Download Wednesday, July 26, 2006

MONDAY, JANUARY 4, 2010
INTERVIEW
A Japanese Rx for the West: Keep Spending
By LESLIE P. NORTON
AN INTERVIEW WITH RICHARD KOO: America seems to be suffering from the same affliction that has hobbled
Japan for so long -- a balance-sheet recession." And no matter how hard the Federal Reserve tries, it won't end until
businesses shake their heavy loads.
RICHARD KOO HAS DRAWN WIDESPREAD ATTENTION for his theories on why Japan's economy has struggled
for so long. In particular, his view of that nation's "balance-sheet recession" has been extensively studied by policymakers
in the developed world.
Though many economists fear that Japan's enormous debt is unsustainable, the nation's economy hasn't collapsed. Still,
the economic malaise has punished investors in Japanese stocks, which topped out in 1989, and some investors fear that
the same stagnation could afflict equities in the North America and Europe, too.
"The most interesting question in macroeconomics today is why Japan developed the way it did over the past 20 years,"
says Gifford Combs, a portfolio manager at Dalton Investments. "What nobody in the West wants to utter aloud is that
western economies, and most especially the U.S., could follow the same trajectory as Japan, essentially a recovery that
almost feels worse than the disease."
Koo is well-equipped to answer questions about Japan and the West, having served as an economist for the Federal
Reserve Bank of New York in the past and as chief economist of Nomura Research Institute now.
To learn his views, read on.
Barron's: You're visiting Washington a lot these days.
Koo: I'm explaining to the Americans that the disease you've got, is the disease we got 15 years earlier. Most Americans
are flabbergasted by the fact that the Federal Reserve has lowered interest rates to zero, flooded the market with liquidity - and the economy is still going absolutely nowhere. Unemployment is still increasing, people are still retrenching,
deleveraging. When the central bank brings rates down to zero, a lot of things are supposed to happen, but there's nothing
happening. But that's what we experienced in Japan. The Bank of Japan brought the rates down to zero, did massive
quantitative easing, with no result whatsoever. This happens because of a balance-sheet recession.
What is that?
This happens because the private-sector companies are no longer maximizing profits; they are minimizing debt. They are
minimizing debt because all the assets they bought with borrowed money collapsed in value, but the debt is still on their
books, so their balance sheets are all under water. If your balance sheet is under water, you have to repair it. So everybody
is in balance-sheet-repair mode. This type of recession isn't in any economic textbook yet, and there's no name for it. I call
it the balance-sheet recession.
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It took us [in Japan] a decade to figure out. People said, "Ah, just run the printing presses, ah, structural reform, ah, just
privatize the post office, this and that, and everything will be fine." Nothing worked. This is pneumonia, not the common
cold. When people are minimizing debt because of their balance-sheet problems, monetary policy is largely useless. If
your balance sheet is under water, in negative equity, you are not going to borrow money at any interest rate, and no one
will lend you money, either.
In an ordinary, garden-variety recession, as we learned in school, the private sector uses money more efficiently, and a
budget deficit is considered bad. But when the private sector is completely absent and paying down debt at zero interest
rates, and the government doesn't borrow this money, what happens? Even a child would understand the whole thing
could collapse. The only way the government can turn this economy around is to do the opposite of the private sector -borrow the money the private sector saved and spend it, which means fiscal stimulus. That's what saved Japan from
entering a Great Depression.
Refresh our memory.
Our commercial real-estate prices fell 87% from the peak, nationwide. I mean just imagine Manhattan, San Francisco,
Chicago down by that much. But our gross domestic product never fell below the peak of the bubble [despite] this decline
in asset values. It is an unbelievable achievement. The point is, private-sector savings, plus the debt repayment together
become the economy's "deflation gap" -- the amount of money that comes into the banking system but is unable to leave it
because no one is borrowing.
You end up losing demand. That's how the U.S. got into the Great Depression of 1929 to 1933 and lost half of its GDP in
just four years. Japan could have fallen into that deflationary spiral except for the fact that the government was borrowing
and spending all that money. That's why our GDP never fell. It was the first country in history that managed to avoid
falling into a depression-type outcome. If you look at the history of this type of recession in the past, the only way those
countries came out was through fighting wars. Japan managed to do that without fighting a war. Once Americans
understand this point, they don't have to fear the housing market collapse. If GDP isn't falling, people have the income to
pay down debt. At some point, your balance sheet will be balanced again and this problem will be over.
Five years from now, a lot of people will be using the term balance-sheet recession. My task now is to get American
policymakers to understand that's how Japan suffered for 15 years. There is no reason the U.S. has to suffer for 15 years.
The U.S. can learn from Japan.
How far along are we in the balance-sheet recession for the U.S., Europe and Japan?
In Japan, we are definitely on the exit side. We have the exit problem of trying to convince people who became so averse
to debt to start borrowing again. If you remember, Americans who lived through the Great Depression, the Great BalanceSheet Recession, never wanted to borrow money again. We have something similar -- I call it the debt-rejection syndrome
-- after paying down debt for 15 years. But we can't repair the government balance sheet until the private sector starts to
borrow money again.
The other countries are still in the entrance part, in the U.S. and Europe ex-Germany, because Germany never actually had
a housing bubble. Germany did suffer a balance-sheet recession after the collapse of the telecom bubble. It was smaller
than Japan's, but the German economy did poorly for a very long time. They're mostly out of it.
In the U.S., it all depends on policy. The economy could be shrinking quickly if the government didn't borrow money so
the GDP would be maintained; the private sector would have income until debt minimization is over. But suppose the
government cut its support in the middle and the economy collapsed one more time? Then people would become very
pessimistic, and the whole process would take much longer. In 1997, Japan made that stupid mistake of cutting our deficit,
and that lengthened our suffering by five years, if not more. I see a similar danger in the U.S. and Europe.
Has the U.S. government done enough to offset the crisis?
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They are a bit too cautious. In this type of recession, government has to be in there in a sustained fashion to take this
entire excess savings in the private sector and put that back into the income stream. It has to be sustained until private
sector deleveraging is over. Individually, everybody is doing the right thing. I can't tell you to stop paying down debt. But
when everybody does it at the same time, who is going to borrow and spend? Once the private sector starts borrowing
again, we're back to the textbook world of maximizing profits. But U.S. households and U.S. financials are still
deleveraging.
What do we need to see?
A three- to five-year program, minimum, where President Obama comes out and tells the American people: "Look, we
have a different type of disease now." That kind of explanation is essential to get Democrats and Republicans to
understand why you need fiscal stimulus. I can assure you if [the government doesn't spend much more], your budget
deficit will continue to increase. During the past 15 years, we in Japan tried to cut the budget deficit twice. On both
occasions, the economy collapsed, and tax revenue dropped. The U.S. will experience that, too. If you say it's political
suicide [to spend], not doing it will be an even bigger suicide.
What's a plausible number?
That's a very difficult question to answer because we have to see what's happened to the deleveraging process. If
deleveraging isn't as large as it was in the first year, then you need to do less. If it's bigger, you need to do more. The point
is to tell people about this kind of disease. And we had a silly accident called Lehman shock, which in my view was
totally unnecessary. The fundamental problem of the U.S. housing market collapse is still with us. The [first] $787 billion
[in Washington's fiscal stimulus package] had to deal with two problems: the housing collapse, and then the policy
mistake called the Lehman collapse. But we still have this one left. So [the number] could be $500 billion, it could be
bigger, it could be smaller. I hope it won't be another $787 billion.
What about Obama telling the banks to lend more?
Just telling them is not enough. There's a wide range of things to do, but the most important is to make sure the fiscal
stimulus is in place until the private-sector deleveraging is over. On the banking side, if you look at the Federal Reserve
senior loan officers' survey, American bankers are still tightening lending standards, which means the credit crunch is still
with us. The TARP [Troubled Asset Relief Program] money was put in place to end the credit crunch, and failed
miserably. I know it's politically difficult, but I suggest that [Washington] put capital one more time into the banks, and at
the same time put together a 10-year non-performing loan amortization program, so give the banks 10 years to clean up
the mess. That's a much more realistic approach than rushing to clean up, and will make them more relaxed and lend
money. The 10-year program should be very closely supervised by the government and one of the agencies so it remains
credible. The credibility of the effort is what's important, not how fast it goes. Many banks are facing potential losses on
commercial mortgages and real estate. They should come up with a 10-year plan to write off problems and inject capital to
keep things going.
The U.S. deficit will remain large, but U.S. interest rates will not skyrocket. With this much fiscal stimulus -- 10% of
GDP and massive monetary stimulus -- the long bond yield is 3.4%. Under ordinary circumstances it should be 8.4%.
Why? The private sector is deleveraging.
What are the other implications of the balance-sheet recession?
Many countries will continue to run massive fiscal deficits for the foreseeable future. There are two issues. One is how to
rate the sovereign debt of countries that have fallen into balance-sheet recessions and require heavy fiscal stimulus.
Issuing more government debt when an economy isn't in a balance-sheet recession leads to a variety of problems,
including higher interest rates, crowding out, inflation, and inefficient distribution of resources. Any of these would be
ample justification for a rating downgrade.
But increased issuance of government debt during a balance-sheet recession is a positive. Unless the government issues a
sufficient amount of debt and boosts fiscal expenditures, the economy will fall into a deflationary spiral. At such times,
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rating agencies that don't understand the concept of balance-sheet recessions can send the wrong signal with credit
downgrades, preventing governments from doing what is necessary and sparking further weakness in the economy. Of the
two main U.S. rating agencies, Moody's appears to be paying much more attention to this issue. Standard & Poor's, on the
other hand, remains entirely indifferent and continues to apply orthodox rating criteria in a doctrinaire fashion.
It was the haphazard assignment of AAA ratings to subprime CDOs by these two organizations that enabled those
instruments to be bought by investors around the world, ultimately triggering the global financial crisis. The problem of
sovereign-debt downgrades represents another opportunity for these agencies to exacerbate problems in the global
economy. National and international authorities urgently need to pursue further regulation and reform of the rating
agencies as part of their efforts to tighten regulation of the financial sector.
What other types of collateral damage are you expecting?
The Dubai [World] default was part of it, and some Eastern European problems, and we still haven't seen a U.S.
commercial real-estate resolution yet -- it's falling very quickly, and there's no relief in sight. This will hit the U.S.
banking system one more time. Some Western European banks were more opaque than American banks, so we might see
some land mines there, too.
Abu Dhabi is helping Dubai. For Greece, what will happen isn't clear. If this were an ordinary recession and Greece was
going crazy spending money, we'd have to tell Greece to cut its deficit. But balance-sheet problems are at the heart of the
problem, and the rest of the world shouldn't push Greece to cut its deficit.
Is Japan's recent 7.2 trillion yen ($78.3 billion) stimulus enough to pull it out of its current slump?
It's far better than nothing, but this time around, I'd like to see a long-term vision, which is completely missing from this
government at the moment. In the past, when we ran a big budget deficit, there was a vision, and it was that we could end
this once the private-sector deleveraging was over. But this time around, the private-sector deleveraging is happening
outside Japan, and there is a view, pronounced at the G-20 meeting in Pittsburgh, that external imbalances should not
grow too much.
That means Japan, China, and the rest of the Asia region will really have to find [their] own domestic-demand-led growth
model. China is definitely helping; they put in the largest fiscal stimulus among any of these countries in November 2008.
The 4 trillion Chinese yuan package was 17% of China's GDP. But China's consumption is a fraction of U.S.
consumption.
In Japan, [demand] could be stimulated [by] environmental projects or housing -- areas where we still lag behind the
West. Unless a vision is presented, we'll have to rely on fiscal stimulus before exports go back up. People may be spooked
by a large deficit. We need to say that we need fiscal stimulus to buy time, but have long-term growth strategies kicking in
soon. Then the bond market would be more relaxed because there would be an exit strategy.
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