Balance Sheet Recession

Book by Richard Koo

Article and Review by GlobalMacroForex

This book was written in 2003 – after Japan’s lost decade but before the US subprime crisis.  It offered an excellent diagnosis of the reasons the central bank’s monetary policy had been so ineffective at stimulating Japan’s post-bubble economy.  Mr. Koo argues this was a balance sheet recession, which means that companies should have been focused to pay down debt to improve their underwater balance sheets; lowering the interest rate won’t help. However, while I agree with Mr. Koo’s diagnosis, I disagree with the author’s prescription to fix it, which is an increase in fiscal policy (instead of monetary policy).

Although I disagree with the solutions presented in this book, I highly recommend it for understanding not only of Japan’s economy but of any highly leveraged recessionary bust.

Let’s dive right in…

Balance Sheet Recession

Mr. Koo’s main premise is that Japan was in a balance sheet recession.  In this particular type of recession, non-financial corporations have a high amount of debt and assets that are decreasing in value.  Because of the deflationary nature of this situation, the debt was becoming harder and harder to pay as the yen rose in value.  In addition, the assets were falling in value, so the firms had decreasing owner’s equity.  Mr. Koo argues that non-financial corporations right now (albeit in 2003) are struggling to pay down the debt they already have, so therefore they’re extremely unlikely to take on even more debt

Mr. Koo points to data from the Bank of Japan that shows non-financial corporations have been just paying down debt, not taking on new debt.

Because of this situation, having the central bank lower interest rates is not going to stimulate demand.  The factor holding back non-financial corporations from borrowing isn’t the interest rate. Even if the interest rate were literally zero, it would still make debt grow as the yen rises in value from a deflationary post-bubble economy.

Fiscal Policy

Mr. Koo’s prescription is fiscal stimulus and this book does an excellent job of describing the differences between monetary and fiscal policy.  Monetary policy is when the central bank creates money (i.e., by “electronically printing it”) and then buys Japanese government bonds to lower the interest rates throughout the economy.  Mr. Koo recommends fiscal policy, such as the Ministry of Finance buying non-financial goods in the marketplace with the money from government bond sales.  After this book was written, the Japanese government has actually done similar ideas to what he suggested.

I disagree with Mr. Koo’s prescription of fiscal policy because I don’t share his optimism that the government can allocate resources as effectively as the private sector.  In fact, Japan’s original bubble was because of an overreliance on government direction in allocating resources, so all that fiscal policy would do is temporarily create a fake “feel good” bubble of recovery, which would later have to be reversed.

Mr. Koo argues that the Japanese government’s fiscal deficit wouldn’t crowd out private borrowing because interest rates are so low that the government could fund tasks at a cheaper cost than could the private sector. 

What Mr. Koo overlooks is that the government can’t be as productive as the private sector with that same level of funding, even if it’s funded at a cheaper borrowing rate.  It doesn’t follow that just because rates are low for Japanese government bonds that therefore the government will be good at the businesses they undertake.  This is like saying that just because someone has a cheap margin rate with an equity broker, the individual automatically will be successful in picking investments.  The ability to leverage isn’t itself a predictor of success.

My chart from 10/5/2017 (below) shows Japan has one of the flattest yield curves of the developed nations.

Flat yield curves usually mean investors expect deflation and are bear growth assets.  However, note that Japan’s interest rates are still higher than “actual” safe havens interest rates from countries like Germany or Switzerland.  That shows that even as the Bank of Japan buys massive bonds, the market still doesn’t trust Japan in the long term.

Trade ideas

One idea that emerges from reading the book (one that was not suggested by the author) is to measure how effective monetary policy is based on how much debt banks are taking on in response to changes in the interest rate.  Below is a chart from the author of the 3 month CD rate compared with net borrowings of financial institutions. 

Using the Tankan survey from the Bank of Japan, one could effectively assess a bank’s use or neglect of the BoJ’s decrease in interbank interest rates.  If banks increase debt as the rate goes down, short the yen; if they still won’t lend with a lower rate, go long the yen.

Comparison to 1989 US S&L Crisis

Mr. Koo argues that the approach the US Federal Reserve took to stop the S&L crisis in 1989 should not be used in Japan.   In 1989, Savings and Loan (S&L) banks lent heavily to Latin American governments.  When these loans went sour in bulk, the decline of asset values triggered massive loan losses in American S&Ls.  The Federal Reserve lowered interest rates creating a “fat spread” that guaranteed bank profitability.

Not only did the Federal Reserve give banks a bunch of printed money with the fat spread (at the expense of US taxpayers), but it also coordinated among the banks to not sell the assets so the banks wouldn’t all suffer losses (basically threatening banks with “if you sell, you don’t get printed money”).

Mr. Koo argues that this situation will not work in Japan because in 1989 America only 5% of banking assets were part of the crisis, while in Japan, it’s closer to 95% of total bank assets at about 1,200 trillion yen.  This is roughly equal to 2 ½ years of GDP.  Therefore Richard Koo argues the US Fed’s tactics of strongarming private banks to continue to hold the assets will not work in Japan due to the massive size of the problem.

1997 Asian Crisis

This book also provides some insight into the 1997 Asian crisis, which I’ve discussed in another article.

Richard Koo’s ideas are mostly Keynesian nonsense but it does provide some insight into this crisis because entire Southeast Asian economies are built around a perverse money printing model (see my previous article, the Asian growth model).  So while the concept of an active central bank is horrible for actual prosperity and wealth of the citizens of a country, it is relevant to the immediate market reactions.

Mr. Koo suggests part of the problem was that for years (the mid-late 1980s) the Japanese yen was rising, making it productive to ship manufacturing to other southeastern Asian neighbors, such as Korea, Thailand, Indonesia, and Taiwan.  Once the Japanese lost decade began (in the 1990s), the yen falling no longer gave firms the motivation to ship manufacturing to Japan’s neighbors.  His graph puts a break in the chart for the crisis and reversal or rates:

Koo further argues none of the Western firms that were investing in the 1990s in these southeast Asia, were paying attention to the fact that these currencies were falling relative to the yen, thus losing their export competitiveness to Japanese firms.  While I personally disagree with Keynesianism and the Asian growth model, Koo offers an interesting perspective on the irrationality of the currency bubble.