THE The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession The Holy Grail of Macroeconomics: Lessons from Japan's Great R~cession Richard C. Koo @ WILEY John Wiley & Sons (Asia) Pte. Ltd. Copyright © 2008 by John Wiley & Sons (Asia) Pte. Ltd. Published in 2008 by John Wiley & Sons (Asia) Pte. Ltd. 2 Clementi Loop, #02-01, Singapore 129809 All Rights Reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons (Asia) Pte. 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Printed in Singapore by Saik Wah Press Ltd. 109876543 To my mother AmyKooMa Contents Acknowledgments ix Preface xi Chapter 1 Japan's Recession 1 Chapter 2 Characteristics of Balance Sheet Recessions 39 Chapter 3 The Great Depression was a Balance Sheet Recession 85 Chapter 4 Monetary, Foreign Exchange, and Fiscal Policy During a Balance Sheet Recession 125 Chapter 5 Yin and Yang Economic Cycles and the Holy Grail of Macroeconomics 157 Chapter 6 Pressure of Globalization 185 Chapter 7 Ongoing Bubbles and Balance Sheet Recessions 221 Appendix: Thoughts on Walras and Macroeconomics 253 Index 279 Acknowledgments This book would not have been possible without the help of many people. In particular, clients and employees of Nomura Securities, who made me think deep and hard about the problem of the Japanese economy and what it means for the world were of immense help in shaping my ideas. The fact that they had their money in Japan meant that they never allowed me to go off on a tangent. I have also benefited from countless discussions with Mr. Robert McCauley, a former colleague at the Federal Reserve Bank of New York who is now with the Bank for International Settlements. His extensive review of my manuscript was invaluable. Frequent exchange of ideas with Mr. Shosaku Murayama, who headed the research department of the Bank of Japan until recently and is now the president of Teikoku Seiyaku Co., was also helpfuL Professor Takero Doi of Keio University also helped me understand the latest developments in academia. Any mistakes in the book are, of course, mine and mine alone. In the actual preparation of the book, I benefited greatly from the support provided by Mr. Hiromi Yamaji, executive vice president of Nomura Securities. My secretary, Ms. Yuko Terado, helped me with the preparation of the text of the manuscript. My assistant, n x Acknowledgements Mr. Masaya Sasaki, not only produced the graphs and provided the numerical data but also assisted me in locating professional articles and historical materials that are used here. Their dedicated help is the only reason I was able to write this quasi- academic book while working full-time as the chief economist of Nomura Research Institute. They both worked very long hours in order to get the book out on schedule. I cannot thank them enough for their efforts. I am also grateful to TOYo Keizai, the publisher of the initial Japanese version of this book, and Mr. Chris Green, who not only translated the Japanese original beautifully, but also added valuable nuggets to make the text easier to understand for English-speaking audiences. Finally, I wish to thank my wife, Chyen-Mei, and our children, Jackie and Rickie, for enduring my absence on so many weekends and holidays. I am truly indebted to them. Preface Ben S. Bernanke, the current Federal Reserve chairman and a highly acclaimed academic economist, wrote in 1995 that "to understand the Great Depression is the Holy Grail of macroeconomics," but that "we do not yet have our hands on the Grail by any means." He added that "not only did the Depression give birth to macroeconomics as a distinct field of study, but the experience of the 1930s continues to influence macroeconomists' beliefs, policy recommendations, and research agendas." Indeed, since the publication of Keynes' General Theory in 1936 ushered in the era of macroeconomics, various explanations have been offered for the depression in an endeavor that, in Bernanke's words, "remains a fascinating intellectual challenge." It remains a fascinating challenge, because it has not been explained to this day how things had gotten so bad for so long after the October 1929 stock market crash. With that in mind, I will argue that Japan's "Great Recession" of the past fifteen years, to use Adam Posen's term, has finally given us the clue to understanding how the Great Depression unfolded in the U.S. more than seventy years ago. Although history never exactly repeats itself, I believe that there are sufficient similarities between the two extended downturns to suggest that the forces that weakened the effectiveness of traditional macro policies, and lengthened the recessions were the same in both cases. It also seems that the same negative force has been operating, albeit on a xii The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession much smaller scale, in both the U.S. and German economies after the bursting of the IT bubble in 2000, and again in the U.S. after the subprime crisis that erupted in 2007. To highlight the similarities between the two prolonged recessions that happened in two different countries more than seventy years apart, this book begins by analyzing what happened to the Japanese economy. It starts with the Japanese economy not only because the author lived through the recession, and was an active participant in the policy debate during the past fifteen years, but also because Japan offers a far more comprehensive pool of data to draw from than the Depression-era U.S. Furthermore, understanding why Japan's economy slowed so suddenly in the 1990s after being so powerful until the very end of the 1980s is a fascinating intellectual challenge in its own right. In doing so, I use the "balance sheet recession" concept first presented in English in my earlier book Balance Sheet Recession: Japan's Struggle with Uncharted Economics and its Global Implications (John Wiley & Sons [Asia], 2003). It is a new concept in the sense that unlike neoclassical macro theory, which assumes that private-sector corporations are always maximizing profits, it assumes that some companies may respond to daunting balance-sheet damage by minimizing debt. After explaining the exact mechanism of the extended slowdown in Japan, I move on to see whether the same mechanism was operative in the U.S. seventy years ago. The analysis is then extended to cover the recent episodes, including the U.S. subprime crisis. This book was written with two main objectives and one goaL First, it seeks to analyze the current state of the Japanese economy and the outlook for the future. Chapters 1 and 2 are devoted to this purpose. Although I believe that the ongoing economic recovery in Japan is real, policymakers need to keep a close eye on risks that are highly specific to this type of recovery. My second and far more ambitious objective is to incorporate the legacy of Japan's long recession into the body of macroeconomic theory. Chapters 3 to 5 are devoted to this objective. This section extends and generalizes the balance sheet recession theory, and compares and contrasts it with conventional economic thought. The ultimate goal of this exercise, of course, is to use the lessons learned from the Great Depression and Great Recession in fighting similar economic problems that are brought about by the bursting of asset-price bubbles, especially the U.S. subprime fiasco. [...]... (% of nominal GOP) 10 5 -1 0 " ~ -, (Financial surplus) ~ " i Households Corporate Demand fell by 22% of GOP 7 Corp?rate sector General government (nonfinancial corporations + _ - _ - - - - - - - - - - - _ - - - - - -financial institutions) (Financial deficit) -1 5L -~ ~ M~~~M~M~M~OO~~~M~OO~OO~OOm~OOM~OOW (FY) Note: Figures adjusted for the assumption of debt related to the. .. Structural problems and banking-sector issues cannot explain Japan's long recession Japan's recovery did not happen because structural problems were fixed Much has been said about the causes of Japan's fifteen-year recession Some have attributed it to structural problems or 2 The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession to banking-sector issues; others have argued that improper... because their growth rates were higher, and the value of assets they bought with borrowed funds kept on appreciating before the bursting of the bubble Anyone running a highly leveraged company, however, would have rushed to pay 16 The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession down debt at the slightest sign of economic trouble or collapsing asset prices on the horizon It is the. .. America's Great Depression, as was Japan's Great Recession, was a balance sheet recession triggered by businesses striving to minimize debt As in Japan, the problem lay in a lack of demand for loans in the private sector, and not in a lack of funds supplied by the monetary authorities xiv The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession Chapter 5 brings everything together and... across the country But this was not the case Before 1997, foreign banks needed authorization from the Ministry of Finance for each new branch in Japan This requirement was eliminated as part of the "Big Bang" financial reforms of 1997, making it possible in principle for foreign banks to open 8 The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession branches whenever and wherever they... balance-sheet problems 20 The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession Exhibit 1-6 a A sudden shift in corporate behavior drove post-1990 changes in the Japanese economy (1) Financial Surplus or Deficit by Sector (% of nominal GDP) 15r - (Financial surplus) Households J 10 5 -5 -1 0 Nonfinancial corporations General government (Financial deficit) -1 5L... the peak ~ 80 -5 4 . THE The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession The Holy Grail of Macroeconomics: Lessons from Japan's Great R~cession Richard C. Koo. fifteen-year recession. Some have attributed it to structural problems or 2 The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession to banking-sector issues; others. as when they are most counterproductive. The synthesis of economic theories so obtained may well be the Holy Grail of macroeconomics we have been searching for since the 1930s. The balance