 Good afternoon. Thank you all for coming. I am Michael Green. I'm Senior Advisor in Japan Chair here at CSIS. And we are very pleased today to have my friend Richard Koo to speak to us on great recessions, lessons learned from Japan. Many of you probably have heard of Richard, read his books or his articles in Nikkei Shimbun or the Wall Street Journal. He joined the Nomura Research Institute in 1984 and he's now the chief economist for NRI for Nomura Research Institute, which is the research arm of Nomura Securities. He's had careers in Japan and in the United States. He was an economist at the Federal Reserve Bank of New York, 1981 to 1984, a doctoral fellow on the Board of Governors for the Federal Reserve System, 79 to 81. His reputation in Japan is strong. He's considered one of the most reliable economists and analysts of the Japanese financial markets. He's also the first non-Japanese to participate in the making of Japan's five-year economic plan, and the only non-Japanese member of the Defense Strategy Study Conference for the Defense Agency. Richard's originally from Taiwan. He's from the famous Koo family of Taiwan. And on another day, with another title, we could easily do a two-hour session on cross-trades relations based on Richard and his family's extensive involvement in dialogue between Beijing and Taipei. Richard has a BA in political science and economics from the University of California at Berkeley and an MA in economics from Johns Hopkins, and he's the author of a number of books. We have one of them outside for you to pick up afterwards. We deliberately have half as many books as there are people in the audience. This is to test a scarcity theory in economics, but we'll have at least some available for those who are interested copies of his book Balance Sheet Recession, which is an analysis of Japan's lost decade. And then today he'll talk about his new book, The Holy Grail of Macroeconomics, Lessons from Japan's Great Recession from Wiley Press, which just came out this year. And in Balance Sheet Recession and in this book, Richard makes the argument that contrary to what you tend to read in the Western press, Japan's lost decade was not really about restructuring. It was a balance sheet recession. Companies had to write down their debt, and the best thing the government did of Japan, according to this argument, was not the actual restructuring and reform process, but stimulus packages. So Richard has placed himself right in the center of the debate in Japan about what happened in Japan and right in the center of the debate about what needs to happen in the current financial crisis that we're facing globally. So please join me in welcoming our distinguished speaker, Richard Koo. Thank you very much for that nice introduction. That kind of gave the impression that I'm against reform, but I'm not against reform. In fact, when there was the first Bush Administration, the Bush Administration senior, there was a structural impediments initiative that came out of Washington, and I had a very large input in that one. A lot of the work that I did in Nomura Research Institute was put into that structural impediments initiative, and then was pushed back to the Japanese. So I was very much at the forefront of structural reform argument until I realized that Japan actually is settled with something else. And I tried to explain to you what that something else is all about because this is not in economic textbooks anywhere in the world, the kind of a problem that we suffered. And now I see the same thing is happening not just in the United States, but in Europe and in China as well. I think it's important that what we learn in Japan going through this process is put to good use in this town and in Europe and China as well. In fact, I have been invited by the Chinese government a number of times already to explain what happened in Japan so that they don't have to make the same mistake over there as well. Now, when I say what happened in Japan is something that the United States can learn something from, I see a lot of blank faces in this town. It says, gee, do we have anything to learn from the Japanese? They screwed themselves up in the monetary policy, physical policy, structural policies, and last 15 years. We have nothing to learn from those guys. So I have to fix that perception first before I guess we can move on to describe the usefulness of this lesson for the current US situation. But let me first start with this chart which shows what happened to Japanese land house prices in Osaka and Tokyo area compared to what happened in the United States. And this heavy line is what happened in the United States up to here. And the other two lines are what happened to house prices in Japan. And you can see that on the way up, it's exactly the same magnitude on the way down. Well, we don't have US house prices down all the way yet, but in the United States we have a housing futures market in the Chicago-American Tire Exchange. And this yellow part is the futures, and it shows that it's going to go as low as this level, which will be reached November of 2010, and it will be almost where the Japanese prices have gone. So on the way up, it's very similar on the way down, it's going to be quite similar as well. This is how much money banks have lost in these two crises. In the Japanese case, this is just Japanese banks. They lost nearly $1 trillion, or 100 trillion yen was written off over the last 15 years. And this is where the global banks are relative to the subprime crisis. And it's almost the same level. And if you add losses incurred by the Japanese life insurance companies and others, over here will probably look quite similar too. This one is taken directly out of the most recent IMF financial stability report. So in terms of magnitude, it's very, very similar. And that was just looking at the housing market, but what drove the Japanese market was really commercial real estate. Commercial real estate prices collapsed, and housing prices went down with it. Now if you look at what happened to Japanese commercial real estate, this red line, we lost 87% of the value from the peak. Just imagine Manhattan real estate prices down 87%. San Francisco down 87%. What kind of economy do you think you have left in the United States? But that's what we've suffered in Japan. And other line, golf club memberships, you might laugh at it. Well, we lost, that asset lost 95% of its value. And golf club memberships used to be a very important part of household assets because some of the better memberships cost 3 to 5 million US dollars. And so when that thing lost 95% of its value, a lot of households were hurt badly. But it's the commercial real estate that really made us all very pale. And the amount of wealth we lost as a result of these collapsing asset values just on land and shares was 1,500 trillion yen, three years worth of Japan's GDP, about the largest loss of wealth in human history during peacetime. Well, how about the Great Depression you think about? In Great Depression, US asset prices fell dramatically also. But when you look at the data, the amount of wealth the United States lost from 1929 to 1933 was equivalent to one year's worth of US 1929 GDP. We lost three years worth. And in Great Depression, United States lost 46% of its GDP. Unemployment went up to as far as 25%. In Japan, we managed to keep unemployment at the highest point about 5.5%. What happened to the bottom of this chart? Oh, here. And that's just what happened to asset prices. But in this kind of recessions, the asset prices then start driving the market, driving the real economy in what ways? Well, when asset prices collapse, liabilities remain. And all these people who bought those assets with borrowed money will have their balance sheets underwater because asset is down 87% of its value. Liability is still there. So suddenly everyone's bankrupt. Now, if your cash flow is not there also, then you have nothing more you can do. You just raise your white flag and walk away. But if your cash flow is still there, what do you do? Your cash flow is there, but your balance sheet is underwater. Well, it doesn't matter whether you're Japanese or American or Taiwanese or whatnot. I think the choice is just one choice. And that is use the cash flow to pay down debt. Because as long as you have cash flow, you can continue to pay down debt. And at some point, your balance sheets will be balanced again. And at that point, you say, I'm out of this mess. Now I'm going to go after these other competitors. But in this process, you keep your mouth shut, make sure not people like yourselves don't pay too much attention to your balance sheets, and you quietly pay down debt. Well, that's what the whole economy was doing for the last 15 years. And this chart shows how much funds Japanese companies raised from both the capital market and the banking system. And the other line is the short-term interest rates in Japan. And as you can see during the bubble days, just like in the United States, a lot of people borrowed money to invest in all sorts of assets. And after the bubble burst, fund procurement drops dramatically. Bank of Japan also brings interest rates down as well. By 1995, short-term interest rate in Japan is almost zero. But look what happens to fund procurement. It goes into negative. Negative means people paying down debt. And there are not too many textbooks in economics that tells you that companies should pay down debt in the environment of zero percent interest rate. Because these things are not supposed to happen. People paying down debt in the environment of zero percent interest rate means, in ordinary sense, that the corporate managers are so inept that they cannot find good use of the money even with zero percent interest rate. So those companies should just dissolve themselves, give the money back to the shareholders, and let the shareholders find something else to do. But in Japan, we have this whole 10 years where companies were doing nothing but paying down debt. Well, what's wrong with this? Well, there's a lot of things wrong when, goes wrong when corporate sectors start paying down debt. Because when you look at the national economy, in the national economy, you have a household sector saving money. We are all part of the household sector when we walk away from this room. And then we have a corporate sector borrowing and spending money. And between the two are people like ourselves, financial types, intermediating the funds. So if I'm a member of the household sector, I have $1,000 of income. I spend $900 myself, or my wife spends it. And then $100 we decide to save. The $900 is already someone else's income. So it's already part of the economic process. The $100 that comes into the banking system or to the securities houses, this is lent out to the corporate sector. The sector borrows it, spends it. So $900 plus $100,000 against the original $1,000, then the economy can move forward. If there are too many borrowers, interest rates are raised. If there are too few, interest rates are lowered to make sure that the entire $100 are borrowed and spent. Well, what happens when corporate sector refuses to borrow money even at 0% interest rates? What happens to the household savings? What happens to the banking system? It cannot leave because there are no borrowers. And on top of that, all these corporate debt repayment, and on some of the bigger years, the amounts are like 30 trillion yen, 6% of Japan's GDP coming back into the banking system. That money cannot leave either. So what happens is that some of household savings plus corporate debt repayment becomes the net leakage to the income stream. Because no one is borrowing and spending this money. So if you do nothing about the situation, each year you will lose demand equivalent to the sum of household savings and corporate debt repayment. And in Japan, some of the bigger years, this was like 8%, 9% of Japan's GDP. So each year we could have lost 8%, 9% of GDP. And then that is exactly the Great Depression scenario. And when you go back to 1929 to 1933 and view it from this angle, everything is explained. Why Great Depression got so bad and the process went on for so long? Everybody was paying down debt. No one was borrowing money. And in four years, the U.S. lost half of its GDP, as I mentioned to you earlier. So we were in this process. Everybody's doing the right thing at the micro level. If I were running one of those companies, I would be paying down debt. If you're running one of those companies, you would be paying down debt because that's in the best interest of all the stakeholders of the firm. If I say I'm bankrupt, then all the workers will lose their jobs. Shareholders will have their shares turning into a piece of paper. Bankers will be stuck with huge non-performing loans. So it's for everyone's benefit that the corporate sector uses the cash flow to pay down debt. And once the payment is finished, we're all back to the textbook world. Everything is fine. But the problem is when everybody does it all at the same time, we enter what might be called the fallacy of composition. Everybody's doing the right thing at the micro level. But when everybody does it all at the same time, the macro economy just collapses. And the greatest example of that was the Great Depression. Well, in Japan, Great Depression somehow did not happen. Even though we lost commercial real estate values, 87% of our commercial real estate values, 1500 trillion yen of wealth was lost. Companies are all paying down debt. But our GDP, which is shown in this chart, never fell below the peak of the bubble in both nominal and real terms. Now, during when we have a bubble, this red line, the purple line, is the commercial real estate values. And when real estate values were increasing, when people were feeling rich, you can see the GDP increasing rapidly. But what is truly remarkable in Japan is that after the bubble burst, and commercial real estate prices falling in this nice curve that looks like Mount Fuji, but it's nothing pretty about this picture, actually. And the prices falling to the level of 1973, our GDP kept on going up higher and higher. Even though we had some areas of negative growth, overall we managed to keep our GDP from falling. How did we do that? Because this, I think, has a very important implication for this country. Because house prices are still falling, some of the financial assets have lost 90% of their values. But how do we keep the GDP from falling? Well, Japan managed to do that with fiscal stimulus. Government borrowing and spending the money. If government came in and borrowed $100 and put that back into the income stream, $900 plus $100, $1,000 again. So there's no reason for economy to weaken. Next year the same thing happens. House or sector saving, corporate sector not borrowing. Why same thing happen year after year after year? Well, to repay a balance sheet with this much damage, one or two years of debt repayment is not enough. It takes years of debt repayment before the balance sheets are balanced. So year after year, year after year after year, the same thing happens. And at that time in Japan we had liberal Democrats running the show. Those people are highly liberal with public spending. And so soon as economy weakened they said, hey, let's build roads and bridges. Thinking all along that this is just a cyclical downturn, one or two years of pump priming, everything should be fine. Well, when they put in the fiscal stimulus, that $100 was borrowed and spent, economy stabilized, began to look better. And then at that time everybody was happy. But then soon enough when the stimulus, the effect waned, the economy began to weaken again. Then another one was put in and then the economy is picked up and then we have been doing that for the last 15 years. As a result you can see that this is government spending. This is the government tax revenue. And even though tax revenue was very weak because bubble was bursting, companies were incurring losses, Japanese government increased the spending and the gap between the two is the budget deficit. And the budget deficit naturally had to increase in the environment like this. And a lot of people argue that with so much spending, Japanese economy went absolutely nowhere. So money has been used on some of the most useless projects on Earth. Well, that assumption, that argument is based on the assumption that even without fiscal spending, Japanese GDP would have been zero. But I'm arguing here that without the spending, Japanese GDP would be way below. Maybe Japan would have lost half or 75% of its GDP because of the damage that it sustained on its balance sheet. And so the point here is that it is possible to keep the GDP from falling, keep the unemployment from rising in spite of massive falling asset prices, massive loss of wealth, as long as government puts in large enough fiscal stimulus from the very beginning. And I am no great fan of fiscal stimulus in most of my economic learnings. I'm originally from the central bank. I much prefer to operate through a monetary policy. But in this kind of situation where private sector is no longer maximizing profits, they are minimizing debt, then in that instance alone, we need to use fiscal stimulus because government cannot tell the private sector, don't repay your balance sheets. Don't pay down debt. No government cannot say that. Or even if the government say that, no one will listen to you because from the private sector point of view, repairing balance sheets is the issue of survival. If someone finds out that your balance sheet is actually under water, your credit rating drops very sharply, your funding costs go sky high, people might not accept your checks anymore, and you are in a terrible mess. From the individual private sector, households, banks, companies, they have no choice. They have to repair their balance sheets, put the financial house in order as quickly as possible. But when everybody does it all at the same time, we enter this kind of world. And in this kind of world, government has to do the opposite of the private sector to keep the situation from collapsing. And thanks to all this effort, this is the debt of Japanese companies. It went up very rapidly during the bubble days. It came down due to debt repayment. And when it reached the level of 1985, well, the bubble started somewhere around 1987. So 1985 is two years before the bubble, the debt repayment stopped because all the problems, problem assets that Japanese companies acquired during the bubble days were all removed from the balance sheets. And the other line shows the debt as a percentage of GDP, corporate debt as a percentage of GDP. During the bubble days, it was highest 85%. It's now down to 52%. The level lost seen in 1956. So after all that, Japanese corporate balance sheets are cleaned, and now Japanese companies are moving forward. Now, this raises the issue about the budget deficit, this huge budget deficit. How can we handle this large budget deficit? Well, there are many issues relating to this budget deficit problems. But one thing that can be said for certain is that one can never cut budget deficit in this kind of recessions because if you try to do that, more economy will collapse first and you end up incurring even greater budget deficit. And in Japan, we tried to do it on two occasions, 1997 under Prime Minister Hashimoto and 2001 under Prime Minister Koizumi. And on both occasions, even though Prime Minister Hashimoto raised tax rates, cut spending, did all of that, tax revenue actually fell and budget deficit actually increased. And again, when Mr. Koizumi tried it, he had this ceiling on how much government debt Japanese government can issue per year, but when they put the ceilings in, economy collapsed, tax receipts fell, budget deficit actually increased. So Prime Minister Koizumi was never able to meet his target that he promised to the electorate because the economy collapsed to first. Why does the economy collapse once the budget deficit is removed when the government tries to reduce its budget deficit? Well, going back to the original idea of this $100 and $900 and $900, if the $100 are not spent, that unspent, unborrowed funds will become the deflationary gap of the economy and economy collapses from that point onwards. When Hashimoto tried to cut the budget deficit in 1997, we had five quarters of negative growth. The whole economy just went into meltdown because no one was borrowing and spending that money. And so even though budget deficit is highly unpleasant, I wish we don't have to worry about this problem, but once you are in this situation, a more proactive government spending is far better than a reactive one. And because of this budget deficit, fiscal reform fiasco, we shouldn't have cut the budget deficit, but we did, budget deficit actually increased and the net result is that our cumulative budget deficit is probably 100 trillion yen more now as a result of efforts to reduce the budget deficit. So this was entirely unnecessary. Accumulation of deficit. So my point is that don't even try to think about reducing budget deficit because if you try to do that, the situation could get a lot worse. And we actually have exactly the same example during the Great Depression. 1937, after five years of new deal policies that pushed the U.S. economy to a recovery, 1937, President Roosevelt began hearing comments from others that this budget deficit is bad, economy seems to be already on a recovery path, you should cut it. So he cut it. He cut the budget deficit. I tried to cut budget deficit in 1997, 1937, sorry, and the economy collapsed, completely collapsed. And it took literally a tack on Pearl Harbor to get to U.S. economy out of that. And so when you are in this kind of situation, what I call balance sheet recession, where private sector sorts are minimizing debt instead of maximizing profits, we need a proactive fiscal stimulus and the fiscal stimulus in the sense of government spending is far better than tax cut because when private sector sorts are minimizing debt, trying to put their financial houses in order and you give them a tax cut, much portion of that will be used to pay down debt or rebuild the savings. And only maybe 30 or 40% of that will be used for new spending. Whereas if the government spends it, $100 that government spends it will add to $100 of aggregate demand. And so even within the fiscal stimulus, it's far better to have government spending than tax cut. One other point that I want to add to this fiscal spending is that what we learned from Japan is that it has to be a medium-term commitment by the government. We in Japan at the beginning had no idea that it's this kind of recession. We all thought this is just a cyclical downturn, one or two years of fiscal stimulus and then we should be out. Well, we kept on doing that for 15 years. And we had known in advance that this is this type of recession that happens once every maybe 67 years when the whole population go crazy over some asset values. We should have stated from the very beginning that this process would take 5 to 10 years and in the whole 5 to 10 years government will be in there with fiscal stimulus to keep the GDP from falling. If the government came up with that kind of announcement with the explanation that I just gave you that this is a fallacy of composition problems at the micro level, you're doing the right things and the government cannot tell the private sector not to put financial houses in order but when everybody in the private sector is trying to put financial houses in order, we all die. In that kind of situation the government have to do the opposite of the private sector. With that explanation given first, the leadership should then tell the people that this will take minimum of maybe 5 years so the 5 years government will be in there with fiscal stimulus within this 5 year window of opportunity. Private sector, please repair your balance sheets during the 5 year period. Once your balance sheets are repaired please come back and start borrowing money again. At that time we the government with this large budget deficit will then go on to repair our balance sheets. That kind of commitment early on if that were given to the Japanese people I think the whole process would have been shortened. We didn't have to spend probably 15 years we could have done this in maybe 10 years or maybe even 8 years but unfortunately we learned this as we experienced this whole process and so I very much like to see the new administration in Washington on the State of the Union address coming out and says this is the kind of disease we are stuck with and this might take many years but the government will be in there with the proper remedy for the whole duration of the recession and there should be some sort of social contract between the government and the people so that people know what kind of disease they are stuck with but they know exactly how to come out of it as well. I mean this is not a pretty picture by any stretch of imagination but it's far worse if people have no idea how we will come out of it but if you tell them that this is a balance sheet recession and at the micro level everybody is doing the right things but taken together we end up having these problems and so the government which is not part of the fallacy of composition will be acting to do the opposite of the private sector once that kind of understanding is established I think it's much easier for the government to come up with fiscal stimulus and then the rest on how to spend the money we can talk about it for hours on end but I hope we don't spend too much time on it before the economy collapses but that's what we learn in Japan on the real side of the economy and this chart kind of shows what happens but this is probably too small for many of you to see it's in my book so hope you can see it later now that's half of the story what I just told you is what happens to the real economy but with the falling asset prices that also hurt the banking system and in the US case the banking system problem actually come to surface before the real economy in Japan it was reversed the real economy problem started first and then the banking system problem came little later now I'm not very proud of this experience on my own part but I have had fair share of banking crisis management over my career I started at my New York Fed as a syndicated loan desk officer when the Latin American debt crisis happened and for those of you who are old enough to remember that was about the worst possible banking crisis in US modern history at that time we at the New York Fed were able to tell what kind of exposures major banks had toward Latin America and I think our conclusion was that 7 out of 8 US money center banks were actually under water it was so bad because everyone from Mexico down to the southern tip of Chile went bankrupt or went on default and US banks think which not that they have they know that area very well led tons of money into that region and suddenly they realize that they are all under water at that time Paul Volcker the chairman of the Fed called central banks and ministry of finances all around the world on the critical Friday August 1982 and later on some later date a bank of Japan official who took the telephone call from Paul Volcker on the Friday night told me the exact word he used he said you better give me Governor Michael right away if you don't give me Governor Michael there might not be any US banks left on Monday and that was August August in Tokyo is really humid terrible weather so Governor Michael was in his mountain retreat in Karuizawa 4 hours drive from Tokyo and the secretary had to scramble to find Governor Michael to get on the phone and what we the New York Fed had to do was to arrange all the foreign banks to make sure they keep credit lines open to the American banks knowing fully well that all these American banks are actually bankrupt and we also could not tell to the outside world how bad the situation is because if you go out and say all American banks are bankrupt I mean next day they will be bankrupt and so we had to come up with these stories that well Latin American problems there are some problems but they are all good debt they are not bad debt and then we had to lengthen the cleanup process it was a very very difficult period for US central bankers and bank regulators in general because I still remember clearly that before Friday August 1982 we were telling the American banks to get the hell out of Latin America these countries are run by dictators who don't know what they are doing inflation rate is way over a thousand percent per year huge current account deficit get the hell out sell the exposure to someone else and just get the hell out we were telling these things when the crisis hit we got a call from Paul Volcker who says make sure that not a single US bank will leave Mexico that they continue lending to those dictators and four years we were saying one thing and suddenly when the crisis hit we were proven correct we had to say the opposite it was very very difficult for people at the New York Fed at that time but the reasons are very clear if one bank tries to leave everyone would try to leave at the same time Mexico will collapse and then you will be clear to everyone's eyes that all US banks are under water so by keeping this myth going that everything is fine US banks are lending money so that Mexico can pay interest back to the US banks so that we can keep these long categories unchanged we had to do that for a very long time but this policy actually worked beautifully the whole process took about 13 years and US taxpayers never had to pay a dollar or cent to clean up this mess and because it was done so well very few people are aware that there was a crisis and savings alone on the other hand it was handled very badly and authorities had to go to the Congress for money $60 billion and everybody found out what went wrong so a lot of Americans only remember the savings and loan crisis not realizing that there was a crisis ten times larger it's actually ten times larger the Latin American debt crisis that was going on actually behind the scenes well after that experience I moved to Japan and then there's a massive banking crisis in Japan and given my experience handling the Latin American debt crisis I spoke up on a lot of issues and I was appearing on television very frequently and there I argued for capital injection and I'm the first person in Japan who argued for capital injection and I was able to convince a lot of suspicious Japanese about the need for capital injection and LDP at that time realized the need for it right away and within two months the capital injection was put in place and the crisis subsided after that and so based on those experiences I believe that there are four different kinds of banking crisis and these four are localized banking crisis meaning many banks are okay but some are rotten and systemic banking crisis where most of the banks are in difficulty and on here I'll refer to this yin and yang a little later normal demand for funds meaning private sector source are willing to borrow money and weak or non-existent demand for funds what I mean the balance sheet recession kind of situation and when you divide a banking crisis in these four categories only in this type type one where quick disposal of non-performing loans will be the right thing to do because in this case 95% healthy 5% rotten in that case you can actually have an operation get the 5% out the 95% can still go on and so this one a quick non-performing loan disposal is good and pursue accountability because everyone else made the right decision they had a choice but these few executives made the wrong decision they should be held accountable because they actually had a choice and they made a wrong decision but in this case systemic banking crisis we have to go slowly because 95% rotten 5% healthy in that case you can have an operation you have to use Chinese medicine and Paul Volcker used the Chinese medicine for 15 years and they actually cured the problem and here I have a word fat spread well how did Paul Volcker cured Latin America debt crisis well he allowed bankers to keep their lending rates relatively high while the central bank brought the short-term rates down this way the spread between the two is the profit for the banks and we call that fat spread if you keep this long enough this amount is the revenue to the banks that's the profit to the bank and then you can use this profit to write off problem loans and this fat spread and as long as there are plenty of borrowers out there we can use the fat spread to strengthen the banking system and use the fat spread to dispose our problem loans well how about the Japanese one or the one we are facing in the United States today well we have weak or non-existent demand for funds why did people put money invested in subprime mortgages in the first place because corporate sector in the United States was not borrowing money remember Greenspan talking in congressional testimonies says I cannot understand why US companies are not borrowing money at that juncture in the business cycle he mentioned that on a number of occasions and the reason US companies were not borrowing money 2004-2005 was because their balance sheets were hit badly after the bursting of the IT bubble so when the IT bubble burst there was a mini balance recession in the United States where companies were paying down debt no one was borrowing money but Greenspan managed to offset that by bringing interest rates down and creating a housing bubble but housing bubble burst and then we are stuck with the problem at the moment but what that means is that we have weak or non-existent demand for funds and in that case we cannot use fat spread because there are no borrowers if you try to raise interest rates there won't be there will be even less borrowers so in that case you have to use capital injection government putting in the capital so the bankers can continue lending and we in Japan were in this situation as well that's why I suggest the capital injection it worked this shows bankers willingness to lend as seen by the borrowers and Bank of Japan has been producing this data for a very long time and I strongly suggest that US monetary authorities will produce this chart as well in this one Bank of Japan asks about 10,000 companies both large and small and ask them what are the bankers telling you and this is important to ask the borrowers because lenders, the bankers typically say oh we are always trying to lend because if they say something else then people begin to suspect that you have some other problem somewhere else so bankers are not very forthcoming in this regard but if you ask the borrowers what the bankers are telling you then you can have a much better gauge of what's happening to the financial market and if you look at this during this period late 80s there's a huge deterioration in bankers willingness to lend but that's very easily explained by the fact that Bank of Japan was tightening monetary policy and interest rate was as high as 8% so to the average borrower it felt like bankers were not particularly willing but after the interest rates were lowered you can see that bankers willingness to lend improved dramatically by 95-96 bankers willingness to lend was almost equal to the bankers willingness to lend during the bubble days but in 1997 when Prime Minister Hashimoto tried to cut the budget deficit the whole economy collapsed and as a result suddenly bankers couldn't lend any money and it was against this that I suggested capital injection the first capital injection the government prepared huge sum of money but bankers were so timid in availing themselves to this money thinking that government could go after them after they take this money and the stigma attached to it so only 1. trillion yen was injected even though we prepared something like 10 times bigger than that but we were able to keep the deterioration from getting worse and then the second capital injection 7.5 trillion we virtually eliminated the credit crunch and so I strongly suggest that capital injection program which is now in place in the United States be expanded to all banks so that the credit crunch that we are facing now can be eliminated and I think the capital injection did work because when you look at the CDS spreads of these financial institutions after the capital injection the CDS spread came down dramatically and even though it's higher than many banks would like to see it's nowhere near the danger zone that we saw before the capital injection these are for the banks and this is for European financial institutions Europeans have gone even faster on capital injection and basically eliminated these danger signs on the CDS spreads we have one problem in the United States that Japan never had to experience and that is that as many of you are aware US house mortgages are non-recourse notes in the sense that the money is lent to the house and not to the person and as a result if the house prices fall below the mortgage outstanding many people have this incentive to just return the key and walk away I hope we don't get too deeply into this one we assume that all houses were bought with mortgage with no down payment nearly 30 million mortgages will be facing this kind of problems going forward at the current level of house prices now if there was a 10% down payment the number comes down to around here 9 million mortgages where the people who borrow the money has an incentive to return the key these numbers are significant because when you add all the subprime mortgages together that costs so much problem for all of us it's only 2 million mortgages here we are talking about 30 million so if this problem hits we are going to have real problem in our hands house prices will fall even further and I think the need for fiscal stimulus even greater to keep the GDP from falling now if the house prices fall to where the futures market is indicating it will come down to here and 70% of the mortgages will be subject to that kind of risk and as many as 15 trillion mortgages the borrowers will have incentive to return the key even if they had a 10% down payment in Japan we never have to face this problem because in Japan you cannot walk away and in Europe you cannot walk away either but in the United States because it's a non-recourse loan you can walk away by just returning the key put your stuff in your van and go to station wagon and go to the next town that's possible in this country but that's what a lot of financial types are worried about because if this problem hits then our housing problem will get a million times worse now how about monetary policy when we were having our problems in Japan people like Paul Krugman, Ben Bernanke, Milton Friedman they all came to Japan and bashed the Japanese left and right saying just print the money and then everything would be fine and why Japan is having so much problems when central bank can print its money and even Greenspan was saying that on some of the congressional testimonies he said he cannot understand why Japan has a deflation when central bank can print all the money at once but when you think about it monetary policy is largely useless in this environment where no one is borrowing money even with a 0% interest rate and all the teaching in economics particularly during the last 20 years when so-called monetarists or someone close to that kind of thinking took over and hijacked the entire profession they've been arguing all along that monetary policy you can solve any problems and actually Paul Krugman came to Japan and I was asked to debate with him for two hours for a Japanese magazine and he kept on pounding this point just print money, just print money, just print money and I kept on saying no it won't circulate because no one's borrowing money and we had this completely parallel line for full two hours and I'm so glad to notice editorial on the New York Times two weeks ago when Paul Krugman talked about fiscal stimulus a lot of people said you must have written that piece because that's what I was arguing all along and why does monetary policy doesn't work in this environment? Well the intuitive answer is of course that if everybody in the private sector has a balance sheet of problems a debt overhang you bring interest rates down even if you bring interest rates down these people have no incentive to borrow money they have to reduce their debt as quickly and quietly as possible so monetary policy in that sense is largely ineffective but if that's the case if everybody's paying down debt all at the same time what happens to money supply? and some of you are not financial type so let me explain the difference between money supply and liquidity or the printing money central banks can provide liquidity to the banking system but the banks then have to lend money so that the money began to circulate so the banks will lend money the money comes back to the banking system because someone spends it that bank then lends money again and then comes back to the banking system and this process is called money creation because as bankers lend money and get the money back if you take the banking system as a whole you end up creating lots of deposits in the banking system deposits on one side and loans on the other side and when we talk about money supply growth we are just talking about the deposit side so if deposits increase the source of more money to spend it's good for the economy so that's why people say let's increase money supply when you think about it when everybody's paying down debt what happens to money supply? when everybody's paying down debt money supply is supposed to shrink why does it shrink? because how do you pay down debt? you take your money from your deposits and pay back to the banks so your deposits shrink and if everybody's doing this all at the same time they cannot lend the money to someone else so the total money supply should shrink during the Great Depression the money supply shrunk by 33% because everybody was paying down debt no one was borrowing money in Japan however the whole period this is the money supply growth year over year and we never went below zero so every year money supply was growing and you ask yourself what would that happen when everybody's paying down debt? money supply should shrink well this chart shows who borrowed the money to keep the money supply from shrinking the red areas the government borrowing white areas is the private sector borrowing and as you can see from 1995 or 1996 or so private sectors being paying down debt but the government through its fiscal spending was borrowing money by issuing bonds and during this period Japanese banks end up buying Japanese government bonds because there are no other borrowers in the economy and as a result we managed to keep our money supply from shrinking what this means is that once we enter this kind of world where private sector thoughts are more worried about their balance sheets or financial health than making money there will be no monetary policy there will be no independent monetary policy all depends on how much government borrows money because that's the only borrower left and so this is another way of looking at it this is a bank's balance sheets and money supply which is mostly bank deposits is the liability of the banking system and if you look at liabilities on this side there was this much money supply back in 1998 2007 money supply is a little bigger but if you look at who borrowed the money which is the asset side of the banking system you'll notice that credit extended to the private sector actually shrunk because people were paying down debt but credit extended to the public sector grew and because this growth money supply on this side did not have to shrink and so don't put your hope on Mr. Bernanke that's basically what this is saying he might bring rates down further that might happen within our today or maybe happen already and stock market might get excited for 24 hours or so but it's not going to do any good we need government out there borrowing and spending money to keep the economy going and to keep the money supply from shrinking so this is completely opposite of what universities have been teaching you over the last 20 years I mean if Milton Friedman has seen this chart while he was alive his life could have been shortened as a result because it is so shocking I mean when I first saw this myself I couldn't believe it this is what's happening in the Japanese economy and then I looked at what happened during the Great Depression this is exactly the same chart for United States 70 years earlier in 1929 before the bursting of the stock market bubble a lot of private sector are borrowing money and as a result large money supply on the other side and in 1933 everybody was paying down debt so as a result the credit to the private sector shrunk and the money supply shrunk with it but from 1933 to 1936 money supply grew and people like Bernanke Ahin Green Jeffrey Sachs all these people started saying wow so it's the money supply growth that pulled the US economy out of the Great Depression so it was the Fed policy that changed the outlook for the US economy wrong you look at this side credit extended to the private sector actually shrunk from 1933 to 1936 so during this period private sectors were still paying down debt but money supply grew because credit extended to the private sector public sector grew dramatically this is the new deal policy of the Roosevelt government so they were issuing bonds and the bankers were buying them and that's what allowed money supply to grow strangely in all the economic literature on this issue written during the last 30 years or so no one mentions this part of the picture everyone's just concentrating on this part and arguing that if you just print money, economy should improve but once you look at this side of the picture you know that just printing money was not the reason why US economy came out of Great Depression it was actually government borrowing and spending money that brought the US out of the Great Depression and so don't put your eggs on it's amazing some people get excited a lot of people were brainwashed into thinking the monetary policy is useful that's what professors are teaching in universities these days but it's largely irrelevant in this recession government borrowing determines how much money supply will be in the economy and I hope US government understands this quickly that they won't rely on the Federal Reserve to pull the US economy out but instead put in fiscal stimulus to both increase money supply and get the aggregate demand up this is another way to see how this world is different from the one we learn in schools if you go back to your econ 1A or 101A they tell you that if the central bank increases the liquidity by 10% eventually money supply will increase by 10% and you might wonder is that really true if you look at this chart from 1970 to 1990 credit extended to the private sector money supply, high power money this is the liquidity injected by the central bank they all move beautifully together so the textbook would actually existed 10% increase in central bank liquidity, 10% increase in eventual money supply but after we enter what I call balance sheet recession the three lines are all over the map bank of Japan and the pressure from people like Krugman, the US government and others push the money supply the liquidity all the way from 100 to 300 but credit extended to the private sector went from 100 to 97 instead because people were paying down debt money supply went from 100 to 150 thanks to, as we saw earlier government borrowing and so even for monetary policy to work we need government borrowing in there we don't have independent monetary policy in this kind of situations so putting this all together what we need to make sure that US economy doesn't weaken any further fiscal policy basically are two parts economic stimulus that's building roads and bridges or whatever you can think of government spending more effective than tax cuts it must be seamless for the duration of recession when everybody is trying to repair balance sheets at the same time it becomes very difficult for any one of them to repair their balance sheets because the economy will be so weak and so the whole process might take five years maybe even longer my time is up and so it's very important that the package of fiscal stimulus is seamless and not on again, off again type that we put in Japan 15 years earlier and the other one is capital injection it's very effective in ending the credit crunch it's politically unpopular but sooner the better and I'm glad to see that now I've moved to that stage CVS spreads are now coming down even the stock market is very volatile I hope much wider or greater program on capital injection should stabilize the financial market going forward and on monetary policy it's largely ineffective because there are no borrowers out there the liquidity injection engineered by FED since September of last year that is absolutely essential because what's happening is that the banks they no longer trust each other for the last years and there was no provider of funds to the interbank market if I may explain what interbank market does every bank has all these depositors moving money and we write checks we deposit money and some banks are completely passive as far as the activities of depositors are concerned and some banks on some days have more money going out than coming in and if some bank in the system has that problem there are some other banks in the same system with more money coming in and going out and so how does banks clear all their transactions well those banks with more money coming in and going out will put the extra cash and some other bank with more money going out than coming in will go to the interbank market, borrow that money and use that to clear our checks basically from the last year or so those banks with surplus funds, more money coming in and going out refuse to put the money into the interbank market because they can't trust the other banks whether they want to pay those banks back day or two later and given what happened to Lehman Brothers and so forth I'm afraid their fear was fully justified as a result the banks that are experiencing money going out but not coming in they were desperate for funds and the central bank had to provide funds directly to those banks so that they can clear their checks and that's basically this process liquidity injection by the central bank but this liquidity injection can never improve the health of the banks in a sense that if their capital is impaired as a result of huge losses on their subprime lending that problem cannot be rectified with additional liquidity injection by the central bank that problem can only be rectified by injection of capital which is a fiscal policy, not a monetary policy another possibility is of course a weaker dollar, the dollar fallen fell as a result of lower US interest rates and that stimulated exports to some extent in this country but now that Europe and China all have their housing bubbles bursting if everybody tries to lower exchange rates so that they can export their way out we will go directly to the 1930s scenario because that's exactly what happened during the 1930s no one wanted to expand fiscal stimulus everybody tried to use exchange rates to export their way out but that exchange rate as you know is a relative thing you need to counter parties and if everybody tried to lower exchange rate at the same time nothing happens the whole world trading system just collapsed and so we can only use this weak dollar route only at the margin we can never rely on this to pull the US economy out we have to use basically fiscal policy for recovery now how about the accountability issue I this one I just dreamed up thinking about all these warning signs on the cigarettes the surgeon general has determined that this and this and that I think we can have something like that for all the rating agencies announcements that subprime crisis and I think it's important that ratings produced by the agency sometimes worthless or worse and therefore investors should make their own judgments this warning should be on everything that rating agencies produce for the next 50 years and I think that would be a tremendous discipline on them to make sure that their ratings will not be affected by their business interest this is what's happening to Europe European sentiments are also falling very sharply now Europe has a problem in that Maastricht Treaty restricts individual governments from using fiscal stimulus more than 3% of GDP and 3% of GDP is nothing in this world so when the economy began to dive they have to come to an agreement quickly to, yes to remove the Maastricht Treaty so that they can use the fiscal stimulus to turn situations around last point who's going to buy the US Treasury bonds with these large fiscal stimulus and that question has been raised many times during my visit too the US have no savings to finance all these fiscal stimulus that I'm talking about my answer to that is no worries there is absolutely there should be absolutely no problem with the funding issue and the reason is the following the amount of fiscal stimulus needed to stabilize the GDP in this instance is exactly the same amount as the excess savings created in the US economy through increasing household savings and increasing debt repayment this is the funding that government should pull out of the banking system and put back into the income stream which means the entire amount of savings needed is generated in the economy and US government will be just taking that extra savings generated and putting that back into the income stream so there's no reason for interest rates to increase quite the contrary the fund managers of the banks who have to manage these funds should be more than happy to lend to the government because there are no other borrowers who would borrow the money so that the banks can earn interest and we saw this happen in Japan as well at the beginning when we saw our budget deficit growing very rapidly a lot of people out there saying the whole thing will collapse higher interest rates will result and we'll be all dead but interest rates actually came down over this period our budget deficit in Japan now is 180% of GDP the highest of any industrialized nation at the moment our interest rate 10-year Japanese government bond is only 1.5% that's lower than the lowest rate US have reached during the Great Depression which happened to be 1.85% and why is the rate so low because there's no private sector borrowers and people are still saving money so the government borrowing that money I mean the fund managers are still unhappy to give money to the government because that's the only borrower left same thing will happen in this country as well and so I don't think people should be too worried about interest rate implications of these large fiscal stimulus of course if you don't put in the fiscal stimulus the economy will collapse and the interest rates go even lower but I think you'd rather have a slightly higher interest rates and a working economy and it would be a long while before interest rates would go back up to anything we remember seeing in the normal times after Great Depression those people who remember who experience Great Depression they never came back to borrow money in their entire lives the remaining lives and as a result it took the United States 30 years to bring interest rates back to the level of the 1920s 30 years 1929 New York Stock Market crashed it was 1959 that interest rates finally reached the average level of interest rates in 1920s because private sector sorts just pull themselves out of the borrowing altogether you might know some parents, grandparents who lived through the Great Depression they never borrowed money the rest of their lives because the pain of down-debt during the Great Depression was just so overwhelming we'll have this problem we have this problem in Japan right now that's why our rates are so low 1.5% the US will soon have that problem Europe, China they all have this problem soon that there are too much savings too little borrowings on the private sector and the government trying to put that money back into the income stream and so I don't think interest rates is going to be a big problem I don't think inflation is going to be a big problem but maintaining aggregate demand that is going to be the challenge thank you very much thank you Richard that was very comprehensive very clear two books in the current crisis nicely presented in one comprehensive report I have questions but I got to ask them last night at dinner so we'll go right to the audience please identify yourself if you're from a credit agency please hold your question and wait for Richard in the alley outside afterwards yes sir we have microphones yeah Richard you gave me your book the new book what four weeks ago or so and I read it and I thought it's the most important analysis of Japan's experience that has been written so that's the first point but the second one is this fallacy of composition problem that the world faces we have since Gordon Brown's with capitalization of the banks and now spreading to virtually all governments not only the advanced economies but any emerging market economies so we have basically every government at the same time injecting capital and probably this will spread to the manufacturing sector in many countries also so everybody is going to have to raise capital through bond issues at the same time so when you have the whole world in a single financial marketplace raising capital at the same time what will that do in global interest rates and will it shrink the private sector worldwide relative to government well my answer is that we don't have to worry about that either now some part of the manufacturing part may be adding to interest rate increases but within the financial sector all this capital injection by the government I don't think will add to interest rate pressure upwards because that's the money that will not leave the capital market the easiest way to think about it is that if a bank goes under and then the depositors needs to be compensated so government goes into the capital market raises funds and give it to the depositor that's the simplest bank rescue scheme the depositor is a depositor so when the depositor gets the money the depositor will probably deposit the money in the remaining healthy bank which means the total amount of money available in the financial market for lending is still unchanged government budget deficit increases of course but the money itself hasn't left the financial market yet if it leaves the financial market to become some on salaries or procurement of machinery and equipment that's when the interest rate is raised but if it doesn't leave and it stays within the system it will not raise interest rates because the total funds available within the system is unchanged and if you remember this argument was actually raised during the savings and loan crisis the 160 billion dollar bailout through the RTC earlier period a lot of people worried about higher interest rates but the higher interest rates never came because when you think it through the money doesn't leave the capital market and so even if all these countries raise money to inject money to the financial institutions I don't think it will add to interest rates maybe some for the manufacturing it might leave the capital market and goes and become someone else's salaries or procurement and in that case that will add a little bit to higher interest rates I don't think too many people will be investing in manufacturing capacities going forward given the kind of recessions that we are facing so that might just stay within the capital market I think I wonder if you would compare or contrast what you said about capital infusions and government borrowing when the expenditure is not for infrastructure development but rather one for social programs healthcare education and other social programs and two when it is expenditure for military either war fighting or military preparation with very large expenditures and large borrowing and third when there is an industrial cooperation with a credit division that allowed customers to purchase its goods on credit and as in today's Wall Street Journal General Motors Acceptance Corporation is possibly going to be asking to be reclassified as a bank holding company so that they can participate in what's being called the bailout well the General Motors part I have to think about it more clearly but you mentioned about social spending as opposed to military spending as opposed to infrastructure spending from macroeconomic perspective I think they're all the same but if you have to really rank which one would produce the maximum aggregate demand per budget deficit I have to say I don't believe in it but I have to say that it's military spending and the reason is quite simple military spending you produce something totally useless which means you increase demand without increasing supply because battleships, fighter planes are totally useless, hope they remain useless if you build something useful you end up creating supply as well and someone who has to compete with this particular thing will see their demand falling from purely economic perspective military spending is the most effective way to get economies out of this type of recession and I think Roosevelt proved that or Hitler proved that before everyone else now I don't want to be propagating for that kind of fiscal stimulus now and as a taxpayer myself I would like to see something that is useful built but I don't want to get into too deeply into this problem as a macroeconomist because we don't have a choice of not spending money if we cannot find good projects the way you pose the questions suggests that if we have good projects we will spend it but what happens if we cannot find a good project do we have a choice of not spending it and the answer I'm afraid is no and so it's good to have good projects but if the good project there are only 30 billion of them but we have to use 40 billion to keep the economy going the remaining 10 well we still have to spend it I have to ask you Richard if you advise the LDP that they should spend that 3 trillion dollars stimulus package on weapons well no I'm not suggesting that at all are there some over there just as a follow up question healthcare spending especially to cover the uncovered would also not compete with others while creating wells for the future in the form of the health of those who haven't been covered so far so would that be the kind of spending you would advise to do or I'm not against our healthcare spending at all I think it's one area that government can spend and if the population's health improved as a result it's a kind of infrastructure as well and education spending also I'm actually suggesting to Prime Minister also who I do advise at home that more money should be spent on education because this is a good investment for the future the problem Richard is coming to Washington and saying we need to spend more and then saying it doesn't matter because everyone wants to talk about how to spend the money now and indeed if you saw Professor Samuelson's piece this morning in the Washington Post he argues that the stimulus package argument is building momentum I don't know if you saw that maybe he's reading your book as well I think we have time for one more question and then we have to end because we have another event in this room hi thank you I have two questions the first one is you just said unfortunately the United States is already in a situation where we have a very large deficit what effect on our currency do you think that expanded government spending would have expanded deficit spending would have and secondly you've outlined a very specific policy recommendation how much room for error do you think we have and what do you think the consequences will be if we don't follow that issue if the United States is the only country with this problem and everybody else is fine then we'll be seeing dollar collapsing but unfortunately that's not the case everybody else have the same problem and so in United States well two countries Japan and Germany at the moment do not have any of these balance sheet problems because they had a bubble earlier and these two are just recovering from it but those two are also highly dependent on exports Germany and Japan the others all have this problem what I just described here balance sheet problems and so it's a very difficult comparison because everybody has the same problem so dollar cannot collapse because other ones are just as bad and because the US has a fundamentally very large current account deficit so there's no way on the US dollar going forward and I do like to see dollar come down a little further so that US industries can export become a little more competitive and trade balances do come narrower because I think that's really necessary for the long term but on the short term I think it's very difficult to tell which way the exchange rates will go because so many of us have the same problem at the same time but the error I forgot to mention one point and that is that after capital injection we also have to tell the banks not to write problem loans or their losses too quickly that has to be part of the package because if the banks are forced to write off problem loans quickly all the capital the government puts in will be used for that purpose and there will be no let up on the credit crunch and when we face that in Japan that's exactly what we did we injected the funds into the banks and told the banks to write their losses over some period of time and make sure that this capital the government injected will be there to support the lending and Paul Volcker was very useful because he wrote to a major Japanese magazine and told the Japanese that don't listen to some American investment houses go slowly on writing our problem loans and even suggested setting a speed limit on how fast the banks are allowed to write off loans and I think those are the kind of thinking that has to go through here as well it's not a very popular thing to do so I suggest that government just tell the bank examiners at the Federal Reserve the ICN control the currency to just tell the banks to go slow because if you don't do that the banks feel the pressure to write and that can negate all the capital injection the government's making on the other side to stop the credit crunch this process saving the individual banks and saving the system sometimes is highly contradictory for saving the system banks must continue lending but many of that loans may not be all that great loans but for saving the system we have to put that in place we should go after the health of individual banks after the systemic risk to the whole system has subsided and so it has to be done in that sequence we cannot try to do both of them at the same time with just one, two or capital injection as for the macro if we don't follow this path that I just described then I'm afraid economy will be weaker further the wounds will be deeper and the cost of repairing it will be much higher I think Japan did most of the things correct but we did have the stop and go, stop and go fiscal stimulus which lengthened the process lengthened the recession by at least five years but if we have a policy from the very beginning from the state of the union address let's say that yes this is a social contract between the government and the people we're going to keep the economy going with a seamless proactive fiscal stimulus then I think at the end of the day budget deficit will be the smallest and the economic growth will be the fastest but one thing that I have to warn people in this room is that if you avoid crisis you'll never become a hero you just get bashed and bashed and bashed you spend so much money economy is still doing fine why do you have to spend this money and that's basically what we got in Japan as well we kept on avoiding crisis and then as a result we have this large budget deficit and we are all blamed for it because they assume that even without the fiscal spending economy would have grown at zero percent GDP growth to become a hero crisis has to happen first and crisis happens thousands of people are there and the remaining few that's saved by this guy he becomes the hero and that's the Hollywood movies and if you continue avoiding crisis the way I just described you'll never become a hero so you have to be prepared for that I wouldn't worry too much Richard about being blamed I think your book and your presentation and the facts on the ground are leading a lot of people to reassess exactly what happened with the Japanese economy and there are some very important lessons for us today and you've really captured them for us CSIS is doing its part to stimulate the economy we have another event right now and it's on the US Japan Global cooperation agenda our fellow Hideki Wakabayoshi is issuing a briefing on his report so if you're here for that please stay if you'd like to stay please do but we'll adjourn here thank you Richard very much thank you