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15 March 2011

Nomura Research 2

I myself was stuck in a taxi for five hours in the worst traffic jam I have ever experienced

trying to reach home from Tokyo�s Haneda airport. During that excruciating five hours, I

never heard anyone use the horn in his or her car. The taxi driver was also nice enough

to charge me only for the distance traveled, not for the time it took to reach the

destination.

In short, the view overseas is that a country with these national characteristics and this

level of technical prowess is bound to recover. In that sense, I feel as though the world is

supporting Japan from afar.

This focus of global attention on Japan should reassure the government that it can take

necessary fiscal measures without fear of being downgraded by overseas rating

agencies.

From an economic perspective, the short-term outlook is bleak, and demand fueled by

reconstruction projects is unlikely to emerge for some time yet. But I am confident the

Japanese economy will be able to pull through this disaster if the public, the government,

and political parties on both sides of the aisle join together and work as one.

* US government officials becoming increasingly receptive to balance sheet

recession concept

Over the past two weeks I had the opportunity to speak with many investors, academics,

and policymakers in Europe and the US. My discussions with key officials at the Fed and

the White House were especially fruitful.

In the course of these talks it became clear that Fed and White House officials have

become increasingly receptive to the concept of balance sheet recessions, which was

why I was able to see them in the first place.

I last spoke with high-level US policymakers last October, some five months ago. At that

time, many of them were aware that there was such a thing as a balance sheet

recession concept, but few had a detailed understanding of the theory.

There were some Fed staff members arguing that the US was in a full-fledged balance

sheet recession, but they were clearly in the minority.

But this time was different. Our discussions were based the premise that the US

economy is in a balance sheet recession, and I was asked to talk about Japan�s

experience in that context.

* Japanese companies were cash-rich when bubble burst

Corporate sector deleveraging efforts were the main driver of Japan�s balance sheet

recession. In the US, on the other hand, companies on the whole have very strong

balance sheets; the problems lie mostly with households and financial institutions. Manypolicymakers asked about the implications for policy of this difference between the two

countries.

I reminded them that in 1990, when Japan�s bubble burst, most Japanese companies

were actually awash in cash.

At that point in time, Japanese companies maintained tennis courts for their employees

on prime real estate in Tokyo, owned impressive employee resorts in popular tourist

destinations, and held memberships in a variety of clubs, not to mention their paper

profits on equity and real estate holdings.

These internal reserves accumulated because of the postwar Labor Act made it difficult

for companies to lay off employees.

In other words, companies could not respond to economic fluctuations by adjusting staff

levels, but staff represented their largest expense. Their only option was to retain and

accumulate profits during good times and consume them when the economy turned bad.



15 March 2011

3 Nomura Research

* Post-bubble companies drew on internal reserves to maintain employment in

post-bubble economy

Japanese companies engaged in this process throughout the postwar era, during which

the economy underwent a period of high growth and grew dramatically. By 1990, when

the bubble burst, companies had accumulated large stores of profits in the form of

internal reserves, and this forced both management and labor to adhere to certain

patterns of behavior.

When the economy weakened, labor expected management to use these accumulated

profits to look after workers, and management viewed that as its natural responsibility.

But no one expected the recession to last for 15 years.

Companies therefore entered the recession drawing down these reserves to look after

their employees. Despite the severe economic deterioration triggered by the bubble�s

collapse, Japan�s unemployment rate increased only gradually, rising from 2.0% at the

peak of the bubble to only 3.5% in December 1997 (both figures seasonally adjusted).

Although this situation collapsed in 1997 when then-Prime Minister Hashimoto embarkedon a program of fiscal consolidation, triggering five consecutive quarters of negative

growth, it continued for a full seven years after the bubble burst.

This made it possible to sustain employment levels, thereby helping the companies by

bolstering final demand.

* In US, jobs were lost while companies remained cash-rich

In the US, in contrast, the expectation from the outset was that the recession would be

prolonged, and as a result companies quickly slashed staff levels, sending the

unemployment rate above 10%. Businesses remained cash-rich, but final demand fell

sharply as jobs were lost.

In that sense, the argument that the US is better positioned than Japan because itscorporate sector is awash in cash needs to be taken with a grain of salt. When the

household sector and final demand are as weak as the corporate sector is strong, we

can hardly say that the overall economy is doing well.

Although US companies are in fact cash-rich, weak final demand means they have few

investment opportunities, and as a result many are said to be considering repurchasing

more of their own shares.

The situation faced by the corporate sector in Japan 20 years ago and the US today is

therefore utterly different. I think it is rather short-sighted to focus exclusively on the

positive aspects of the US (corporate) situation and conclude that the US economy today

is better positioned than the Japanese economy was 20 years ago.

* Companies are reorienting balance sheets for period of low growth

A second point we need to keep in mind is that the healthy state of US corporate balance

sheets today is no guarantee they will not attempt to deleverage.

If it becomes clear that the kind of high growth seen before the bubble burst can no

longer be expected, even companies with strong balance sheets will need to reduce

leverage to levels commensurate with a more slowly growing economy.

I suspect that many of the Japanese companies that spent the 1990s paying down debt

had another motive in addition to the repair of balance sheets driven underwater by the

bubble collapse�namely, the need to reduce leverage to levels more appropriate to a

future characterized by subdued growth.

It would therefore come as no surprise if US businesses, convinced that high pre-bubble

growth rates were a thing of the past, moved to reduce leverage and position themselves

for more gradual economic expansion.



15 March 2011

Nomura Research 4

* No need for US banks to rush bad loan write-offs

Considering the corporate, financial and household sectors separately is also

questionable, in my view. What is important is the state of the private sector as a whole.

If the private sector�whether households or businesses�continues to deleverage, a

deflationary gap will form.

This point is closely related to the issue of bad loan write-offs. When borrowers�

whether businesses or individuals�file for bankruptcy, the borrower may be released

from the debt, but the problem is passed on to the lender (generally a financial

institution). The resulting write-offs can sap the strength of banks, reducing their

willingness to extend new loans and causing the flow of money in the economy to stop.

Naturally, when the broader economy is sound and bad loans are concentrated in a

small area, rushing the disposals is unlikely to damage the economy as a whole. But in a

situation like the current one, in which much of the economy faces the same problem

and there is a shortage of buyers for distressed assets, panic sales of bad loans can

lead to further declines in asset prices, causing conditions to worsen. Under such

circumstances the only option is to dispose of these loans gradually.

Many in the West remain convinced that faster disposals of bad loans will translate into

an earlier recovery for the US compared with Japan. But the reason why Japan was

forced to go slowly in its loan write-offs was that the problem was simply too large in

scale and affected too many institutions simultaneously.

Former Fed Chairman Paul Volcker, who also experienced this type of systemic financial

crisis in 1982 Latin America debt crisis, wrote in the 23 June 2001 edition of Shukan

Toyo Keizai magazine that the Japanese authorities should institute �speed limits� on

bad loan disposals by the private sector.

Even the US authorities, despite insisting initially that they would rush ahead with bad

loan write-offs, adopted a policy of �pretend and extend� for commercial real estate in

October 2009 that was essentially identical to the approach chosen by Japan a decade

earlier.

This decision signaled an understanding that write-offs have to proceed gradually when

the problem is this large.

* Past lessons have not been passed down to US authorities

The US policymakers I spoke with on this trip listened with great interest when I spoke

about Mr. Volcker�s recommendation of �speed limits� and my own experience working

under Mr. Volcker at the New York Fed during the Latin American debt crisis. They also

asked a variety of questions.

I find this worrying inasmuch as it suggests that the experiences of the US in 1982 have

not been passed down to the current generation of policymakers. If that is the case, it is

entirely possible that this lack of institutional memory was at least partly responsible for

the disaster called the Lehman Shock.

In any case, I think we should welcome the fact that senior US authorities understand

that write-offs must not be rushed when the problem is this extensive.

* Recovery in real private loan demand necessary before economy can emerge

from balance sheet recession

These policymakers also asked what kinds of indicators would signal an end to the

balance sheet recession. Specifically, they wanted to know what conditions were

required before the government could safely embark on fiscal consolidation.

I answered that such efforts must wait until private loan demand in the true sense has

recovered. Many companies hoarded money out of a desire to keep plenty of cash on



15 March 2011

5 Nomura Research

hand, and these funds were effectively stockpiled as financial assets. As such, their

borrowing does not represent real loan demand.

In the second half of 2009, the corporate bond market gradually resumed functions that

had been lost in the wake of Lehman Brothers� collapse the year before. Businesses in

Europe and the US raced to issue long-term debt. But instead of investing the proceeds,

companies simply stockpiled them because they were considered bank financing to

remain unreliable.

Funds procured through such borrowing were ultimately reinvested in the financial

markets and never flowed into the real economy.

Fiscal consolidation will succeed without any decline in GDP if the private sector is able

and willing to quickly borrow and spend the money no longer being borrowed by the

government. But for that to happen the private sector must actually take the money it

borrows and put it to use in the real economy.

From that perspective, the fact that private loan demand in Europe and the US remains

so weak despite historically low interest rates is a danger sign. I told US policymakers itwas a clear signal that now is not the right time for fiscal consolidation.

* Authorities� lack of explanation of balance sheet recession led to midterm election

results in 2010

While the authorities I spoke with expressed understanding of my point regarding loan

demand, they were also disturbed by calls for fiscal consolidation in last November�s

midterm congressional elections.

I replied that the fact that the private sector is paying down debt despite zero interest

rates is a sign that businesses and households are weakened and suffering from a

serious economic malaise. I also said the government needs to do more to communicate

this to the public.

Proponents of fiscal consolidation base their arguments on the fundamental assumption

that the private sector is healthy and forward-looking in its behavior. That, however, is not

the case today. In fact, the private sector is so weak it is paying down debt in spite of zero

interest rates. I recommended that they emphasize this point in their communications.

I also argued that one reason for the Democratic Party�s losses in last year�s elections

was the fact that the Obama administration, despite administering the proper treatment

for this economic disease, had neglected to tell the patient the nature of the disease.

It is as if a medical doctor had correctly treated a patient for pneumonia but had told the

patient she was suffering from a common cold. When the patient received the bill for the

treatment (which translates to fiscal deficits in this analogy), she would naturally be angry

at seeing the high cost of being treated for a common cold.

While repeatedly saying it will require a great deal of time and effort to heal the economy,

the Obama administration has failed to explain even once why such actions are necessary.

Without such an explanation, the administration�s efforts are bound to be unconvincing.

That is why the midterm elections turned out as they did: the doctor allowed the patient

to think she had a common cold but then sent her a bill for a costly (but necessary)

treatment. Her reaction was predictable: �There was no need for such expensive

treatment; now it�s time for fiscal consolidation.�

The authorities listened closely to what I had to say, and to that extent I felt our

discussions were meaningful.



15 March 2011

Nomura Research 6

* Private sector deleveraging may be more extensive than reported

The White House official told me they closely follow the household savings rate. The

recent stabilization of the savings rate at a historically normal level has led them to

conclude that balance sheet adjustments in the household sector would not weigh on the

economy.

I replied that any further negative impact on the economy would likely be avoided if the

savings rate stabilizes at around 5% of GDP. But I also pointed out, as I did in a previous

report, that US flow-of-funds data for the last two years are deeply flawed and noted the

possibility that private-sector deleveraging is actually much more extensive than

commonly reported.

Specifically, the increase in �private sector� savings since the bubble collapsed amounts

to 8.3% of GDP according to flow-of-funds data (household sector + corporate sector),

which is not a particularly alarming amount. But if we define the private sector as zero

minus the sum of general government and the rest of the world, the figure rises to more

than 13% of GDP, which would indicate a massive and sustained increase in savings

(see the 14 December 2010 issue of this report for a detailed discussion of this point).

Both methods should produce the same number for private savings if the flow of funds

data are correct. Unfortunately, the data are not perfect. When I recommended that

policy should be decided based on the assumption that the increase in private-sector

savings could be as high as 13% of GDP, I was told they would take it under

consideration.

* Private financial institutions entirely dependent on agency ratings

I also argued that during a balance sheet recession, when fiscal stimulus is essential,

rating agency attempts to assess fiscal policy based solely on orthodox yardsticks will

naturally lead to downgrades for countries running large and continuous fiscal deficits.

But such downgrades make it even more difficult for authorities to pursue the right

policies.

The Fed official�s response did not inspire a great deal of confidence: he said that they

had tried to deal with the problem of the rating agencies themselves, but that their efforts

had ended in failure. Even Fed Chairman Ben Bernanke has stated in congressional

testimony that it does not make sense for professional investors to rely on the rating

agencies.

However, another senior official I spoke with recently told me that a proposal to reform

the rating agencies had been circulating within the US government, but was rejected due

to opposition from the private sector.

In other words, eliminating the rating agencies� raison d�être would force private investorsto carry out their own credit research, and some private financial institutions were

strongly opposed to this.

If true, this is pathetic. It suggests that in the US financial industry, which boasts of

having the smartest people and the highest salaries in the world, many people are

unable to allocate credit without having their hands held by the rating agencies.

On the other hand, some argue that rating agencies play a useful role because

information is difficult to collect but easy to disseminate. The big assumption here, of

course, is that the agencies are capable of conducting accurate analyses of the economy

and individual companies.

In any event, I was reassured that the key Administration and Fed officials not onlyunderstand the concept of balance sheet recessions but they are actually using it as a

framework in which to consider the US economic outlook.



15 March 2011

7 Nomura Research

Both of the Fed and White House officials I spoke with on this trip had read my book, and

one of them went so far as to point it out on his bookshelf and emphasize that he had

actually read it.

* Enhancing public understanding of balance sheet recessions

I was extremely pleased that the message I had been trying to communicate for 15 years

was finally gaining acceptance, but two new issues were raised.

One is the question of how to achieve better understanding of this concept among the

general public in the US. Even if policymaking officials grasp it, a lack of understanding

among the general public can lead to disastrous election results, as noted above.

Complicating the problem is the fact that balance sheet recessions are not discussed in

any business or economics text, which means time is needed to explain it. I myself have

been trying to communicate this message in Japan for the last 15 years, yet outside

financial and economic circles it has failed to gain general acceptance.

One of the reasons for this is that the theory has yet to gain much of a foothold among

academic economists. On my recent trip I gave speeches at the University of Zurich and

my alma mater, Johns Hopkins University. Students at both schools were extremely

interested in what I had to say, but the professors, whose minds are steeped in orthodox

neoclassical economics, remain unable to accept or understand the reality that balance

sheet problems can sometimes prompt private-sector agents to try to minimize debt

instead of maximizing profit.

* Impossible to know in advance how much fiscal stimulus will be required

Another issue is that even when policymakers understand the economy is in a balance

sheet recession, it is quite difficult to know in advance just how much fiscal stimulus is

needed to treat the disease. This is because what constitutes a �clean� balance sheet

can only be known when a person or business stops paying down debt. It is difficult to

observe because people facing balance sheet problems are reluctant to discuss the

issue with outsiders until their balance sheets are repaired. The question then is how

policymakers are to gain a good grasp of these problems.

One thing that can be said is that the social costs of overshooting with fiscal stimulus are

far less than the costs of undershooting.

Overshooting is analogous to keeping a cast on a bone fracture even after it has already

healed, whereas undershooting is akin to taking the cast off when the bone has yet to

heal. In other words, undershooting is far more dangerous than overshooting.

The correct response when it is impossible to identify in advance the size of the

deflationary gap is therefore to engage in more fiscal stimulus rather than less. But as

Japan�s example makes clear, that is easier said than done. Both the general election in

the UK last year and the midterm congressional elections in the US underlined the fact

that this difficulty is not limited to Japan. Japan adopted a piecemeal approach to fiscal

stimulus which frequently ended up �too little and too late� and as a result the recession

lasted far longer than was necessary.

Still, the fact that key Obama administration officials are considering the possibility of a

balance sheet recession in the US is a sign that Japan�s experience is finally being put to

use. And to that extent, I think US policies are less likely to undershoot.

Richard Koo�s next article is scheduled for release on 29 March 2011.



8

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