know, it's that kind of argument that kind of social Social contract. I think it's desperately needed and so far. I failed to see President Obama or Mr. Larry Summers or Tim Geithner coming out and says this is a different type of recession and therefore we have to do these things They're still saying it's a recession. It's a very serious recession So in a sense they're within the economic orthodoxy And that's why they are being hit from both sides those people who argue that the government is going too large And those people are arguing that it's too small But once you turn the table and say this is a different type of recession a balance you recession. It's a pneumonia It's not just a cold Then once everybody knows it's a pneumonia Then, you know, no one would argue about the treatment that's necessary But that hasn't been said yet. And I think that's why President Obama is having so much trouble once the diagnosis is Clearly explained to the people and we all know that the leveraging is happening Financial institutions are the leveraging households are the leveraging so we know that they're minimizing that But someone has to put this argument together to say okay When everybody's minimizing that these things happen and therefore we have to take those measures Which is government spending Now tax cut even though fiscal stimulus often have these two choices government spending a tax cut tax cut doesn't work in this kind of environment at all people minimizing debt you take the tax cut and used to pay down debt or increase their savings and Tax rebate in the summer of last year now people say only 12% added to their consumption. That's the kind of Problem you face in the tax cut. It has to be government spending Now there is a seven hundred eighty seven billion dollar package out there and that's no peanuts in my view But what we have to worry about in the current environment is that is that fast enough to? Arrest the deterioration in the economy Because right now we are losing more than five hundred thousand workers every month And we know that for the fiscal stimulus to kick in They have to first of all select the good projects Engineers will have to design it then we have to put in the public bidding process All of these things designed to protect the taxpayers could take months maybe more than a year's By the time all of these procedures are followed and our fiscal stimulus are in place How many people would have lost their jobs already? If it takes ten months five million people would have lost their job The whole package is designed to increase 3.5 million jobs right that's what President Obama saying so by the time it starts working. We're already behind the curve So we have to move away from this idea of peace time. We are in a war zone now If I get to talk to President Obama, I would suggest to him that Even if you have to dig the ditches and fill in them up, just do it now Keep the world from deepening and widening keep the workers employed keep the income flowing and then while you're winning time with these potentially lousy project Let other people come up with a good project and soon as these good projects already you switch to the good projects But don't just wait there. They all 787 billion dollar package has passed everything is fine. We just sit still It's not gonna work that way. We are in a wartime situation. This is not a peace time situation at all And all these nice measures that are fully in place to protect taxpayers We're actually backfire Because when the wound gets so bad unemployment gets so horrible The tax payers money necessary to bring the economy back back to life would be so much bigger Then if they just use the money now Digging the ditches and filling them up if necessary. I'm not suggesting that we should dig the ditches and fill them up but even with Less than fully desirable projects It's far better to have that in place get the economy moving then wait and do nothing for this very critical period Now many people would argue that Well, Japan could have done this because Japan is a low savings a high savings country United States cannot afford it because the savings rate in the United States is so low I will say that's not a problem. And I think Japan has also shown us the way Actually when this is a Japan's this is Japan's cumulative Government deficit and as you can see grew up very very sharply during this period Rating agencies the IMF the OECD those people who know nothing about anything Captain bashing Japan saying gosh with this kind of increasing Government debt Japanese interest rate will go sky-high the whole thing will come crashing down Never happened This is what happened to Japanese government bond yield It kept on coming down and stayed low for the last 10 years at the lowest level in human history Less than 1.5 percent more in many many periods when you understand now Once you understand the exact mechanism of this recession you can understand why this thing happens In a balanced recession the money the government has to borrow and spend is the money that is saved within the economy But not borrowed within the private sector So it's sitting there in the financial system and Fund managers in banks and insurance companies are desperate trying to find someone to borrow to lend places money So when the government comes in as the borrower of last resort all these financial institutions are more than happy to Lend to the government because that's the last borrower out there Furthermore in the balance you recession with collapsing collapsing asset prices financial institution balance sheets are typically all on the water with huge damage to their capital base and Because they don't have enough capital They really cannot lend to the private sector even if they wanted to lend to the private sector but when the government comes in to borrow and if you lend to the government the The burden on your capital isn't very much less and so for these two reasons government end up procuring funds at ridiculously low rates for Extended period of time and that's what happened in Japan And I think this is what's going to happen in the United States UK and other parts of the world Once people understand the savings are actually generated inside the economy But that but the savings are not borrowed if they were borrowed they won't be in this recession in the first place so Whether you start out as a low savings rate country or high savings country doesn't matter. It's the additional savings that causes problems Now going forward we are going to have problem with rating agencies and they created enough problem in the subprime We're they're going to try to downgrade Countries during this process, right? Because there's a water budget there was increasing economy collapsing. It's terrible downgrade. I hope bondholders of a bond market participants and governments Remain firm in their belief that that's the right thing to do We actually wasted some time because rating agencies kept on downgrading Japan and Japan was rated to the point below Botswana in Africa Botswana is out there because Japanese government is supporting with all sorts of funds and That Botswana is now rated at the point at one point rate the higher than Japan and Once those downgrades come in all the policy makers become scared that if they put in any more fiscal stimulus that you as Rating agencies may downgrade even further Bond market participants get scared because bonds are being downgraded. Maybe they shouldn't buy these bonds If those things happen and necessary fiscal fiscal stimulus will not put in I'm afraid situation will just get worse and worse and worse and when it gets worse those guys will downgrade anyway And so I very much like to Wore knew that rating agencies can really throw a monkey wrench into this this corrective process I think this is a corrective process in a sense that Market is telling the government that this is the one once in a lifetime opportunity to really do something on the fiscal side because there is no crowding out dangerous because private sector souls are not borrowing money and By government taking this action GDP can be kept and as long as GDP can be kept Private sector has the money to pay down that and eventually this problem will go away So market is trying to tell the government to do borrow and spend But if rating agencies come in and screw up the whole sentiment that we all suffer So please be careful about the rating agencies now This is the Japanese case. We this is a debt of the Japanese Company it increased sharply during the bubble came down and stabilized at the level of 1985 our bubble stopped around 1986-87 so all the debris that we accumulated during the bubble the luggage that we accumulated during the bubble finally removed that repayment stopped and 2005 we actually came out of this mess the other line shows Corporate debt as a percentage of GDP and during the bubble days It was as high as 85% and then it dropped to the level of 52% level last thing in 1956 The Japanese corporate balance sheets were fully repaired over this 15-year period now I like to skip few slides to get to the banking issues as I indicated you at the very beginning I have had quite a bit of banking crisis experience under under my belt not to my liking, but it just so happened that way and From this experience. I came up with this idea that there's actually full type of banking crisis not just one localized crisis systemic on the vertical axis and No more demand for funds or weak or non-existent demand for funds on the horizontal axis Now no more demand for funds means private sector souls are maximizing profits. They're looking forward Their balance sheets are clean and this one is the balance you recession and if you divide it world in these ways only in this Quadrant it makes sense to dispose non-performing loans quickly because in this case Problem is localized a small problem relative to a big banking system and There is demand for funds So as soon as the banking system can move forward economy will move forward and everybody benefits and savings and loan crisis In my view was this type of crisis Savings and loan crisis got a lot of public attention because it was handled so poorly by the FSL I see before it hit the wall but Savings and loans were very small financial institutions at the mall together. It was like only 5% of US assets and so And of that a couple hundred went bad But it's a case of 5% sick 95% healthy the 5% sick and 95% healthy You can have an operation take the sick part out and you can still move forward But on this case systemic crisis where it's 95% sick and 95% healthy And that's the Latin American debt crisis that I had to handle myself Where thousands of American banks have their balance sheets on the water? In this case you cannot really do an operation a quick operation Because if you have 95% sick and 5% healthy, how can you cut the 95% off? you know that option doesn't exist and Paul Volcker knew this very well and What we have to do in the Latin American debt crisis for those of you who are not aware of it. We basically said Keep all the banks continue lending to Latin America even though Latin America has completely collapsed and We kept the situation on for five six or seven eight years Calling those bad debt good debt but Forcing banks to use the profits generated after their capital and at that time we use this Medical fat spread that spread refers to this concept of keeping the lending rates high bringing the deposit rates low So that the banks will gain the difference between the two and that's what's called fat spread And we kept this policy in place for very many years to recapitalize the banks and it was in 1988 I think around 1989 that Federal Reserve finally said, okay He's a bad debt. Please write them off and that's the Brady Bond and all of that The whole process took like 13 years cost of the taxpayer zero The problem was so big at the beginning When it happened on that Friday night 1982 Paul Volcker had to call central banks all around the world and beg All the country the banks in the countries around the world to continue lending to the American banks knowing fully well that American banks are all under water and Just to give you an example Bank of Japan Paul Volcker naturally called Bank of Japan, but this is August 1982 August in Tokyo is a miserable place So the governor Michael Bank of Japan was already in his country home in Karuizawa four-hour drive from Tokyo And this poor soy bank of Japan who happened to be at the telephone picked up this Hong Kong from Paul Volcker and Paul was so desperate to get my car And so he said if you cannot get if you cannot get Michael on the phone, there might not be any US banks left on Monday That's how serious the August 1982 was and That person who picked up the phone was the one who actually told me What kind of words for Volcker used to get my Michael on the phone In that kind of situation You have to go slowly. There's no two ways about it With global banks involved and so many of the US banks on the water There's no way we can quickly sell the assets because there's no one out there to buy those assets What's unfortunate about the Latin America debt crisis? However, is that because it was handled so beautifully? that Federal Reserve never had to go to the to the Congress for money and During the first seven or eight years or so and we might have to keep them out shut right because they're all technically bankrupt We all have to keep our mouth shut And then when American banks were sufficiently strong to start writing them off No one's interested in the story anything any anymore so This whole experience of Latin American debt crisis is completely missing from American institutional memory From academia from from elsewhere people can remember the savings and loan crisis because the government had to go to the Congress for money cost taxpayers hundred sixty billion dollars Everybody remembers everybody knows all the details, but that American debt crisis very few people aware Because those of us who are involved couldn't say it and when the problem we were able to say it No one was interested in hearing our stories Paul Volcker actually wrote to the Japanese in 2001 Telling them not to listen to American investment bankers and some other crazy journalist who wants Japan to go slowly for Japan to go quickly on Non-performing loan disposal because the size of the problem is so large That if you try to do that they won't be biased for those assets asset prices will collapse and the situation will just get worse So he even suggested Japanese government come up with a speed limit on how fast banks are allowed to write a problem loan This and in the Japanese case also We never have so Japanese case is this one And in Japan we had to go slowly on on this possible NPO disposal because the problem was too large And we needed the capital injection because in in this situation where there's no borrowers We can use the fat spread right in order to that you know for fat spread to work there has to be borrowers out there and In a balance you recession there's so few borrowers we can use the fat spread and that's why I suggested That we use capital injection. I was the first person in Japan who argue for capital injection and I saw the This concept all the way to the parliament And I can tell you how much I was bashed just like Situation here in the United States People say all Japanese bankers are paid so much higher salaries could build the average people How can you bail out the bankers all of that argument that you're hearing here in Washington today was repeated in Japan 10 years ago and I had to go on National television against the key members of all opposition parties and explain to them that we are fixing the credit crunch first We are not helping the banks. We are fixing the credit crunch to save the economy and One thing that you have to remember in this situation is that Fixing the banks and ending the credit crunch are two contradictory goals If you want to fix the banks and you want to make them lean and mean you have to allow banks to let go of some less than desirable assets as quickly as possible, but when all banks Allow to do this all at the same time We fall into a fallacy of composition problems asset prices collapse and then the situation just get worse and worse and worse So what we did in Japan is that when we injected capital? We told the banks You cannot use this capital injection to write off problem loss. You have to use this capital injection to support the lending And that's the reason how we managed to come out of this credit crunch that happened in 1997 You know Tim Geithner and so many people even people like James Baker are saying Japanese economy never recovered Took so long to recover because somehow Japanese never addressed the banking problems, you know You must have seen this argument many times over I'm afraid that argument is completely incorrect We never had a credit crunch Accepted this very limited period right here 9th October of 1997 to March of 1999 that 18 months Before that as you can see bankers willingness to lend was almost as Eager as during the bubble days when it was said that If you call a banker to get bring the money that go bring faster than delivery pizza That was the period of bubble and this line is that It's from the Bank of Japan tank on survey where 10,000 Japanese companies were asked by the Bank of Japan what the bankers are telling you and So it's a borrower saying yes bankers are very willing to lend a bank. Yes bankers are willing to lend But what they borrowing? You look at this side. This is the fund that Companies actually borrow from the banks and even though banks willingness to lend was equal to the level of the bubble They were not borrowing money at all So what happened in Japan is that borrowers disappeared faster than lenders? And here too bankers willingness to lend was quite high, but people were paying down debt Here too bankers willingness to lend were quite high, but people are paying down debt so yes, we had a banking problem and 1997 to 1998 We did have a credit crunch, but that's it. That's the only part. We had a credit crunch Our economy a Japanese economy did not Stagnated for so long because of the banking crisis It's stagnated for so long because nobody was borrowing money. Everybody was paying down debt And I think this is a very critical message that Could change the debate here because I sense that many American officials who are led to believe That if you don't address the banking problems quickly United States will fall into the same Lengthly prolonged recession that Japan did so they're trying to come up with a quick solution as quickly as possible But for a problem of this magnitude, I'm afraid there is no quick solution Some people said it's four trillion dollars to pick the US banks. How do you get the four trillion dollars? Where do you get the money? or some says all Chinese and Japanese will buy it but four trillions almost Japanese GDP So the arithmetic just doesn't add up And so I would argue that If the idea that if you don't act quickly you've only the Japanese trap is removed Because this is wrong analysis That you can actually do things slowly Then people the policymakers have a lot more options and they can pick whatever that is Of lowest cost of taxpayers lowest burden to the economy Right now that option is not there so people have to come up people have to come up with something very quickly and They cannot come up with anything quickly and that's why people seems so depressed and so I think this part of Japanese understanding has to be part of the debate in Washington so that People don't feel so pressed to do something so quickly and this argument that until banks are Completely repaired that they cannot lend is absolute nonsense Japanese banks were lending and during the period from 1982 to 1992 or so this aftermath of Latin American debt crisis US banks were lending also There is no sign that US banks went on to credit crunch after Mexico went on default So with a proper care proper Management of banks it is possible to let them To keep the banks ready money Even if their balance is maybe underwater If and Paul Volcker was the master in putting this all together during the Latin American debt crisis and so It is possible even with banks balance sheets underwater to keep bankers lending It is possible to do these things slowly if proper pieces are put in place So that you know some of the moral hazard problems and things that can go out of control all contained by the bank regulators as we did with the period after that American debt crisis Once these points are made known That would give so many more options to the American policy makers and as a result people don't have to be so So disappointed right now This seems to be a this obsession that they have to do everything very quickly And they're not able to do it or that the bill seems so sticker shock is so big And then people are saying oh my gosh, what we're gonna do And so I hope this message gets out From you people right here in this room to your congressman and others that hey We don't have to go so quickly as long as we do bank supervision correctly banks can't lend and Taxpayers won't have to be such a large burden American banks are still making lots of profits. The cash flow is not bad at all And so if they use the cash flow to write off problem loans after some years this problem will go away Well, the real challenge in my view is to put together a framework where banks will use the cash flow to pay down that about pay down remove the non-performing loans and But we still need capital injection of course to make sure that they can continue to lend So I what I would like to see is a large capital injection to make sure the banks can lend But allowing banks to use time on their side using the cash flow to clean up their balance sheets If those things are put in place Together with what I said earlier medium term government spending based on medium term fiscal stimulus Centered on government spending if those two packages come in and it's properly explained to the people why they are necessary This is pneumonia. That's why we need these treatments Then I think people should feel a lot better. And if they feel a lot better that Then all these unnecessary fear Those will go out the window and then they can plan ahead. Okay next five years government will keep the GDP On falling we will do this this and this at the end of five years our balance sheet should be clean You know that that kind of planning can can also be made for my point is Please study the Japanese example with open mind I'm afraid many of you have been flooded with wrong analysis and wrong information on what happened to Japan But if it's properly understood, I think there's a lot that Countries today can use from the Japanese example to overcome the crisis you are facing today. Thank you very much Yeah, yeah, that's right. I think this distinction that you've made is is really you know critical between normal recessions and the recession we're having today Most recessions in the US occur when monetary policy tightens because of higher inflation. This is an asset bubble bursting now Let me first defend the Obama administration Larry Summers gave a speech at Brookings only a week or ten days ago When he made precisely this kind of a distinction, this is not the kind of talk you do to the general I think to the American public, but but he did it in his talk to to To Brookings now, I think you make the distinction too sharply because you'd say that borrowing is borrowing completely collapses and That's not the case. We have undone. We have a credit crunch. There's no question. We have a credit crunch But because you have this notion that nobody wants to borrow You dismiss and didn't even talk about the various fed interventions in private credit markets Okay, the ability to bring down long-term rates by buying treasuries with the intent to bring down long-term rates And then B. O. J. Never wanted to do that. They didn't want to distort The yield curve in their view and they didn't make these interventions into private credit markets So I think I think that's important and third You know, I think it's a question of how fast you go You I think if you go through Recapitalization and you let banks recapitalize out of their income that's an incredibly slow peer slow process But you can speed it up with capital injections and we don't know if this will be be work But a main element of this program in principle now is to lift tax toxic assets off bank balance sheets Recapitalization plus lifting the toxic assets is going to make a world of difference. It may not work We don't know whether it'll work. There's great uncertainty about it so That's a I'll stop there because You mentioned about the B. O. J. B. O. J. knew this very well from the very beginning Because we don't have we didn't have a credit crunch as you see And so there's no need for the kind of measures that are taken here because there was no credit crunch Here there is a credit crunch and therefore some of the measures you suggested are I think helpful, but as a Almost central bank of myself That kind of activity should really be done by the Treasury's balance sheet Not the Federal Reserve balance sheet and I am very concerned about the Federal Reserve balance sheet used for this purpose because So many investors outside the United States and maybe some here too are worried about that every time I go to breathe investors around the world as the chief economist of the Nomura people ask me about this question What do you think of the Fed's balance sheets? And of course that balance sheets are guaranteed by treads pop up and guarantee the Treasury all of that But we still have to be very careful in that our currencies are not backed by gold or silver If it's backed by gold or silver Federal Reserve balance sheets not not particularly relevant But because it is not backed by gold and silver It's only the trust people have in the currencies that allow Federal Reserve or the central banks to operate the way they do and if people start worrying about how the Federal Reserve is actually Bankrupt or the balance sheets wasn't that of the city bank and these things began to hit the market We don't know what's going to happen And I very much prefer that Mr. Bernanke do this reluctantly Because some of his academic writings and the way he bashed Bank of Japan ten years ago Not knowing what was happening in Japan Made a lot of people worry that he's going to go all out and at some point that Threshold is reached and people become really scared and so Yes, Federal Reserve will have to do it because it's very difficult to get Treasury money in the current political climate Federal Reserve is the only institution in the government with a kind of mobility to to act But I Want mr. Bernanke to impart an image to the outside world that this is done only reluctantly It should be really the Treasury's balance sheet that should be used for all these risky assets and that under When the normal times comes these assets will be either moved to the Treasury or Be fully guaranteed by the Treasury that kind of guarantees Okay, one last point before I leave This is a major issue certainly inside and outside the Fed the intervention of the private credit markets We should understand however that the Fed has taken on at this point only high quality assets onto its balance sheet number one number two when it took up assets that were more questionable and Even in the case where it got triple-a got first-last protection from Treasury to secure those loans and I agree that the rescue operations the various made-in-lane operations that are taking credit risk should be transferred to Treasury and In the joint statement that fed that Treasury and the Fed Announced earlier this week. They said they would be That's good Excellent Thank you very much Can the US pull this off alone? I mean there's a debate right now is I read it anyway between the US and the EU for example about the degree to which this kind of Deficit spending is needed and so if the US were to pursue it, but the rest of the world weren't what happens That's the real danger. We face this Accusation of free-riding and I think in that regard what Tim Geithner said that everybody put in 2% of GDP It's a step in the right direction What I wrote in my book is that everybody should put in Enough is still stimulus to keep their GDP from falling and if everybody does that there's no reason for Exposed of other countries to fall because the GDP is kept and I think that kind of mechanism Would be very much essential going forward Because otherwise, you know the free-riding problems accusation of free-riding and then rise of protectionism all of that can come together And that can cause lots of problems going forward now Chinese are very much aware of this risk and they put in the very large fiscal stimulus Before anyone else steal the largest in the world as a percentage of GDP Because they realize that if they are viewed as free-riding on the US package There's no more no future for them and they actually studied my work very extensively for very long time Because they were facing the bubble themselves and they realized that If they cannot keep the GDP from falling their regime is going to go out the window also What I do worry is Europe because they have the master treaty which is so so Binding and at the same time Never considered what I call balance you recession when that treaty was put together. There was no concept about she recession and so fiscal stimulus is limited to 3% of GDP which is nowhere near enough to handle a problem of the sort and I very much like to see Europeans come together and says Yes, there's something wrong without our treaty. Let's make exceptions for this type of recession and Well What I like to see in Europe is that if this type of recession happens in within the eurozone that country Let's say Ireland We'll have to do the fiscal stimulus to keep its GDP from falling to make sure that the problem doesn't spread to other parts of Eurozone and if all the individual countries all abide by that rule that they should not be Zone-wide policy of composition, right? I think that kind of treaty I think is really necessary both for the eurozone and for the world Thank you very much. That was very interesting. I'm Crokel Patterson with Raytheon company. Yeah, you mentioned about economic stimulus and the That the multiplying of multiplier effect of that was about eight to nine times Some studies said that infrastructure has a multiplier effect of age Do you feel that that that where should the economic stimulus money most effectively Placed in order to get the best out of stimulus. He said that it should be somewhere where the Can be turned around quickly What would you see is the best in the US economy? Where would the best use of that money be spent? well if you go back in history and see how Countries came out of this type of recession So the dollar of taxpayers money the most effective way to come out is military spending because military spending creates demand While not creating supply Because battleships fighter planes absolutely useless and they better remain useless So you increase demand without increasing supply and that's why economies do Recover very quickly if you increase supply with the demand then you're kind of chasing each other But of course, I'm not here to suggest that we should just increase military spending. That's That's not what I'm here to say but If you want the smallest budget deficit and the largest bang for the money You know, that's the kind of thing you end up spending money like When I moved from United States to Japan 25 years ago, I Criticized Japanese roads Very poor quality and all of that 25 years later. My sons were going to college here I came back show my kids the college I have to do all the driving I Realize how much work is needed here now? And so I think there's plenty of things this government can do and on health care energy areas So it doesn't have to be roads and bridges, but even roads and bridges. I'm afraid there's a lot that this Sorry, that's by the way Mark Finley from BP. Thank you again. Um, so how long does it? Even if you were to follow this this path, how long does it take to work it out? I mean, it seems to me that the Bubble wasn't quite as steep as in Japan. So how long on the back side if it was 15 years in Japan? right, um, I Think still it may take three to five years But I'm just guessing because we haven't seen the bottom of the asset prices yet Now Japanese case. There's one area the number key areas of difference one is that Japanese companies and Japanese banks actually have lots of resources Where we fell into one of these this recession? Japanese banks in particular in those days had a very conservative accounting system. You never Mark up you only mark down And if you have that kind of accounting system for 30 40 years There are a lot of assets that were held at original cost 30 40 years ago that could be sold and You know have this massive capital gains to off that the losses Japanese banks wrote off total of one trillion dollars 100 trillion yen of bad assets over the 10-year period But that was no no peanuts one trillion dollars 100 trillion yen off that total about half were Realizing the unrealized capital gains they had on their books and the other half was by current profits Now US banks don't have that They all spend it on bonuses already vacation in Bahamas and so forth So they'll have to use their current profits to offset all of this so in that sense It might take a little longer, especially for the banks But on the other side and on the other point is that Japanese at the time had a export markets to rely on and Even though some people made Big thing about this export market export market in Japan Actually did not add or subtract from Japanese growth throughout this period and if I may ask you to look at This chart which shows Japan's trade surplus throughout this period. It was remarkably stable for the whole period So Japanese export did not add or subtract From what happened to Japan The point being that Japan basically handle its problems within its borders And what I like to see is all countries Operate this way whatever the problem they have they solve it within their national borders so that it won't spill over to other countries then We would be all better off Now that means little more than what Japan had to do because Japan never had to worry about falling exports But I think that's what we are faced at the moment Well, I think what some of the key indicators would include demand for funds from the private sector I showed you earlier that like this is a demand for funds from senior loan officers opinion survey from the Federal Reserve and we see the demand falling very sharply Now if this is beginning to come back up and people are now forward-looking You're not so worried about minimizing debt they're beginning to maximize profits for those signs come back in That's the time for the government to cut the budget deficit Because if the government still in there borrowing money and the private sector comes back try to borrow money Then we were writing to discounting our problems This allocation of resources higher interest rates inflation all of that so when you when we see this turn around and People become a lot more forward-looking private sector becomes a lot more forward-looking. That's the time you switch But so this would be one of them interest rate would be another one My interest rates can go up for all sorts of silly reasons Middle-east investors might get panic with what the Federal Reserve is doing with its balance sheet pulled the money out Interest rates could go sky-high So you have to look at both what's really happening in the market and some of these sentiments that might be changing and Corporate number in the Japanese case It was actually quite simple because it was a corporate balance sheet that was that will Drive in the recession In the US case, it's the financial sector balance sheets any household sector balance sheet So you have to look at these two very carefully to see whether people are waiting to Borrow money again or start spending money again So I would be looking at balance sheets Of these two sectors very carefully Thank you very much if I can ask maybe possibly the last question one of the things that I thought was very fascinating by your work you talked about this going on for a long period of time and One of the differences from the Japanese situation This is a global situation that we're facing now and we're already seeing some political and strategic impacts protests from Latvia to Russia In China, how do you see this impacting the global political and also strategic situation going forward? actually, I think this Going forward We are going to see some democracies fail. We might see some governments fail because this is such an unusual recession that most economists in those countries are probably unprepared to deal with it and They might go back and forth between cutting taxes Monetary easing this and that and Those failing to produce results and people become very upset Those are the kind of things that we have to really worry going forward and Nothing is worse in my view to have Dictatorships with the wrong agenda having the right economic policy and the democracy is all arguing for a large government no small government no large government no small government end up having no government and these Dictatorships doing the right thing. That's basically what happened in the 1930s Hitler got everything right on Handling this type of recession and that's why German unemployment is one of the charts in here For German unemployment This is what happened to German unemployment After Hitler and you can see that it was nearly 30% In 1932 33 it was brought down to 2% in just this very short year That's why he became like God Everybody thought my gosh all the other countries are still in a mess. Germany got everything right Then United States is this one Our unemployment rate did go almost 25% and with a new deal policy It improved quite dramatically, but in 1997 very fatal year Roosevelt made the same mistake Prime Minister Hashimoto made in Japan 70 years later So all the economy is improving everything is fine. We don't need a fiscal stimulus anymore, but the deficit is too large He cuts the budget deficit and unemployment skyrockets And it took so many years for this thing to improve a lot of people say our new deal policies did not working To pull the US economy out what it was working, but it was interrupted if Roosevelt did not make this mistake and economy continued to improve and Other countries follow suit. I wonder very much whether Hitler would have a gut to Start a war, but at that time all the other countries were in a mess Only that that dictatorship was doing well and that gave him an enormous confidence that maybe this time they can get away with it so there's a huge political implications to to this Economic crisis and I very much like to see Democratic governments come to grip with this problem and put in the right policies before the dictators Thank you so much for that really compelling Description and we welcome your insights and really appreciate you taking the time We hope you'll share it with many other Americans and others around the world in the weeks and months to come And I hope you share this with your friends as well. Thank you very much