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The Holy Grail of Macroeconomics: Lessons from Japans Great Recession

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Richard Koo, chief economist of Tokyo's Nomura Research Institute, has written a fascinating and important book. He claims that capitalist economies have two phases: the ordinary phase, in which firms aim to maximise profits, and the post-bubble phase, when they aim to pay off their debts. He believes that he has found the missing link of economics: "corporate debt minimisation, therefore, is the long-overlooked micro-foundation of Keynesian macro-economics."

It's still boom and bust. Koo claims that in the boom phase, monetary policy works, but not fiscal; in the bust phase, only fiscal policy works, not monetary. He shows how monetary policy cannot fight a slump. He contends that only huge fiscal stimuli, government actions to boost domestic demand, can prevent slumps.

Koo claims that, in the 1930s depression, in Japan's recession since 1990, and in the present crisis, the problem was the private sector's lack of demand for loans, not a lack of funds from the central banks. Contrary to the consensus, these depressions were not caused by the wrong monetary policy.

How to fight a slump? Cutting spending to reduce government debt is the road to disaster. In the 1930s, both President Hoover and Chancellor Bruning insisted on balancing the budget, which crashed the US and German economies. In 1945 the British government's debt was 250% of GDP, but the country survived. Between 1933 and 1936, President Roosevelt raised government spending by 125%, so GDP rose by 48% and tax revenues rose by 100%. But in 1937 he changed tack and cut spending: industrial output fell by 33%.

Japan's recession (caused by falls in the value of its assets - land and loans) destroyed 1500 trillion yens' worth of wealth - three years of Japan's GDP. (The USA's depression lost it one year's GDP.) In Japan, monetary stimuli failed, so the Japanese government proposed irrelevant Thatcherite supply-side changes, like privatising the post office.

In 1997 the Hashimoto government, under IMF pressure, cut spending and raised taxes to balance the budget. As a result, output fell for five quarters, Japan's worst post-war meltdown, and the budget deficit rose from 22 trillion yen in 1996 to 38 trillion in 1999. In 2001, the Koizumi government did the same - with the same result. It also tried the monetary policy of quantitative easing. But this did not increase lending or the money supply. It was irrelevant.

Subsequently, the Japanese government adopted a policy of no fiscal consolidation without growth, i.e. no spending cuts or tax rises before private-sector demand recovered. This fiscal stimulus prevented a 1930s-style depression; by 2005, firms had started to borrow again.

Again, in Germany's balance sheet recession of 2000-05, "the Maastricht Treaty prevented it from applying the fiscal stimulus it needed. This deepened the recession", as Koo observes.

Finally, he notes the harmful effects of the free movement of capital: "in view of the explosion of cross-border capital flows during the past two decades contributing to adverse currency movements and the widening of global imbalances, some restrictions on those flows may be desirable." He also notes the damage done by free trade: "that market forces have not only failed to rectify trade imbalances but actually made them worse suggests that some kind of government action may be necessary."

I am a neophyte in economics, I should have put my attention hear years ago -- being a "do gooder" at heart. The past three months I have delved into the dismal science. I never anticipated such divergence of opinions and theories. The Holy Grail of Macroeconomics is simply a gem of knowledge. Of the many books/texts I have aquired, this one is the best in gaining the meat. I mean by this, it is written in a dense style, reminisent of college texts years gone by -- yet each paragraph holds my attention and interest, unlike so many others. The author's analysis and view points are clearly stated with ample examples and "evidence." This fine writting is simply not of the "dismal science" but a wonder of clear analysis and clarity of writting.

This book is a good account of the phenomenon of debt aversion. The thesis of the book is pretty straightforward and is that, after asset bubbles burst and businesses are technically insolvent through liquidation analysis, they are likely to pay down debt irrespective of monetary policy. The fact that the businesses are technically insolvent despite market prices is described as being a function of information asymmetry and bank incentives.

This realization is deemed to be the missing link to complete economist's understanding of how to bridge fiscal macroeconomic thought and monetary economic thought and the solutions required in the aftermath of a burst asset bubble. Discussing the shortfalls of Friedman's positions on the demand function for money to be a function of nominal interest rates, it is argued that when one is in the position of being insolvent yet operational, the focus shifts from using lending lines to maximise ROE to using free cashflow to minimize the debt that is causing this insolvency. When this market regime is upon us, it is the need of the government to use fiscal policy to fund the output gap.

I think this is pretty accurate as an analysis of the problems that arise in monetary policy when the world is in fear of the phenomenon that hurt them (being burdened with debt that is greater relative to the asset base one had assumed would back it) and this aversion has macroeconomic repurcussions. My only criticism is, I dont think this is as obscure a result as is described. Most ecnomists realize how output gaps can arise, how debt aversion can form. Richard Posner, who is a judge, talks about debt aversion off-hand as though its well known. So all in all i think its a god perscriptive piece on a very real phenomenon we deal with but its not revolutionary and this phenomenon is discussed by others (though few have gone in to as much detail about it).

At the risk of getting taken to the wood shed by both Academics and Economists, I will venture out and provide a few comments from the view of an aspiring autodidact.

First, I would like to commend both the author and editor on a good job in the editing process, as this translation reads and flows like an English first edition. Second and as for the subject matter, the thesis is well documented and one would have a hard time to find fault with its premise. However, I will take issue with two minor points (A & B below) of which I hope will expose a small point for possible improvement and betterment for the "search of the holy grail" that hopefully in the end, may actually boost the thesis.

At issue, and from page 108 "we must conclude that the Great Depression was 13.6 percent a credit supply problem and 86.4 percent a credit demand problem."

A) I am very surprised that any discussion about the Great Depression would not even mention the Smoot-Hawley Tariff Act of 1930, which started moving thru congress the year before in 1929. Some have previously argued that this legislation started the intial cracks in the stock market before it eventually broke in October. In addition, and a very important consequence of this act was what subsequently happened to world trade and its subsequent higher retaliatory tariffs from around the world after it became law. As the US economy moved thru the next 2 years, many more tariffs were increased even after its original passage into law all thru and up until the 1932 elections at which point the winning candidate ran on a non-Nationalistic platform (i.e. on a reduced tariff platform). Why is this so relevant? It is very relevant because on top of the already pre-existing war debt, even more private debt was lent to foreign entities during the boom of '21-'29. As the entire world contracted due to the reduced trade, the repayment of domestic debt by foreign entities became tough and may have contributed more than marginally to further decreased asset prices and of debt deflation? -- Which leads to my next point B.

B) Though discussed, it appears that the short discussion to dismiss Irving Fisher's debt-deflation thesis may have missed the point that Mr. Fisher was making. In the light of both the asset bubble cracking in late '29, then the subsequent reduced trade which played havoc not only on meeting interest payments, but actually principal debt repayment, placed further pressure on asset values. Toss in some increased tax rates, and the (9) point debt-deflation thesis (see below) holds up very well, at least in my view.

Assuming a state of over-indebtedness exists (meaning corporate and private), this will lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences 1) Debt liquidation leads to distress selling, 2) Contraction of deposit currency, as bank loans are paid off which leads to the slowing of the velocity of money which precipitates more selling, 3) A fall in the level of prices, causing, 4) A still greater fall in net worths of business, precipitating bankruptcies, 5) A like fall in profits, curtails employment and production, 6) A reduction in output, trade, and employment, lead to, 7) Pessimism and loss of confidence, which in turn leads to, 8) Hoarding and slowing down more the velocity of circulation, and the above eight cause, 9) Complicated disturbances in the rates of interest, or the fall in money rates and the rise in the real, or commodity, rates of interest.

Outside the two points above (A) & (B), a highly recommended book on both the macro economy and the benefits of fiscal policy over monetary policy under certain (or specific) economic conditions. A truly worthy read for one's Macro Economic education.

Side note: If there is a 2nd Edition, note that Long-Term Capital was not a bank, but a highly leveraged US Hedge Fund. However, the reference maybe was meant to be for Long-Term Credit Bank of Japan.


Post Script: Given the recent actions by the US Government in September 2008, many policy makers appear to be aware of the dangers to which Mr. Koo warns about in his earlier book "Balance Sheet Recession" and in the updated version of "The Holy Grail of Macroeconomics". Time will tell if the US Congress will comply, or repeat some of the mistakes of the past.

I've read through half of this book (having known some of the author's articles), and so far I can say it's great.

The point of the author is that Japan's crisis was due not to a lack of institutional reform, or BoJ doing wrong. The reason was that the burst of the asset bubble and the ensuing asset-price decline put Japanese corporate and household sector in a high-debt position. All agents spent most of the following 15 years cleaning up their balance sheets (thus the expression "balance sheet crisis").

The author argues that because conventional theory is based on agents maximizing profit (which usually would imply agents borrowing leaps of money while interest are low or zero), it is difficult to perceive an scenario where agents are "minimizing debt", curtailing aggregate demand.

Hardcore keynesians will recognize this as the "effective demand" argument established by Keynes' General Theory. The main lesson of Japan's balance-sheet crisis is that government spending kept the economy afloat during the whole period. The author makes great use of basic monetary/credit indicators and a very clear employment of national accounts (the book is written in a crisp-clear style).

Additionally I believe it's fair to say that the author's argument leads to the conclusiong that a reform hich would impact Japan's keiretsu organization (i.e. reforming Japan's financial system) would actually do more harm than good - since businesses were still generating cash, they needed time; a system different from that of the "special relation" between finance and manufacturing such as Japan's would probable had forced closure on many of those businesses.

This is not to say the author embraces a non-market (dirigiste) approach to macroeconomics. Though to give a definitive opinion on this, it will be interesting to see what treatment the author gives to the essential characteristic of a market economy: risk. What does he make out of the "green cheese" and expectations-management that Keynesians haved lived by as written in chapters 16-17 of the General Theory.

I was trained as a Chicago school quantitative economist, left that school of thought after studying Galbraith and realizing the scale of the holes in the neo-classical method. After reading Koo, I don't have a name for my school of economic thought, but if Krugman won it, then Koo should be a shoo in. This book puts together the defects in Keynes and the monetarist theories for an inclusive new explanation for economic behavior.

When do banks and businesses not seek to maximize profits? When they've fallen into a state of negative net worth, such as after the bursting of an asset bubble. In this situation, it doesn't matter how cheap money is -- the usual monetarist response to a recession -- because, survival taking precedence, businesses opt to pay down debt instead.

Author Richard Koo calls this situation a balance-sheet recession. He discovered it while working on the long Japanese recession of the 90s that extended into the 2000s. He particularly noted the beneficial effect of a fiscal stimulus, versus monetary policy, or worse, an attempt to balance the budget. The same conclusions can be drawn about the Great Depression in the 1930s US, where the economy would improve as long as FDR kept up government spending, but would fall back into recession when he let programs lapse or when pressured to adhere to conventional neo-classical economics, such as trying to balance the budget in 1937.

We can see the same thing happening today in the US, where the Fed has reduced the bank loan rate to almost zero, handed out hundreds of billions of dollars to banks, only to find out that banks have used the money to pay down debt and strengthen their balance sheets, rather than make new loans. It's the old "pushing on a string" analogy. And so much for Ben Bernanke's helicopter.

Koo sees the concept of a balance-sheet recession as something that is missing from both neo-classical and Keynesian economics. He asserts that there's an economic cycle of upturn (yang) and downturn (yin) and what works in the yang environment, like monetary stimulus, fails in the yin environment.

I have a personal quibble here with Koo's concept that neo-classical economics ever works, even in the yang phase.... That is, the thirst for profits in the yang phase inevitably produces a growing disparity of income, where the investor class takes an ever-larger share of the profits, which goes back into ever more investments. But if the income of the salaried middle-class stagnates, as it did in the 1920s and again in the 1990s-2000s, then the middle-class can't afford to buy what business is producing. Business then responds by encouraging the increased use of credit in order to maintain rising sales, necessary for rising stock prices. Eventually this produces both an asset bubble and a credit bubble, finally collapsing into the yin phase where the taxpayers have to bail out the system.

In this work, Koo concentrates on the yin balance-sheet recession phase, fortunately. (Though he does make some solid criticisms of neo-classical theory.) His experience in Japan has given him a good insight into what works and doesn't work. Even though Japan struggled for some 14 years, until 2005, and is now struggling along with the rest of us in this global downturn as their exports have crumbled, Koo notes that it could have been much worse. After all those years, they finally figured it out -- and their experience should be a lesson for the US, if we're paying attention.

Koo also adds an interesting appendix on money, Walras, and macroeconomics. Basically, why neoclassical economics fails to understand what money really is, and the results of that failure.

Hopefully, Pres Obama's economic advisors will take Koo's recommendations to heart. (According to a blurb on the book cover, Larry Summers has at least read it, though he seems non-committal as to whether or not he agrees with it.) As physicist Max Planck once noted, new ideas may only get accepted when the supporters of the old ideas die off.

The book is not a difficult read for the layman, though not a quick read either. It does tend to get repetitious at times. But it's a solid contribution to our understanding of how a market economy actually works, and so not to be missed by anyone interested in macroeconomics. As for those of you who are macroeconomists by profession, working in the shadow of St. Milton, read this book and come into the light. :-)

This is an interesting book .The author clearly demonstrates his understanding of the dangers that banker induced and financed speculation,particularly the leveraging of debt in the socalled good times that leads to massive deleveraging of these same debts in bad times.Deleveraging in bad times fails since all indebted financial institutions attempt to deleverage simultaneously,driving down the value of assets at even a quicker pace.

The author correctly demonstrates that speculative finance by the private commercial and investment banking institutions is at the core of the problem.Thus,the error was the deregulation of financial institutions, carried out in the 1920's and 1980-2006 time period in the USA and in the period 1986-1992 in Japan.Speculative bubbles ,inflated by a private banking system that no longer was subjected to oversight,no longer required to maintain sufficient capital reserves ,and freed from the requirement to impose basic creditworthiness standards,inevitably leads to a panic , crash,and recession/depression.

I have taken one star away because the author has apparently never read anything written by Keynes or has skimmed Keynes's comtributions .His entire discussion of Keynes on pp.170-180 is completely erroneous.Keynes's major point in the GT was that speculation leads to economic collapse .Keynes was in favor of maintaining low fixed rates of interest permanently in the long run .This would be combined with a policy of credit restriction imposed on the private commercial banking system that would prevent them from loaning to rentiers and speculators.Keynes's identification of categories of dangerous borrowers is the same as those identified by Adam Smith in the Wealth of Nations-projectors,imprudent risk takers,and prodigals.Keynes limited the use of expansionary fiscal policy to long run infrastructure projects that would pay for themselves in the long run.Keynes required that the government budget be split into two parts, a capital account and a current account.One part of the budget,the current account ,would always have to be balanced.The other account,the capital account,could only be unbalanced for long run projects.

The author's claim that Keynes had no knowledge or experience with balance sheet items or debt finance is one of the worst errors that this reviewer has ever seen in print as regards Keynes.Hopefully,this egregious error can be corrected in a later edition.

In this book Dr. Koo posits that economies in a balance sheet recession, as opposed to a slow down due to decline in aggregate demand, due not respond to textbook monetary remedies involving the use of expansionary monetary policy. The reason, he proposes, is that during this period companies and households are primarily interested in reducing their debt balances. Hence low interest rates provide little incentive for economic actors to invest. The impact is the same as in a Keynesian liquidity trap framework. However, the reason is different. In a liquidity trap, as Keynes proposed, monetary policy is not effective because economic actors do not demand funds because they see no need to invest as they see insufficient demand for their product. In Dr. Koo's framework, these same actors instead are too busy reducing their debt holdings. In this framework, Dr. Koo proposes, monetary policy is not effective while fiscal policy is. Dr. Koo is very careful to emphasize, however, that fiscal effeciveness in the Japanese case has consisted of preventing a collapse of the Japanese economy as opposed to providing a gross positive increase in either employment or GDP. This has made it difficult for proponents to justify the continuation of the policies. Dr. Koo specifically examines the case of the recent 15 year Japanese recession to make his point. This he does well by providing considerable empirical evidence for his views. He makes his argument very convincingly. As a result this is must read book for any serious student of macroeconomics. Considering the fact that the developed world's economies are facing a similar debt problem Dr. Koo's arguments need to be seriously and closely examined.

Despite its strengths, Dr. Koo's framework does have weaknesses. The most important of these, by far, involves the accumulation of debt. Dr. Koo proscribes expansionary fiscal policy to offset the private sectors debt reduction but the million dollar question becomes how long can this continue? Is there a point at which public sector debt accumulation reaches the point where it proves counterproductive? This is a very important question as Japan's GDP to debt ratio, at the time of the latest printing of this book, was about 220%. Authors such as Rogoff (see his "This Time Is Different: Eight Centuries of Financial Folly"), in their research, posit that when debt levels reach about 80% of GDP fiscal policy becomes less efffective. Hence a very important question, very relevant to Dr. Koo's framework, is when does debt reach a limit at which it can limit the use of fiscal policy. This is question that needs to be, simultaneously, answered for Dr. Koo's framework to be applied in real life policy framework over a long term period.

I am not a great fan of economists as they have a poor track record of helping investors make money they tend to cluster around the consensus and are mired in the ideallic theories of the neo classical approach. This book and Koo's approach is a breath of fresh air, it is clear, logical, practical with real world conclusions which I believe will help investors time equity market and economic cycles.