Koo’s Keynesian Key to the Balance Sheet Recession

I had the privileged opportunity to attend the David Finch lecture at the University of Melbourne two weeks ago. Amidst many academics and esteemed guests, Mr. Richard Koo from Nomura Research Institute presented his lecture about Japan’s burst asset bubble, and its lessons which are now applicable to many of today’s troubled economies. Koo asserted that the problem was unlike the textbook-typical case of recession. Instead, countries like the United States, the UK, Spain and Ireland were suffering from what he called a ‘balance sheet recession’[1], akin to what Japan suffered from the 1990s through to the mid-2000s.

After a debt-financed bubble bursts, asset values plummet significantly, whilst the attached liabilities to those assets remain. With their balance sheets now underwater and on the precipice of bankruptcy, Koo contends that firm behaviour makes a sharp turn. Instead of seeking profit maximizing projects to undertake, businesses exclusively deleverage – focusing all spare cash flows to repay liabilities until they meet new asset values. This is in spite of monetary policy lowering interest rates as a means to encourage borrowing and expenditures in a slowing economy.

While debt minimization is financially prudent on the individual level, Koo’s concern is that in simultaneity, the macroeconomy stands to suffer from this behaviour. Even as monetary policy drives interest rates to near zero levels, households and firms would rather save their money and continue repairing their balance sheets. This liquidity trap effect highlights a mismatch in the financial market – much of the saved money that should be lent out is unable to find a borrower who will use it efficiently. These ‘stuck’ funds, unable to flow back into the economy simply fail to contribute to further production and income. This cycle of building up savings without sufficient counteracting borrowing has a compounding effect, which results in a gradual yet frightening shrinkage of the economy. It is this spiralling decline in economic activity, driven by a deleveraging private sector, which characterizes the ‘balance sheet recession’.

The Japanese learned the hard way that the singular solution to a balance sheet recession would be a broad-shouldered fiscal stimulus. If the private sector was wholly unwilling to spend, then the only remaining participant would have to be the government. Koo conjectured that if the government borrowed and expended all ‘stuck’ funds in the financial market, production and income in the economy would not spiral downwards. Indeed, this approach kept Japanese GDP buoyant and even above peak bubble levels, despite a tremendous 87% reduction in land prices. He continued to project that during the 1990-2005 period, around 2,000 trillion yen in GDP was preserved with the actual 460 trillion yen spent as fiscal stimulus.

Any premature return fiscal consolidation was sternly warned against by Mr. Koo, as the Japanese took such measures in 1997 and 2001. The poorly timed withdrawal from borrowing in the market resulted in prolonged negative growth and actually worsened succeeding budget deficits. Even the full reparation of balance sheets fails to justify budget surpluses. While debt has been well minimized through deleveraging, Koo asserts that many firms will have been traumatized by the many years of suffering. A pervasive reluctance to borrow will still permeate much of private sentiment, and so the demand for borrowing is likely to stay low for many years. This is the ‘exit problem’ of the balance sheet recession, where a government must tackle with the distaste for borrowing in the private sector. Koo claimed that this was the case both in the Great Depression and in Japan’s ‘Lost Decades’, and will likely be an issue in the future for currently ailing economies. His recommended remedy was in tax credits and accelerated depreciation allowances from the government, to incentivize borrowing and heal the trauma.

This strong Keynesian approach doesn’t sit well with everybody though, especially in current political climates. The popular consensus is that austerity and fiscal consolidation is the right approach, or at least the one that sounds most responsible. In a time when households are feeling the pressure and tightening their belts, a government that seeks to spend in extravagance is sure to look out of touch. Thus to speak of growing budget deficits in the United States (and some European countries) encroaches on political suicide, even if economic survival is at stake. It is in this myopic political context that Koo’s recommendations must fight an uphill battle.

This year’s David Finch lecture was a potent Keynesian recommendation for troubled economies. Mr. Richard Koo has asserted that our inability to find a convincing solution thus far is resultant from a different, but not new, type of recession – the balance sheet recession. While his policy recommendations are contrary to popular opinion, his work in Japan has established his expertise in the matter. The lessons Japan has learned a couple decades ago must not be disregarded if we have any desire to climb out of our current quagmire.