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Balance Sheet Recession: book cover

Book Info:
Balance Sheet Recession: Japan's Struggle with Uncharted Economics and its Global Implications
By Richard C. Koo
John Wiley & Sons (Asia) Pte Ltd: Singapore, 2003, pp. 284.

"Pilate saith unto him, What is truth?"
Nomura Research Institute
In his own words
Confirmation Bias
World Military Spending Statistics
 
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Richard Koo:
The Final Fiscal Solution

By: Paul J. Scalise

"Confirmation 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 Wasn’t Looking.

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.

Anatomy of a Recession

...Selective 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...
Until 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.


Balance Sheet Recession vs Traditional Macroeconomics

At 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 debt-repaying firms.

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.


Assessing the Arguments

or 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 times.”

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 benign.

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 term.

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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