Lessons from

L f Japan:
J
Fighting a Balance Sheet Recession

Richard C. Koo
Chief Economist
Nomura Research Institute
Tokyoy
May 2010
Exhibit 1. US Housing Prices Are Moving along the Japanese Experience

(U.S.: Jan. 2000=100, Japan: Dec. 1985=100) Futures

260

240 US: 10 Cities Composite Home Price Index

220
Composite
Japan: Tokyo Area Condo Price 1 Index Futures
200

180

160

140 1
Japan: Osaka Area Condo Price

120

100

80

60

40
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 US
77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 Japan
Note: per m 2, 5-month
N h moving
i average
Sources: Bloomberg, Real Estate Economic Institute, Japan, S&P, S&P/Case -Shiller® Home Price Indices, as of Apr. 13 , 2010

1
 Exhibit 2. Drastic Rate Cuts Have Done Little to Revive Economies
or House Prices
(%)
8

Australia
7

UK
6

3 EU

US
2
Japan
1

0
2003 2004 2005 2006 2007 2008 2009 2010

Sources: BOJ, FRB, ECB, BOE and RMB Australia. As of April 13, 2010.

2
Exhibit 3. Bursting of the Housing Bubble Weakened the U.S. Economy
(2002=100, Seasonally adjusted) (%, Seasonally adjusted, inverted)
114 3.5

4.0
112 Unemployment Rate
(
(right scale)) 4.5
110 5.0

Industrial Production 5.5

108
(left scale) 6.0

106 6.5

7.0
104
7.5
102 8.0
Last seen in 2003 8.5
100
9.0

98 9.5
(Unemployment Rate) Last
L seen in
i 1983
10.0
96 (Industrial Production) Last seen in 1998 10.5

94 11.0
98 99 00 01 02 03 04 05 06 07 08 09 10
Sources: U.S. Department of Labor, FRB

3
 Exhibit 4. Bursting of the Housing Bubble Weakened
European Economies
(Seasonally adjusted, 2005=100) (%, Seasonally adjusted, inverted)
115 7.0

Unemployment Rate 7.5

110
(right scale)

8.0
105

8.5

100

90
9.0

95
Last seen in 2000
9.5

90
Industrial Production Last seen in 1998 10.0
(left scale)

85 10.5
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Sources: Eurostat, Bloomberg

4
 Exhibit 5. Japan’s Industrial Production and Employment
also Suffered
(Seasonally adjusted) (Seasonally adjusted, 2005=100)
1.2 115

Industrial production (right scale) forecast 110

11
1.1

105
1.0
100

09
0.9
95

Last seen in 2002

0.8 90

85
0.7

80
Job offers to applicants ratio
0.6 (left scale)
75

0.5
Last seen in 1983 70
Last seen in 1999
Lowest on record
0.4 65
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Sources: Ministry of Economy, Trade and Industry (METI), and Ministry of Health, Labour and Welfare
Note: Forecasts are calculated from METI's survey on planned production.

5
 Exhibit 6. Sharp Fall in Demand for Durables Hurt
Japanese Exporters
U.S. Real Consumption
(03/1Q=100, Seasonally Adjusted)
135

Non-durables "Cash for Clunkers"

130

Durables
125

120

115

110

105

100
Services

95
2003 2004 2005 2006 2007 2008 2009 2010

Sources: U.S. Bureau of Economic Analysis, Bloomberg

6
Exhibit 7. U.S. Demand for Funds Is Falling even with Zero Interest Rates
(D.I.)
30

20 housing
IT bubble
bubble
ll
collapse smallll fi
firms collapse
10

-10

large and middle-market firms

-20
business increasing demand for
f funds
f
compared to 3 months ago
-30
0
-40
business decreasing demand for funds
compared to 3 months ago

-50
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Nomura Research Institute, based on FRB, Senior Loan Officer Opinion Survey on Bank Lending Practices.
Note: D.I. are calculated f rom the answers to the question, "Apart f rom normal seasonal variation, how has demand f or C&I loans
changed over the past three months?"
D.I. = ("Substantially stronger" + "Moderately stronger"×0.5) - ("Moderately weaker"×0.5 + "Substantially weaker")

7
 Exhibit 8. Euro Zone Demand for Funds Is Falling even with
Ultra-Low Interest Rates
(D.I.)
15

Small- and
10 medium-sized firms

-5
Large-sized firms
-10
business increasing demand for funds
compared to 3 months ago
-15
0
-20
business decreasing demand for funds
compared to 3 months ago
-25
2003 2004 2005 2006 2007 2008 2009 2010

Source: Nomura Research Institute, based on ECB, The Euro Area Bank Lending Survey .
ote D.I. are
Note: a e calculated
ca cu ated from
o tthe
eaanswers
s e s to the
t e question,
quest o , "Over
O e tthe
e past tthree
ee months,
o t s, how
o has
as tthe
e de
demand
a d for
o loans
oa s o
or ccred
ed itt
lines to enterprises changed at your bank, apart from normal seasonal fluctuations?"
D.I. = ("Increased considerably" + "Increased somewhat" × 0.5) - ("Decreased somewhat" × 0.5 + "Decreased considerably")

8
 Exhibit 9. Japan’s De-leveraging with Zero Interest Rates
Lasted for 10 Years
(% Nominal GDP, 4Q Moving Average) (%)
25 10
CD 3M rate
20 (right scale) 8

Borrowings from Financial Institutions (left scale)

15 6
Funds raised in Securities Markets (left scale)

10 4

5 2

0 0

-5 Debt-financed Balance sheet -2

bubble recession
(4 years) (16 years)
-10 -4

-15 -6
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
Sources: Bank of Japan, Cabinet Of f ice, Japan

9
 Exhibit 10. Cumulative Capital Losses on Shares and Land since
1990 Reached $15 Trillion,
Trillion or 3 Years
Years’ Worth of Japan
Japan’ss GDP
(Tril. yen)
300
Shares Land (Capital Gain)

-300

-600
Equivalent
¥1,560 to $45
-900 trillion trillion loss
i the
in h U.S.
US

-1200

-1500
Land and Shares
Combined (Capital Loss)
-1800
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Cabinet Office, Japan "National Accounts"

10
 Exhibit 11. Japan’s GDP Grew in Spite of Massive Loss of Wealth
and Private Sector De-leveraging
(Tril.yen, Seasonally Adjusted) (Mar. 2000=100)
600
Nominal GDP 800
550 (Left Scale)
Real GDP 700
(Left Scale)
500
600

450
500 Cumulative
Likely GDP Path GDP 1990–2005
400
w/o Government Action Supported by
400
Government
Action:
350
300 ~ ¥2000 trillion
down
87%
300 200
Last seen in 1973
250 100
Land Price Index in Six Major Cities
(Commercial, Right Scale)
200 0
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Sources: Cabinet Office, Japan Real Estate Institute

11
 Exhibit 12. Japanese Government Borrowed and Spent the Excess
Savings of the Private Sector to Sustain GDP
(Tril. yen)
110

Government spending
100

90

80
Cumulative
cyclical deficit
70 1990–2005
¥315 trillion
60

overall
50 deficit
¥460
40 trillion
Bubble collapse
p
30 Tax revenue

20
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source:
So rce Ministry
Ministr of Finance
Finance, Japan
Note: FY 2010 includes initial budget.

12
 Exhibit 13. Large Deficits Do Not Mean Higher Interest Rates if the
Government Is Borrowing and Spending Excess Private Sector Savings
Savings*
(% of GDP) (%)
180 9
Balance Sheet Recession
160 8
JGB Outstanding as % of GDP (left scale)
140 7
Yields on 10-year JGB (right scale)
120 6

100 5

80 4

60 3

40 2

20 1

0 0
83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
* Household savings plus corporate debt repayment that are not borrowed by the private sector
Sources: Cabinet Office, Japan, Japan Bond Trading Co., Japan Securities Dealers Association

13
 Exhibit 14. Financial Surpluses of U.S. Households Are Now Greater
than that of Japanese Households

(% of GDP)
14

12

10 Japan

2
Shift of
0 9.1%
of GDP
-2
U.S.
4
-4

-6
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
Note: For Japan, fiscal year (April to March) is used. For U.S., calendar year is used.
Sources: BoJ
BoJ, Flow of Funds
Funds, FRB,
FRB Flow of Funds Accounts of the United States

14
Exhibit 15. U.K. Private Sector Financial Surpluses Are Increasing Sharply
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
10
Households (Financial Surplus)
8
Corporate Sector
(Non-Financial Sector +
Financial Sector)
6 Rest of the World

-2

-4

-6
General Government
-8
(Financial Deficit)
-10
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: Office for National Statistics, UK

Note: For 2009 figures, 4 quarter averages ending with 3Q/2009 are used.

15
 Exhibit 16. Premature Fiscal Reforms in 1997 and 2001 Weakened
Economy Reduced Tax Revenue,
Economy, Revenue and Increased Deficit
(Yen tril.) (Yen tril.)
70 70
Tax Revenue Hashimoto Koizumi Global
fiscal Obuchi-Mori Financial
Budget
udget Deficit
e ct fiscal
fiscal
reform
f reform Crisis
60 stimulus 60

50 50
*
unnecessary
40 40
increase in
deficit:
¥97.6 tril.
30 30

20 20

10 10

0 0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
(FY)
Source: Ministry of Finance, Japan
*: estimated by MOF

16
 Exhibit 17. Short- and Long-Term Trends of Global Economy

Bubble Lehman Shock

Likelyy GDP Path
Burst Without Lehman Shock

Weaker Demand
from Private Sector
Economic weakness De-leveraging
from private-sector (A)
de-leveraging
?

Economic weakness
from policy mistake (B)
on Lehman Stronger Demand
Actual Path from Government's
Fiscal Stimulus
C rrent Location
Current
Source: Nomura Research Institute

17
 Exhibit 18. Features of Balance Sheet Recession

 A balance sheet recession emerges after the bursting of a debt-

financed asset price bubble that leaves many private-sector
b l
balance sheets
h t with ith more liabilities
li biliti than
th assets.
t
 In order to repair their balance sheets, private sector moves away
from profit maximization to debt minimization.
 Private sector de-leveraging,
de leveraging even with zero interest rates,
rates
means there will be no borrowers of newly generated savings
and debt repayments. With no borrowers, the economy will
continue to lose aggregate demand equivalent to the sum of
unborrowed savings and debt repayment.
repayment
 The economy will not enter self-sustaining growth until private
sector balance sheets are repaired.
 Fiscal consolidation should begin only after it is ascertained that
funds NOT borrowed by the government will be borrowed and
spent by the private sector.

18
 Exhibit 19. Four Kinds of Banking Crises and their Remedies

Normal demand for Weak or non-existent

funds demand for funds

(I) (III)
Localized Quick NPL* disposal Normal NPL disposal
Banking Pursue accountability Pursue accountability
Ci i
Crisis
(II) (IV)
Systemic Slow NPL disposal Slow NPL disposal
Fat spread Capital injection

Type (I): 1989 S&L crisis

Type (II): 1982 Latin America debt crisis, nationwide credit crunch in the U.S. between 1991
and 1993, and the Nordic banking crisis in the early 1990s

Type (III): Japan prior to 1995 (for example, problems at two credit cooperatives)

Type (IV): Japan since 1996, Taiwan since 2000, the U.S. Great Depression of the 1930s,
and U.S.
U S and U.K.
U K subprime crisis since 2007
Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, John Wiley & Sons, Singapore, 2008

*Non-Performing Loan
19
 Exhibit 20. Japanese Banks Took Losses on NPLs Quickly
(¥ tril.)
16

Actual Losses Incurred

on NPLs1 Total NPL Losses
14
¥1021 tril. or $1.1 tril.
@ ¥90 = $1
12

Takenaka
10 Era
¥ 11.7 tril. Equivalent to
$3 1 ttril.
$3.1 il
8 in the U.S.

Losses for
L f U.S.US
4 Financials2
$2.7 tril.

0
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
(FY)
1: Includes commercial banks only; investment banks, insurance companies and other financial institutions
are NOT included.
2: Based on IMF Global Financial Stabilityy Report
p ((Apr.
p 2009).
) Includes all financial institutions,, including
g
hedge funds.
Source: Financial Services Agency, Japan

20
 Exhibit 21. The West Fooled Itself by Looking at NPL Data
NOT Adjusted for Loan-Loss Reserves
(¥ tril.)
45

Takenaka
NPLs of Japanese Banks era
40

35

30

25

20

15

10

0
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
Source: Financial Services Agency, Japan (FY)

21
 Exhibit 22. Inflation a Distant Prospect: Monetary Aggregates
Behave Differently under Balance Sheet Recession
Japan
Quantitative
(1990/1Q=100, Seasonally adjusted) Easing
300
Monetary Base
Money Supply (M2+CD)
250 Bank Credit Extended to the Private Sector

Textbook Balance Sheet

200 Economics Recession
(Monetary Policy (Monetary Policy Down
Ef f ective) NOT Ef f ective) 37%
150

100

1990/1Q
50

0
70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
Note: Private sector borrowings seasonally adjusted by Nomura, adjustments made f or discontinuities in line with
BOJ's "Monetary Survey"
Source: Bank of Japan

22
 Exhibit 23. Inflation a Distant Prospect: Monetary Aggregates
Behave Differently under Balance Sheet Recession
U.S.
(Aug. 2008 =100, Seasonally Adjusted)
260
250
240 Monetary Base
Money Supply (M2)
230
Loans and Leases in Bank Credit
220
210
200
190
180
170
160
150
140
130 Down
120 17%
110
100
90
08/1 08/3 08/5 08/7 08/9 08/11 09/1 09/3 09/5 09/7 09/9 09/11 10/1 10/3
Source: Board of Governors of the Federal Reserve System

23
 Exhibit 24. Inflation a Distant Prospect: Monetary Aggregates
Behave Differently under Balance Sheet Recession
U.K.
(Aug. 2008 =100, Seasonally Adjusted*)
280
270
260 Reserve Balances + Notes & Coin
250
240
M4 excluding intermediate OFCs**
230 M4 Lending excluding intermediate OFCs
220
210
200
190
180
170 08/8
160
150
140
130
120 Down
110 8%
100
90
80
70
07/1 07/4 07/7 07/10 08/1 08/4 08/7 08/10 09/1 09/4 09/7 09/10 10/1
S
Source: B k off England
Bank E l d
*Reserve Balances data are only seasonally unadjusted
**Other Financial Corporations

24
 Exhibit 25. Japan’s Money Supply Has Been Kept Up by
Government Borrowings
Balance Sheets of Banks in Japan
December 1998 December 2007
Assets Liabilities
Assets Liabilities

Credit
Extended to
the Private
Credit Sector
Extended to Money Supply Money Supply
¥501.8 tril.
the Private (M2+CD) (M2+CD)
(-99.8)
Sector ¥621.5 tril. ¥744.4 tril.
¥601.6 tril. (+122 9)
(+122.9)

Credit
Extended to the
Credit Extended
to the Public Public Sector
Sector ¥247.2 tril.
¥140.4 tril. (+106.8)
Other Liabilities
(net) Foreign assets
Foreign Assets Other Liabilities
¥153.2 tril. (net)
(net) (net)
¥74.1 tril.
¥32.7 tril. ¥78.7 tril.
(+41.4)
(-74.5)
Total Assets ¥774.7
¥774 7 tril.
tril Total Assets ¥823
¥823.1
1 tril
tril. (+48.4)
(+48 4)

Source: Bank of Japan "Monetary Survey"

25
Exhibit 26. Post-1933 U.S. Money Supply Growth Was also Made
Possible by Government Borrowings
Balance Sheets of All Member Banks
June 1929 June 1936
Assets Liabilities Assets Liabilities

Credit
Extended
to the
Deposits Private
Credit
$32.18 bil. June 1933 Sector Deposits
Extended to Assets Liabilities $34.10 bil.
$15.71 bil.
$
the Private C
Credit (+10.74)
Sector (-0.09)
Extended to Deposits
(= Money Supply)
$29.63 bil. the Private $23.36 bil.
Sector (-8.82) Credit
$15.80 bil. Extended
(-13.83) to the
Public
Credit Sector
Extended $16.30 bil.
Credit to the (+7.67)
Extended to Public
the Public Sector
Other Other
Sector $8.63 bil. Other Other
Liabilities Assets
$5.45 bil. (+3.18) Liabilities $8.91 bil. Liabilities
$6.93 bil.
$4.84 bil. $7.19 bil.
Other (+2.54)
(-2 09)
(-2.09) (+2 35)
(+2.35)
Other Assets Assets
$8.02 bil. $6.37 bil.
(-1.65) Reserves Capital
Capital
$5.61 bil.
Capital Reserves $4.84 bil. $5.24 bil.
Reserves $6.35 bil. $2.24 bil. (+3.37)
(-1.51) (+0.40)
$2.36 bil. (-0.12)
Total Assets $45.46 bil. Total Assets $33.04 bil. (-12.42) Total Assets $46.53 bil. (+13.49)

Source: Board of Governors of the Federal Reserve System (1976) Banking and Monetary Statistics 1914-1941 pp.72-79

26
 Exhibit 27. New Deal Policies Doubled Fiscal Expenditures
without Increasing Budget Deficit
Deficit*
($ mn, June) (%)
14000 28
New Deal policies
12000 24
Unemployment rate Expenditures (left scale)
10000 (right scale) 20

8000 16

6000 12

4000 8

2000 Revenue (left scale) 4

0 0

Budget deficit as % of
-2000 -4
GNP (right scale)

-4000 -8
23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

* As a percentage of GDP
S
Source: Board
B d off Governors
G off the
th Federal
F d l Reserve
R System
S t (1976),
(1976) Vol.
V l 1,
1 p. 513;
513 UU.S.
S BBureau off th
the C
Census (1975)
(1975),
p.229

27
Exhibit 28. German Fiscal Stimulus Reduced Unemployment Dramatically

(DM bn) （%）

35 35
Nazis come to
Government
30 power 30
expenditure
dit
(left scale)
25 25

20 Unemployment rate 20
( i ht scale)
(right l )
15 15

Fiscal deficit as % Government

10 of GDP revenue 10
(left scale)
(right scale)
5 5

0 0
N.A. N.A.
-5 -5

-10 -10
1930 1931 1932 1933 1934 1935 1936 1937 1938

Source: Mitchell (1975), p. 170; Flora et al. (1987), p. 350; Deutsche Bundesbank (1976).

28
 Exhibit 29. The Exit Problem: Debt Rejection Syndrome
It Took U
U.S.
S 30 Years to Normalize Interest Rate after 1929
(%)
9
US government bond yields
8 Prime BA,
BA 90days
US government bond yields 1920-29 average (4.09%, June 1959)
Prime BA, 90days 1920-29 average (4.13%, September 1959)
7
Oct '29 NY Stock Dec '41 Pearl Jun '50 Korean
6 Market Crash Harbor Attack War

'33～
5 New Deal

0
19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60

Source: FRB, Banking and Monetary Statistics 1914-1970 Vol.1, pp.450-451 and 468-471, Vol.2, pp.674-676 and 720-727

29
 Exhibit 30. Yin Yang Cycle of Bubbles and Balance Sheet Recessions

Yin (Shadow) Bubble Yang (Light)

(1) Monetary policy is tightened, leading the bubble to collapse. (9) Overconfident private sector triggers a bubble.

(2) Collapse in asset prices leaves private sector

U.S. with excess liabilities,
(8) With the economy healthy,
the private sector regains its vigour,
o c g itt into
forcing to debt minimization
at o mode.
ode
Spain and confidence
f returns.
The economy falls into a balance sheet recession.

U.K. (3) With everybody paying down debt,

monetary policy stops working. (7) Monetary policy becomes the main
Fiscal policy becomes the main economic tool economic tool, while deficit reduction
to maintain demand. becomes the top fiscal priority.

(4) Eventually, private sector finishes its debt repayments,

ending the balance sheet recession. (6) Private sector fund demand recovers,
But it still has a phobia about borrowing, which keeps and monetary policy starts working again.
interest rates low and the economy less than fully vibrant. Fiscal policy begins to crowd out private investment.
Germanyy Economy prone to mini-bubbles.

Japan
(5) Private sector phobia towards borrowing gradually disappears,
and it takes a more bullish stance towards fundraising.

Source: Richard Koo,, The Holy : Lessons from Japan’s

y Grail of Macroeconomics: p Great Recession,, John Wileyy & Sons,, Singapore,
g p , April
p 2008 p
p.160.

30
 Exhibit 31. Contrast Between Yin and Yang Phases of a Cycle

Yang Yin
1) Phenomenon Textbook economy Balance sheet recession
2) Fundamental driver Adam Smith's "invisible hand" Fallacy of composition
3) Corporate financial condition Assets > Liabilities Assets < Liabilities
4) Behavioral principle Profit maximization Debt minimization
5) Outcome Greatest good for greatest number Depression if left unattended
6) Monetary policy Effective Ineffective (liquidity trap)
7) Fiscal policy Counterproductive (crowding-out) Effective
8) Prices Inflationary Deflationary
9) Interest rates Normal Very low
10) Savings Virtue Vice (paradox of thrift)
Quick NPL disposal Normal NPL disposal
a) Localized
11) Remedy for Pursue accountability Pursue accountability
Banking Crisis Slow NPL disposal Slow NPL disposal
b) Systemic
Fat spread Capital injection

Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession ,
John Wiley & Sons
Sons, Singapore
Singapore, 2008

31