Nomura R.Koo 2012-02-21

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Richard Koo

EQUITY RESEARCH

.

Real meaning of monetaryaccommodation in Japan andUS

February 21, 2012

Global stock prices received a boost over the last two weeks in the form of favorable

economic data from the US and falling yields on Spanish and Italian debt.

Japanese equities were late to join the party but finally responded to the BOJ’s

announcement of further monetary easing and a weaker yen.

Meanwhile, the response to the problems in Greece continues to stumble, with someEuropean officials now hinting that the region might be better off with a Greek default.

US house prices remain in a deep slump, and Fed chairman Ben Bernanke warned in

a speech on 10 February that the housing market had fallen into a vicious cycle.

Why Fed extended ultra-low interest rates through end-2014

Mr. Bernanke’s speech (“Housing Markets in Transition,”

http://www.federalreserve.gov/newsevents/speech/bernanke20110210a.htm) was

delivered at a meeting of the National Association of Homebuilders and gives a good

indication of how the Fed views the US housing market.

I found the speech extremely interesting because it casts light on the question of why

the FOMC pledged to keep interest rates at exceptionally low levels through the end of

2014.

On the subject of housing market supply and demand, Mr. Bernanke noted there are

currently 1.75mn empty homes in the US, compared with a more typical figure of

1.25mn units, and said the excess supply is weighing on the market.

He also said an average of 2mn units a year had entered the foreclosure process in

each of the last few years and that this form of housing supply was expected to

continue.

On the demand front, the Fed chairman noted that household formation had declined

especially for young adults. This was probably because the recession left young

graduates unable to find work and forced them to continue living with their parents.

He also said the high unemployment rate and job market uncertainty left many new

families hesitant to buy a home.

Housing myth’s collapse strips away investment appeal

Other factors cited by the chairman as weighing on demand include the continued

difficulty of obtaining a home loan and the fact that housing has lost much of its appeal

as an investment.

Analysis conducted by the Fed suggests that while US house prices have fallen about

30% in nominal terms from the peak, the real decline is closer to 40%—not because

the US is experiencing deflation but rather because other prices have risen modestly in

the meantime.

Richard Koo is chief economist at

Nomura Research Institute. This is his personal view.

Richard [email protected]

To receive this publication, pleasecontact your local Nomurarepresentative.

See Appendix A-1 for importantdisclosures. Analysts employed

by non US affiliates are notregistered or qualified asresearch analysts with FINRA inhe US.

Japanese version published onFebruary 20, 2012

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Nomura | JPN Richard Koo February 21, 2012

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An effective 40% fall in house prices after 70 years of steady increases exploded the myth that houses were always a good

investment—much as Japan’s land myth collapsed in the 1990s—and prompted those who were buying in anticipation of

speculative demand to leave the market.

Until 2007 in the US (and until 1990 in Japan), home buyers were encouraged by the belief that prices would always go higher

no matter how much they paid. As long as this myth persisted, houses were considered a safe asset as attractive as—if not

more attractive than—bank deposits.

But the collapse of this view after 70 years and an effective decline in prices of almost 40% prompted homebuyers to become

much more cautious. Like their Japanese counterparts in the 1990s, they began using a very different yardstick to examine

potential purchases.

Demand plummeted as a result, and US housing starts have averaged less than 500,000 units a year since 2009 after a 15-

year period when they never once slipped below 1mn units.

More than half of homeowners’ equity has vanished

Mr. Bernanke also said the drop in house prices has caused more than half of homeowners’ equity to disappear, with losses

amounting to $7trn.

He estimated that some 12mn homeowners—representing one in five mortgages—are now underwater as a result.

The Fed chairman cited several studies estimating that a $100 drop in housing value depresses annual consumption by $3 to

$5 and concluded that the fall in house prices thus far had reduced private consumption by $200bn to $375bn.

Reaction to excessive mortgage securitization

From a financial perspective, the outstanding value of home mortgages has fallen 13% from the 2007 peak in response to a risein defaults, a decline in new purchases, and banks’ unwillingness to lend. Regarding the final factor, Mr. Bernanke argued the

current credit crunch is attributable in some measure to past excesses in the securitization of home mortgages.

The GSEs (government sponsored entities like Fannie Mae and Freddie Mac) demand insurance when purchasing home

mortgages from financial institutions for securitization purposes, but the sharp increase in defaults over the last few years has

left many of the providers of this insurance struggling to survive.

The surviving insurers have become far more cautious as a result, and that has forced banks to become more cautious as well,

since uninsured home mortgages cannot be sold to the GSEs.

GSEs and FHA only functioning cogs in US mortgage market

A second issue is that the dramatic increase in defaults has prompted the GSEs and other investors who purchased these loans

to seek restitution from the originating banks.

This is a reaction to the excessive availability of credit and securitization of home loans in the past, and the securitization marketis unlikely to revive until the extent of legal liability at the originating banks is clarified.

New home mortgage securitizations by private entities remain extremely rare. The GSEs and the Federal Housing

Administration are essentially the only players still active in the securitization market.

The issues of mortgage insurance availability and the legal responsibility of loan originators need to be resolved if this market is

to regain its earlier vitality. Even if these questions are resolved, I do not think we will ever again see home loans being offered

with the same kind of perfunctory credit checks witnessed during the housing boom.

End to US housing myth could have greater impact than in Japan

The issues facing the US housing market are numerous, ranging from the breakdown of the housing myth to the need to rebuild

a securitization infrastructure. In a sense, I think the US may be worse off than Japan.

The US economy, after all, is far more dependent on the housing market than Japan’s ever was, with a slump in the housing

market having a correspondingly large impact on the broader economy. Housing was reportedly responsible for most of the

growth in the US economy in the five years leading up to the market peak in 2007.

The externalities in the US housing market are also far larger than those in Japan, where no one would expect a foreclosed

home to reduce the value of other properties in the neighborhood.

The asset value of US housing, meanwhile, is influenced by the surrounding environment as well as the house itself. Neighbors

often complain if a resident lets the grass in his lawn grow a bit longer than usual. As many foreclosed homes are a mess both

inside and outside, the appearance of even one in a neighborhood can lower the value of nearby homes.

Extension of ultra-low rates reflects time needed to resolve problems

Mr. Bernanke said that 1mn foreclosed properties could be added to the housing supply in each of the next few years.

Such properties are referred to in the industry as real estate owned, or REO. The Fed chairman said houses currently in

foreclosure are more than four times as numerous as the entire existing inventory of REO.

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The Fed also estimates that only half the REO properties owned by the GSEs have been put on the market. That alone has led

to heavy downward pressure on prices, and conditions are likely to grow far worse if the entire REO inventory is put up for sale.

These numbers suggest a great deal of time will be needed for the US housing market to turn around. I think that is the primary

reason behind the FOMC’s pledge to keep interest rates at exceptionally low levels at least through late 2014.

REO properties weighing on house prices

Mr. Bernanke said in his speech that the supply of REO properties would likely exert continued downward pressure on house

prices, and house prices are in fact falling.

Sustained declines in house prices make adjustments that much more difficult and further postpone the eventual recovery by

aggravating private-sector balance sheet problems.

In Japan, it was not until asset prices finally bottomed in 2003–04 that people were able to adopt a forward-thinking mindset

once again. As long as asset prices are falling, people are unable to determine how bad their own balance sheet problems are

and therefore become increasingly cautious. A reliable bottom in asset prices enables them to calculate how many years it will

take to clean up their balance sheets.

Bernanke realizes balance sheet adjustments will take time

In a separate speech, the Fed chairman recently compared and contrasted Japan and the US, noting that Japan had been

forced to take a trial-and-error approach to its crisis because there was no precedent at the time, but that the US is able to apply

the lessons learned by Japan. The Fed’s decision to take seriously the issue of private-sector balance sheet adjustments and

extend exceptionally low rates until the end of 2014 is an excellent example.

Ten years ago Mr. Bernanke singled out the BOJ for criticism, arguing Japan’s economy would improve immediately if only the

Bank had the courage to undertake quick, bold monetary accommodation. Since 2008 the Fed has faced the same problem as

the BOJ did and has responded with quick, bold easing, but thus far has very little to show for it.

The end of 2014 will mark a full eight years from the peak of the US property bubble in 2007. In effect, the Fed has

acknowledged that any recovery will take time when the private sector faces balance sheet problems and that bold monetary

easing alone will not be enough to resolve the problem.

Ordinary consumers may not be as pessimistic as financial sector

Conditions in the US economy have improved substantially, as reflected in jobs growth and a falling unemployment rate.

Purchases of automobiles and other durable goods requiring a certain degree of confidence on the part of consumers regarding

the future have also increased.

I attribute the newfound strength in consumption to two main factors: (1) excessively pessimistic expectations among the

financial sector analysts responsible for compiling market forecasts and (2) a release of pent-up demand that has been building

since the bubble collapsed four years ago.

Regarding the first, the financial sector has become extremely cautious after experiencing first the Lehman-triggered financial

crisis and now the sovereign debt problems in the eurozone, which have the potential to develop into a crisis of similar

magnitude to the Lehman shock if not properly addressed.

But for ordinary Americans the problems in the eurozone across the ocean may seem largely immaterial. Many find it difficult to

grasp the significance of the events unfolding in Europe— partly because of the distance and complexities involved—and that

may be one reason why they were less pessimistic than financial sector analysts.

“Ignorance is bliss” not a sustainable basis for recovery

This may be a variation on the old saw that “ignorance is bliss.” It may also be that people are finally starting to make the

durable goods purchases they have been putting off since the bubble burst four years ago.

The recent stabilization of the economy may have also prompted some workers to resume taking out loans based on the belief

that their jobs are safe for now. And US consumer credit is in fact increasing.

All of this is welcome news; the question is whether it is sustainable. Recent jobs growth is a major positive in that it boosts

incomes, but it continues to be offset by the aforementioned slide in house prices.

As the Fed chairman noted in his recent speech, US economic recoveries have historically been supported by a rebound in

housing construction. With no such revival in sight, I suspect the US economy will continue flying on a single engine.

The strong economic data may continue until the surge in pent-up demand winds down, but the slowdown in China and other

overseas economies means any recovery is likely to be gradual at best.

Is acceptance of Greek default real or a bluff?

As yields on Italian and Spanish debt have fallen, some senior eurozone officials have had a change of heart and are starting to

say it would be better to let Greece default than to exert further effort in an attempt to prevent that outcome.

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Apparently they believe that with yields on Italian and Spanish debt falling, a Greek default is unlikely to trigger a broader

eurozone collapse. This marks a major shift from the view, held until recently, that a Greek default would lead to similar fates for

Italy and Spain.

German finance minister Wolfgang Schäuble is leading this chorus, but he is joined by other senior officials.

Some are taking these statements at face value. Others see them as a bluff designed to prod a recalcitrant Greece into carrying

out needed reforms. Those in the latter camp worry that the eurozone agreement to avert a Greek default at any cost may have

dulled the Greek government’s sense of crisis and dampened its appetite for reform.

Suggesting default is acceptable poses unacceptable risk during systemic crisis

Regardless of the officials’ true intention, I think that such statements are a dangerous mistake under current circumstances and

have the potential to do as much damage as former Treasury Secretary Hank Paulson’s belief that allowing Lehman Brothers to

fail would not bring down the broader financial system.

Such statements and actions may be acceptable during normal times. But in a systemic crisis, where so many borrowers (the

governments of indebted nations) and lenders (eurozone banks) face the same problem at the same time, officials must not risk

allowing the contagion to spread by voicing such views, even if the probability seems remote.

When I worked at the New York Fed, there was something called the “one foreign branch rule.” The understanding was that

banks with even one overseas branch would not be allowed to fail.

The Fed had deemed that doing so posed an unacceptable risk because it was difficult to predict what problems might develop

at the bank’s foreign branches in the event of a failure.

Outlook for Greek default plan should be closely watchedIn the current crisis both government borrowers and the banks that lent to them have shaky credit ratings and are being

supported only by the ECB’s decision to supply three-year funds at low cost and in unlimited quantity.

Nor are the problems limited to the financial system. In 2011 Q4 the real economy of Germany and many other eurozone

countries—France bring the one exception—contracted, and further weakness is expected.

Under such circumstances it is dangerous to suggest that a Greek default, which could aggravate the credit crunch and trigger

economic turmoil, is acceptable. It also represents a rejection of the dedicated efforts made by the public and private sectors

and the relationships of trust that have developed in the process.

Mr. Schäuble’s imprudent remarks and policy swings have exacerbated the crisis on numerous occasions in the past, and his

recent comments regarding a Greek default are merely one more such example, in my view.

Fortunately, German chancellor Angela Merkel’s continued insistence that a default is unacceptable has helped reassure the

markets. But further support for a default could lead to renewed turmoil.

BOJ unveils new easing policies

The BOJ recently announced three new accommodative measures. One was the adoption of a “price stability goal in the

medium to long term” calling for a 1% y-y increase in consumer prices.

The second measure was a pledge to continue the de facto zero-interest-rate policy and the purchase of financial assets until

that price goal is “in sight,” and the third was an increase in the size of the Asset Purchase Program to ¥65trn from the current

¥55trn, with the additional amount to be earmarked for the purchase of longer-term JGBs.

Three factors behind new easing measures

I think the BOJ’s announcement of the new policy was driven by three factors: pressure from the government, a desire to

weaken the yen, and the need to respond to the Fed’s new policy framework unveiled on 25 January.

Unlike its LDP predecessors, which realized monetary policy was impotent during a balance sheet recession, the DPJ

administration continues to demonstrate little understanding of such recessions. Much like the LDP of over a decade ago, it

continues to demand the BOJ take measures to combat deflation.

Behind this pressure stand a host of academics and media pundits with a similar lack of understanding. Their view, drawn from

orthodox economics, is that deflation is a monetary phenomenon and that tackling it is the job of the central bank, which

supervises monetary policy.

Academics and media make no attempt to understand economic reality

I can understand politicians’ mounting impatience in the face of an economy that refuses to recover. But I find it exasperating

that the economists whose job it is to understand why the economy has been treading water in spite of nearly two decades of

ultra-low interest rates have not only ignored their responsibility but continue to argue that the BOJ should carry out further

easing. Their single-minded adherence to orthodoxy cast a long shadow over the outlook for Japan’s economy, in my view.

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That these purported leaders of the economic debate have such a poor understanding of the economic reality essentially

precludes any meaningful discussion of the issues. The end result is a further postponement of the economy’s recovery and

revival.

In Japan during the 1990s and in the US and UK since 2007, central banks tripled the amount of liquidity being supplied to the

market, but the money supplies in these countries grew little if at all. This was because the private sector was busy paying down

debt to repair its balance sheet which turned the (private sector) money multiplier negative at the margins.

Fig. 1: Government borrowing supported money supply growth in Japan

Note: "Credit extended to others"= (1) public sector + (2) foreign assets (net) + (3) others. (1) Public Sector = credit to the government (net) + credit to regional public sector bodies + credit to public corporations. (3) Others= (money + quasi-money + CD) - (foreign assets (net) + domestic credit). Therefore, increase or decrease in "Credit extended toothers" will include impact of increase/decrease in public sector debt, increase/decrease in bank debentures issued by private sector banks and deposits of financial institutions,and errors in data.

Source: BOJ's “Monetary Survey”

No money supply growth means no increase in the money available for the private sector to spend, and without more spending

there can be neither an economic recovery nor an acceleration of inflation.

Although Japan has posted a slightly higher money supply growth than either the US or the UK, the BOJ’s Monetary Survey

shows that this growth was due entirely to government borrowing. In other words, the overall (public and private) money

multiplier remained positive only because private-sector banks lent money to the government with their purchases of

government debt (Figure 1).

Had the government not borrowed and spent at a time when the private sector was undertaking balance sheet adjustments, the

money supply would have contracted sharply—as it did in the US during the Great Depression of 1929–33—regardless of how

much liquidity the central bank supplied.

During the Great Depression, then-President Hoover’s refusal to authorize larger fiscal deficits caused the money supply to

shrink by more than 30% in spite of an accommodative Fed, and the US economy entered a severe deflationary phase.

Was BOJ announcement intended to quiet academics and media?

The fact that the size of the government’s fiscal deficit determines the effectiveness of central bank monetary policy during a

balance sheet recession has been completely overlooked by most traditional economists, but not by the Fed chairman.

That is why Mr. Bernanke has been arguing for the past two years that while fiscal consolidation is necessary in the longer run,

it should be avoided in the short term because of its potential to harm the economy.

Given the current absence of private-sector borrowers in Japan, I see no reason why the BOJ’s new policy should have a

significant impact. In fact, I think it may have been intended merely as a means of silencing politicians and ignorant academics.

BOJ has no means of achieving inflation target

As for all the debate over whether this is really an inflation target, I suspect the Bank chose the term “goal” because it does not

have the tools needed to achieve a target. Higher inflation requires an increase in the money supply, but that is impossible when

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0

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9 0 9 1 9 2 9 3 94 9 5 9 6 97 9 8 9 9 0 0 0 1 0 2 0 3 0 4 05 0 6 0 7

Credi t extended to others (mostly government) *

Credit extended to the private sector

Money supply (M2+CD)

(% y-y, contr ibution, balance at quarterly-end)

Quantitativeeasing

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the private-sector money multiplier is zero or negative at the margins. It would be highly irresponsible for the central bank to use

the word “target” under such circumstances, as that implies it can be achieved.

I suspect the BOJ’s announcement was heavily influenced by the Fed’s new policy framework unveiled on 25 January, but the

Fed chairman has also stated in no uncertain terms that its 2% inflation goal is only a goal and not a target.

Shirakawa has silver tongue

Finance minister Jun Azumi reportedly remarked that the BOJ’s “goal” is a de facto inflation target. I find this statement

extremely worrying inasmuch as it suggests the minister has no understanding of balance sheet recessions or i ts implications

on the money multiplier.

Regarding this point, BOJ governor Masaaki Shirakawa made a very interesting comment in a speech on 17 February. He cited

those who were calling the Fed’s inflation goal an inflation _target_ and said that if the Fed’s goal can be termed an inflation

target, so can the BOJ’s.

He seemed to be saying that if the definition of inflation target can be widened to include what the BOJ and the Fed call “goal”

and if that was all that was needed to satisfy those demanding an inflation target, he was all in favor.

By watering down the definition of “target” in that way, the BOJ will be able to deflect a possible future criticism that it has not

achieved its target (in the event the new measures have no effect) by saying that it was simply a _goal_.

And of course the BOJ is unlikely to complain if market participants convince themselves that an inflation target was adopted

respond favorably by buying stocks and selling the yen.

That was precisely how the market responded to the BOJ’s announcement, which underscores how many people inside and

outside Japan still do not understand the problem of the money multiplier during balance sheet recessions. Put differently, it canbe said that announcement effect of monetary easing by the Fed or BOJ depends on the number of people who are ignorant of

the money multiplier problem during balance sheet recessions.

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Appendix A-1

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Nomura R.Koo 2012-02-21

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