The Final Fiscal Solution
By: Paul J. Scalise
bias.” That’s the technical name statisticians use to describe
a widespread phenomenon in hypothesis testing. Simply put, one
tends to highlight information that agrees with an existing viewpoint
and either ignores, doesn’t look for, or undervalues the relevance
of what contradicts it. How many times, for example, has your
view been challenged by some new factoid to which you quickly
respond “never mind, that’s just a blip!” or “that’s not the point!”
or my personal favorite, “you just don’t get it, do you?”
If that hits a little close to home, take solace in the fact that
the professionals can be worse. Its evil twin, “conservatism bias”,
is the even more disturbing tendency among economists, stockbrokers
and journalists to cling stubbornly to a view despite growing
evidence to the contrary. Remember a certain book’s infamous 1995
subtitle: How Japan Will Overtake the U.S. by the Year 2000?
Well, the year 2000 came and went but the only thing Japan overtook
was our patience. Yet republished in 2003, the same book’s subtitle
now reads, How Japan Won the Race to the Future When the West
And there you have it.
Welcome to Japan’s political economy—one of the last bastions
of organized debate where the leading proponents of some macroeconomic
theory battle over the op-ed pages to interpret the latest data.
Richard Koo, Chief Economist of Nomura Research Institute, the
research arm of Nomura Securities, may join them from time to
time, but he certainly agrees selective thinking is destroying
Japan’s chances for economic recovery. His latest book, Balance
Sheet Recession: Japan’s Struggle with Uncharted Economics and
its Global Implications (John Wiley & Sons Pte Ltd: Singapore,
2003) provocatively argues that Japan’s situation “is unlike any
described in any economics or business textbook.” The intriguing
question that arises as one reads the book is whether Koo suffers
from selective thinking himself. You
be the judge.
of a Recession
thinking overshadows the world's second largest economy.
The reader can form his or her own overall qualitative judgment
of the predictive value of the analysis...
recently, Japan’s macroeconomic and financial policy debates gravitated
around two opposing theories. On the one hand, the “structuralists”
argued that the country’s malaise was inherent in policies, procedures
and mental habits that prevailed during the high growth era of
the 1950s-60s. Theirs was a predominantly supply-side argument
calling for deregulation and bureaucratic reform. On the other
hand, there stood a motley array of “demand-side” theorists ranging
from neo-Keynesians, who advocated further public works spending
to stimulate aggregate demand, to the monetarists, who argued
that material changes in money supply and interest rates would
eventually induce further consumption. Theirs was an argument
that did not necessarily oppose the long-term benefits of deregulation
per se, but simply questioned the causality of Japan’s so-called
“lost decade.” If one misdiagnosed the patient, so the logic flowed,
the cure could be worse than the disease. Hence, short-term adjustments
to fiscal or monetary policy should just about do the trick.
Richard Koo cuts through all of these schools of thought to reach
his theory. He certainly agrees that Japan does have structural
problems. “However, these problems did not come to the surface
abruptly in the 1990s to torpedo the Japanese economy,” he writes.
“Many of these problems had been in existence for 20 or 30 years,
if not longer.”
Instead, the author’s argument starts with a somewhat standard
observation: during the 1970s-80s, companies bought assets with
borrowed funds from the household sector’s savings surplus, using
land as a primary source of collateral. The subsequent bursting
of the “Bubble” economy by the Bank of Japan (BoJ) in 1991 led
to perpetual decline in asset prices (both land and stocks). This
set in motion a series of events that, Koo claims, is a vicious
circle without any natural end.
It goes something like this: the fall in assets prices led to
what is known as a “balance sheet recession”—a term he attributes
to his former New York Federal Reserve colleague, Edward Frydl.
Balance sheet problems caused Japanese companies to move away
from “profit maximization” to “debt minimization.” This absorption
of free cash flow (FCF) to pay down principal on interest-bearing
debt predominately explained (and explains) the fall in aggregate
demand as investment in new businesses became a secondary issue.
As aggregate demand waned, so did the need to borrow from banks
(hence, the low interest rates) and the weak deflationary economy.
Thus, the weak economy forced asset prices to fall further, leading
to more corporate bankruptcies and a BoJ dramatically easing its
monetary policy. With more corporate bankruptcies and low interest
rates, banks suffered ever-increasing non-performing loans (NPLs).
The result is a “liquidity trap,” whereby nominal interest rates
cannot fall much further, monetary policy has become virtually
ineffective, and aggregate demand remains low.
One thing, and one thing alone, keeps this stagnation from turning
into a complete nationwide depression: government spending. “Had
there been no fiscal stimulus,” surmises Koo, “the Japanese economy
today would have contracted by 40-50%, if the U.S. experience
during the 1930s is any guide.”
It’s a fascinating argument in essay format, with a thought-provoking
logic all its own.
Sheet Recession vs Traditional Macroeconomics
this point, monetarists might claim that Koo’s analysis is all
well and good, but couldn’t monetary policy break the cycle? Put
differently, couldn’t the BoJ set an inflation target and then
make a commitment to supply liquidity through quantitative easing
to reach that target, so that people would expect inflation rather
than deflation and start borrowing money to spend?
Koo does not mince words. Using the internal logical of a balance
sheet recession, “businesses and individuals are saddled with
excess liabilities and are forced to pay down debts by curbing
consumption and investment. The last thing they are interested
in is increasing their borrowings.” For inflation targeting to
work, theory must ultimately supplant practice—something,
Koo argues, that is neither borne out in the BoJ’s aggressive
monetary easing in 2001 nor in the subsequent reaction by most
This point is important to re-emphasize as it also differentiates
Richard Koo’s analysis from the Keynesian school of economics.
It is true that both John Maynard Keynes and Richard Koo advocated
fiscal policy as a means of manipulating aggregate demand for
short-term effect. It is also true that both were (are) looking
to fully utilize existing production capacity by pump priming
the economy. Where they differ is in their reasoning. For Keynes,
recession stemmed from the marginal inefficiency of capital and
labor; investment declines because corporations expect low profitability
and growth, which in turn raises savings and lowers consumption.
For Koo, recession stemmed (and stems) from the “fallacy of composition”
behind the corporate uses of free cash flow (FCF); unstable balance
sheets lead otherwise profitable firms to continually pay down
debt despite low interest rates, rather than invest in new businesses.
This situation is something, the author argues, that ultimately
unseated the influence of Keynesian economics by the late-1970s.
As most countries (ex LatAm) did not suffer from balance sheet
problems during the post-war era, expansionary fiscal policy was
largely ineffective. Not so in today’s Japan.
With the timing finally right, Koo now advocates an unprecedented
one year fiscal stimulus increase to the tune of 5-10 trillion
yen in public works spending, allowing debt-straddled firms time—albeit
fixed—to finish adjusting their balance sheets while the
government props up the economy. Why is 10 trillion yen the magic
number? The author really doesn’t explain.
is it clear what the public work increases should be spent on.
As Koo is more the essayist than the strategic planner, he never
assigns specific values to projects and opts for a list of vague
possibilities. Some of his solutions are certainly novel. He argues
that “in the past it is wars that have solved serious balance
sheet recessions, including the Great Depression of the 1930s.”
Or by extension, Japan is the equivalent of Germany’s Weimar Republic
before Adolf Hitler’s military build-up. “War overcomes balance
sheet recessions not because it kills and destroys, but because
it forces governments to respond to the existential threat by
placing huge orders for military wares with very strict delivery
To be sure, all recommendations are not without their consequences.
Some practical considerations raise more questions for Japan’s
situation: first, who’s the enemy—is North Korea enough
of an “existential threat” to justify such a budget increase?
Second, what about Article 9—will the Constitution need
to be amended to facilitate the process? And third, what happens
to Japan’s geo-political relations when it arms to the teeth all
in the name of economic recovery?
Even if the “process” was more important than the “method,” an
additional ten trillion yen to the general account would translate
into a roughly 112% year on year expansion of public works spending.
While the LDP and other vested interests may applaud such a move
for their own short-term ends, one wonders whether they can be
eventually weaned from their pork-barrelling, let alone deliver
long-term positive results. If the past is any indication for
what the future holds in store, the outcome may still be economically
Still, there’s an even larger problem with Koo’s “conditions for
recovery” from a market perspective. Essentially, FCF can be used
to reduce debt, payout dividends or increase investments into
new businesses. It’s the essence of finance. With companies already
earmarking 70-80% of their FCF on the former, one wonders how
companies are expected to quickly fix their balance sheets and
remain attractive to investors at the same time? Will the market
respond favorably to complete dividend cuts to further pay off
debt, or more importantly, would the move collapse the stock market
even further? To institutional investors with large holding in
Japanese equities and business obligations of their own, such
a move may be too risky to tolerate even in the short-to-medium
Which brings us back to the original point: selective thinking
overshadows the world’s second-largest economy. Koo certainly
finds selective thinking amongst opposing theorists, and spends
a good portion of the book rebutting their arguments in favor
of his own. But compelling explanatory power in describing past
events notwithstanding, it takes an enormous amount of faith to
implement such fiscal stimulus; the policy shifts would result
in even greater long-term risks to government finances and international
relations, not to mention stock and bond market valuations.
The reader can form his own overall qualitative judgment of the
predictive value of the analysis. The evaluation should be made
in terms of the adequacy of the forecasts as a guide to policy
decisions. Will this also require econometric proofs? No. But
then again, the world might have been a much different place had
the same been asked of John Maynard Keynes.
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