What can we learn from Japan's lost decade? A primer on Koo's "Balance Sheet Recession" theory

Japan's 'lost decade' is a powerful precedent for our current crisis. There are some fundamental linkages between the aftermath of Japan's real-estate bubble in 1987 and the aftermath of the US housing bust. Some similarities, such as prolonged deflation, the liquidity trap, and unconvential monetary policies (ie Quantitative easing) were dealt with in previous topics. My aim is to expand on how both monetary and fiscal policy functioned in Japan, in light of Richard Koo's "Balance Sheet recessions" theory. I will then try to relate the Japanese crisis to our current situation, and whether it entails any policy lessons for us to follow.

The Japanese lost decade began as the real estate Hesei bubble collapsed. This triggered large reductions in commercial real estate prices, but over time it had spread to asset prices in general, and a 1500 trillion yen in wealth has been dissolved as a result.

There is a lot of debate on the nature of policy responses, and whether they could have alleviated the asset price deflation that has been the cornerstone of Japan's problems. Some analysts believe the problem is the Government refusing to liquidate 'Zombie' Banks, banks which hold a lot of Non-performing loans/Toxic assets. These banks created friction in credit markets, and reduced the supply of funding to firms and households.

The real misunderstanding of Japan's problem, in light of this theory, is to assume that the problem of insufficient investment was a by-product of an insolvent or under-capitalised banking system. Richard Koo makes a compelling case that Japan's problem was in fact a borrowers' problem.

Let us begin by looking at the failure of monetary policy:
Note that in normal times, Money Supply growth, High-Powered money growth and growth of domestic credit are roughly aligned. And yet, on the onset of the bubble crash, the 3 rates of growth diverged! What happened was the liquidity trap, a concept explained in my post 'Deflation and the liquidity trap'. The problem is that the linkage between the Central Bank's money-base and the money supply no longer holds. The Quantitative easing policies are put down by Koo as being the greatest ‘non-event’ of monetary policy. The injection of reserves to levels far in excess of the effective money supply is redundant.

Now, one might conclude that the fact that Japanese interest rates were very low, meant Banks had no incentive to lend excess reserves (theory of liquidity preference). However, one must realise that for the money supply to be increased, it requires not only the availability of lenders, but borrowers. This is often over-looked in determining the money supply, as the money creation process is dependent on loan creation. Though there were credit crunches during Japan's lost decade, notably the 'Takaneka shock' in 01-02, Koo makes the case that the decline in borrowing is the reason for stagnating money supply growth.


The above graph gives Koo's reasons for the corporate sector's unwillingness to borrow. He dissects the 'Zombie bank' argument by saying, that if there were a credit crunch, corporate firms would raise funding by issuing corporate bonds, there would be an influx of foreign banks to lend at more competitive rates, and lending rates by the commercial banks would be much higher than the BOJ cash rate. However, as the above graph shows, the opposite happened! This means that corporate firms did not seek alternatives via bond issuance, and lending rates to firms and households dropped over time! Thus a shortage of demand for funds suggests that excess reserves are not going to increasing lending.

More support comes from surveys conducted on banks' willingness to lend. Apart from the two credit crunches, the surveys indicate that where demand for funds existed, it was easy to obtain.

To explain the Japanese lost decade, Koo formulates a systematic approach called 'Balance-Sheet Recession' theory. His theory gives a negative feedback cycle which runs as follows:

i) The Corporate sector has suffered large falls in assets (from the unwinding of the Hesei real estate bubble)

ii) This leads to a situation where assets are less than liabilities, and firms are under in a negative equity position/undercapitalised

iii) Corporate sector begin to deleverage with the intention of shoring up balance sheets, by paying down debt rather than reinvesting cash flow/profits

iv) This reduces demand for funds even at low interest rates, as firms' are more interested in obtaining a net positive equity position. Evidence of this can be found in graph below, which shows both bond issuance and corporate borrowing from banks falling, and even becoming -ve towards the latter stages of the lost decade.


v) There is a consequent leakage from the circular flow equal to household savings+ net corporate debt repayment

vi) this leakge, if unmitigated, will lead to a deflationary gap, in which the reduced money supply growth (due to lack of borrowers), leads to falling income, prices and monetary velocity

vii) The deflation will cause further balance sheet problems, causing more deleveraging, further falls in asset prices, and feeds back to i), unless...

viii) The deflationary spiral above can be circumvented by a combination of increased net exports and government expenditure

ix) The fiscal expenditures required to fill up the deflationary gap is required until the corporate sector regains the ability to leverage and undergo net financial deficits. This can only happen once the corporate sector has paid debt and accumulated assets enough such that firms feel ready to become net borrowers.

How does the fiscal stimulus circumvent the deflationary spiral due to corporate deleveraging? The best way to look at it is that there is a paradox of thrift applying to the corporate sector, in which all firms are simultaneously paying down debt. This excess private sector savings will depress the economy unless mitigated by a reduction in public sector savings- that is, by government deficits. The reason for why such a plausible theory has only come to the surface recently is because of the simplifying assumption of many macroeconomic models, which implicitly assume that firms are always profit maximising. Though this is correct in normal times, in a 'balance-sheet recession', firms enter a mode of 'debt-minimisation' rather than 'profit-maximisation'.

Now that I have explained the underpinnings of Koo's theory, I will begin to trace some finer points, and to see if there are any lessons for our current crisis.

Fiscal policy is required to maintain money supply growth:

Another way of looking at the usefulness of government expenditure is to see it as increasing the money supply- this occurs as the expenditures by government are either financed by selling debt to financial sector- or by selling treasury debt to central bank, which finances purchases by increasing reserves in banks. Both ways there is an increase in the purchases of assets/reserves by banks, which increases the money supply. Given money supply growth is a determinant of inflation, maintaining money supply growth is imperative to prevent a deflationary spiral. Note that if the Government were not such a heavy borrower, the money supply would shrink, and note the indirect linkage- of how reduced money supply constrains the banks to lend to other prospective borrowers. Thus by maintaining money supply growth, it enables loan creation to be made to the private-sector, contrary to the claim that government borrowing always crowds out private-sector borrowing.

The key is accomodative monetary policy, as in a boom economy, government spending is likely to be over-inflationary, and monetary policy will curb excessive money growth by raising interest rates and offsetting fiscal stimulus by reduced private sector investment. However, given that there is an excess supply of loanable funds in Japan's case, the government is not at all putting pressure on the interest rate, as we shall see in the next point.

Dispelling the treasury view: Deficits do NOT raise interest rates under 'depression-like' conditions!

Contrary to the treasury view, there is negative correlation being exhibited between government deficits and interest rates. This is also occuring for the US at present. The reason is simple, interest rates will remain low until private-sector demand for funds picks up. Interest rates are also low because of the fact that government borrowing is propping up the money supply. If there is ever a crowding out effect, by implication there must be inflationary threats and the prospect of interest rate increases. However, we know that Japan suffered a prolonged deflation of around 0 to -1 percent, and so crowding out is never a reality.

Japan's stop-go policy: how premature fiscal consolidation can lead to disaster

In 1997 the Japanese Government put a 30 Trillion yen cap on new government bond issuance. This move towards fiscal retrenchment was induced by strong growth in 1996, and strong growth in tax revenue. This was a fundamental mistake, as at this stage the corporate sector was still in debt-minimisation mode. The intention of achieving fiscal sustainability was good, but it was too early.

From the above graph, you can clearly see that in 97 the deleveraging by corporate sector was far from over. Indeed, it only bottoms in 2005. Another graph shown previously looks at corporate borrowing, which was still negative in 97.

The fact of the matter is that the leakage generated by household savings and corporate net debt repayment exceeds the cap on new government bond issuance! This means the fiscal retrenchment led to a deflationary gap and a negative multiplier effect of falling income, falling tax revenue and an increasing deficit!

Combined with a credit crunch in 97, it forced the government to issue a new fiscal stimulus in 98, of 16 trillion yen. The below graph shows that the infamous 'stop-go' policy of the Japanese resulted in reduced tax revenue and increased deficits. This shows clearly that the timing of fiscal consolidation is important, and it should coincide with a healthy return of private-sector investment.

How Japan recovered- through net exports rather than a surge in private sector investment

The above graph from Krugman shows the division of growth for Japanese GDP from 2003 to 2007. Given that consumption growth was at trend, one can argue that net exports is the main determinant of Japan's recovery. This is worrying for the current crisis, because of its synchronised nature. The IMF believe that an export-led recovery is effective for a localised recession, however given the globally synchronised nature of the current crisis, it is hard to have an export-led recovery. This means that more of the leakage generated by lack of demand for funds must be mitigated by government spending, and makes more of a case for fiscal stimulus.

How to prevent future bubbles?

I have often felt that the main problem with inflation-targeting is that it often over-looks asset price bubbles. This is well known in the literature on monetary policy, however it is unfortunate that the main exponent of monetary policy, Alan Greenspan, advocated a 'clean up the mess' approach. This approach has worked in the past, to deal with the dot-com bubble, for example, however in this case the contamination of the housing bubble is testament to the danger of under-estimating asset-price inflation. The underlying problem is that many of these asset-price bubbles can occur during a period of stable inflation, money growth and monetary velocity. For example, one can see monetary velocity as quite stable prior to the crash of 1929 and Hesei crash. Why can stable consumer prices and rampant asset prices co-exist?

Koo says the main difference is that the asset prices often reflect an increase in 'deposit turnover' or churning. This occurs from a large velocity (rate of trading) of an asset, which tends to bid upward the prices of these assets (in the case of the current crisis, there would have been much churning from the securitisation of MBS securities, which raised their price and encouraged more lending in the mortgage market). Despite wealth effects generated from asset prices transferring to the rest of the economy, the fact that the 'churning' is localised means there is little pass-through to general prices in the economy.

The real problem is whether a central bank, in seeing the increase in deposit turnover- and various other measures supporting the notion of an existent bubble-can increase interest rates despite stable inflation. This trade-off between short-term and long-term deviations in inflation is tough, simply because you do not know if an asset price bubble will collapse or not. What makes it scarier is that interest rate increases to curb a bubble may actually 'prick' it, by causing asset prices to peak it may begin to fall rapidly. These problems must be addressed in the future, but I think financial regulators are in the best position to curb asset price bubbles, as they can enforce capital ratios and have more flexibility to deal with such situations. Central banking is a blunt instrument, too general in terms of its focus, and may not be enough to hinder destabilising speculation.