Of Interest


Thursday, January 5, 2012

A Global balance sheet recession:

The government of Japan owes creditors something like a quadrillion yen, and public debt has ballooned over the past two decades to 200% of gross domestic product.
Horrible policy, right?
Actually, Japan got a “tremendous bargain,” contends Nomura Research Institute economist Richard Koo in a new paper.
Mr. Koo, long a deficit dove, has sharpened his arguments recently and drawn a following among economists in the U.S. and Europe trying to understand the economy after the 2008 Lehman shock.

He says Japan faced a “balance sheet recession” after its real-estate and stock bubble burst in 1990, as companies and families tried to pare their debt. The country, he says, was at risk of falling into a deflationary spiral, in which the efforts to save money drive down demand, cause wages and prices to fall and make it all the harder to reduce debt.

But Japan “managed to avoid a depression,” Mr. Koo writes, because of huge government spending. Government debt rose by Y460 trillion during the 1990-2005 period, allowing Japan’s GDP to chug ahead slowly instead of contracting at a double-digit pace as the U.S. did during the Great Depression, he calculates.
Over the 15-year period, GDP was some Y2,000 trillion—or, if you prefer, two quadrillion yen—higher than it would have been without all that government stimulus, “making it a tremendous bargain,” says Mr. Koo.

 Significance of Japanese experience
Japan faced a balance sheet recession following the bursting of its bubble in 1990 as commercial real estate prices fell 87 percent nationwide. The resulting loss of national wealth in shares and real estate alone was equivalent to three years of 1989 GDP. In comparison, the U.S. lost national wealth equivalent to one year of 1929 GDP during the Great Depression. Japan’s corporate sector responded by shifting from its traditional role as a large borrower of funds to a massive re-payer of debt, as shown in Exhibit 5. The net debt repayment of the corporate sector increased to more than 6 percent of GDP a year. And this was on top of household savings of over 4 percent of GDP a year, all with interest rates at zero. In other words, Japan could have lost 10 percent of GDP every year, just as the US did during the Great Depression.
Japan managed to avoid a depression, however, because the government borrowed and spent the aforementioned $100 every year, thereby keeping the economy’s expenditures at $1,000 ($900 in household spending plus $100 in government spending). In spite of a massive loss of wealth and private sector deleveraging reaching over 10 percent of GDP per year, Japan managed to keep its GDP above the bubble peak throughout the post-1990 era (Exhibit 6), and the unemployment rate never climbed above 5.5 percent.
This government action maintained incomes in the private sector and allowed businesses and households to pay down debt. By 2005 the private sector had completed its balance sheet repairs.
Although this fiscal action increased government debt by 460 trillion yen or 92 percent of GDP during the 1990–2005 period, the amount of GDP preserved by fiscal action compared with a depression scenario was far greater. For example, if we assume, rather optimistically, that without government action Japanese GDP would have returned to the pre-bubble level of 1985, the difference between this hypothetical GDP and actual GDP would be over 2,000 trillion yen for the 15-year period. In other words, Japan spent 460 trillion yen to buy 2,000 trillion yen of GDP, making it a tremendous bargain. And because the private sector was deleveraging, the government’s fiscal actions did not lead to crowding out, inflation, or skyrocketing interest rates.

“Exit problem” in balance sheet recessions
The long time required for the economy to pull out of a balance sheet recession means the private sector must spend many painful years paying down debt. That in turn brings about a debt “trauma” of sorts in which the private sector refuses to borrow money even after its balance sheet is fully repaired. This trauma may take years if not decades to overcome. But until the private sector is both willing and able to borrow again, the economy will be operating at less than full potential and may require continued fiscal support from the government to stay afloat. Overcoming this trauma may be called the “exit problem.”
In Japan, where the private sector has grown extremely averse to borrowing after its bitter experience of paying down debt from 1990 to 2005, businesses are not borrowing money in spite of willing lenders and the lowest interest rates in human history. As a result, the 10-year government bond is yielding only around 1 percent even though government debt amounts to nearly 200 percent of GDP.
Exhibit (A). Exit Problem: U.S. Took 30 Years to Normalize Interest Rates after 1929 because of Aversion to Borrowing

 After the U.S. private sector’s devastating experience of paying down debt during the Great Depression, the same aversion to borrowing kept interest rates unusually low for a full thirty years, until 1959 (Exhibit A). The fact that it took the U.S. three decades to bring interest rates back up to 4 percent even with massive fiscal stimuli in the form of the New Deal and World War II suggests the severity of the trauma. Indeed many of those Americans forced to pay down debt during the Depression never borrowed again.
The experiences of post-1929 US and post-1990 Japan suggest that interest rates will remain low for a very long time even after private sector balance sheets are repaired. The governments of countries facing exit problems should therefore introduce incentives for businesses to borrow. Such incentives, which may include investment tax credits and accelerated depreciation allowances, should be exceptionally generous in order to attract private sector attention. The sooner the trauma is overcome, the sooner the government can embark on fiscal consolidation. The generosity will more than pay for itself once the private sector trauma is overcome.

Ending panic was the easy part; rebuilding balance sheets is the hard part
A distinction should also be drawn between balance sheet recessions and financial crises, since both are present in the post-Lehman debacle. The former is a borrower’s phenomenon, while the latter is a lender’s phenomenon. This distinction is important because the economic “recovery” starting in 2009 has been largely limited to a recovery from the policy mistake of allowing Lehman Brothers to fail. The collapse of Lehman sparked a global financial crisis that weakened the economy far more severely and rapidly than what would have been suggested by balance sheet problems alone.
Unlike balance sheet recessions, in which monetary policy is largely impotent, financial crises can and must be addressed by the monetary authorities. Available tools include liquidity infusions, capital injections, explicit and implicit guarantees, lower interest rates and asset purchases. According to IMF figures, the Federal Reserve, together with governments and central banks around the world, injected some $8.9 trillion in liquidity and guarantees for this purpose in the wake of the Lehman shock.
The Lehman panic was caused by the government’s decision not to safeguard the liabilities of a major financial institution when so many institutions had similar problems. Consequently, the panic dissipated when the authorities moved to safeguard those liabilities. That was the “recovery” observed in some quarters since the spring of 2009.
Although the panic has subsided, all the balance sheet problems that existed before the Lehman failure are still in place. If anything, the continuous fall in house prices since then has exacerbated these problems. Balance sheet problems are likely to slow down the recovery or derail it altogether unless the government moves to offset the deflationary pressure coming from private sector deleveraging. In other words, the recovery so far was the easy part ((B) in Exhibit 16). The hard work of repairing millions of impaired private sector balance sheets is just beginning ((A) in Exhibit 1).

 Recovery from Lehman Shock Is NOT Recovery from Balance Sheet Recession

It is laudable for policy makers to shun fiscal profligacy and aim for self-reliance on the part of the private sector. But every several decades, the private sector loses its self-control in a bubble and sustains heavy financial injuries when the bubble bursts. That forces the private sector to pay down debt in spite of zero interest rates, triggering a deflationary spiral. At such times and at such times only, the government must borrow and spend the private sector’s excess savings, not only because monetary policy is impotent at such times but also because the government cannot tell the private sector not to repair its balance sheet.
Although anyone can push for fiscal consolidation in the form of higher taxes and lower spending, whether such efforts actually succeed in reducing the budget deficit is another matter entirely. When the private sector is both willing and able to borrow money, fiscal consolidation efforts by the government will lead to a smaller deficit and higher growth as resources are released to the more efficient private sector. But when the financial health of the private sector is so impaired that it is forced to deleverage even with interest rates at zero, a premature withdrawal of fiscal stimulus will both increase the deficit and weaken the economy. Key differences between the textbook world and the world of balance sheet recessions are summarized in Exhibit 2. 

With massive private sector deleveraging continuing in the U.S. and in many other countries in spite of historically low interest rates, this is no time to embark on fiscal consolidation. Such measures must wait until it is certain the private sector has finished deleveraging and is ready to borrow and spend the savings that would be left un-borrowed by the government under an austerity program.

There will be plenty of time to pay down the accumulated public debt because the next balance sheet recession of this magnitude is likely to be generations away, given that those who learned a bitter lesson in the present episode will not make the same mistake again. The next bubble and balance sheet recession of this magnitude will happen only after we are no longer here to remember them.

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