The World in Balance Sheet Recession:

What Post-2008 U.S., Europe and China

Can Learn from Japan 1990-2005

Richard C. Koo
Chief Economist
Nomura Research Institute
Tokyo
November 2011
Exhibit 1. US Housing Prices Are Moving along the Japanese Experience

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

260

240 US: 10 Cities Composite Home Price Index

220 Japan: Tokyo Area Condo Price1

Composite
Index Futures
200

180

160

140
Japan: Osaka Area Condo Price1
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 14 US
77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 Japan
Note: per m 2, 5-month moving average
Sources: Bloomberg, Real Estate Economic Institute, Japan, S&P, S&P/Case-Shiller® Home Price Indices, as of Oct. 28, 2011

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 Exhibit 2. Drastic Liquidity Injection
Failed to Increase Money Supply (I): US
320 (Aug. 2008 =100, Seasonally Adjusted)

300 Monetary Base

280 Money Supply (M2)
260 Loans and Leases in Bank Credit
240
220
200
180
160
Down
140 25%
120
100
80
3.0 (%, yoy) Consumer Spending
2.5 Deflator (core)
2.0
1.5
1.0
0.5
08/1 08/4 08/7 08/10 09/1 09/4 09/7 09/10 10/1 10/4 10/7 10/10 11/1 11/4 11/7 11/10

Sources: Board of Governors of the Federal Reserve System, US Department of Commerce

Note: Commercial bank loans and leases, adjustments for discontinuities made by Nomura Research Institute.

2
 Exhibit 3. Drastic Liquidity Injection
Failed to Increase Money Supply (II): EU
150 (Aug. 2008 =100, Seasonally Adjusted)

Base Money
140 Money Supply (M3)
Credit to Euro Area Residents
130

120

110

100

90

2.2 (%, yoy)

2.0 CPI core
1.8
1.6
1.4
1.2
1.0
0.8
0.6
08/1 08/4 08/7 08/10 09/1 09/4 09/7 09/10 10/1 10/4 10/7 10/10 11/1 11/4 11/7

Sources: ECB, Eurostat

Note: Base money's figures are seasonally adjusted by Nomura Research Institute.

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 Exhibit 4. Drastic Liquidity Injection
Failed to Increase Money Supply (III): UK
280 (Aug. 2008 =100, Seasonally Adjusted)
265 1
Reserve Balances + Notes & Coin
250
235 Money Supply (M4)
220 Bank Lending (M4)
205
190
175 Aug. 08'
160
145
130 Down
115 17%
100
85
70

6 (%, yoy)
5 CPI (ex. Indirect Taxes)
4
3
2
1
0
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 10/4 10/7 10/10 11/1 11/4 11/7
Sources: Bank of England, Office for National Statisics, UK
Notes: 1. Reserve Balances data are seasonally unadjusted. 2. Money supply and bank lending data exclude intermmediate
financial institutions.

4
 Exhibit 5. Drastic Liquidity Injection Failed to
Produce Drastic Increase in Money Supply (IV): Japan
260 (Oct. 97 = 100, Seasonally Adjusted)

240 Quantitative Earthquake

Easing
220 Monetary Base
200 Money Supply (M2)

180 Bank Lending

160

140
Oct. 97
120 Down
37%
100

80

60

3.0 (y/y, %)
2.0 CPI Core
1.0
0.0
-1.0
-2.0
-3.0
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Note: Bank lending are seasonally adjusted by Nomura Research Institute.

Source: Bank of Japan

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 Exhibit 6. Japan’s De-leveraging with Zero Interest Rates
Lasted for 10 Years
Funds Raised by Non-Financial Corporate Sector
(% 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 10
Sources: Bank of Japan, Cabinet Of f ice, Japan

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Exhibit 7. 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 Cumulative
600 90-05 GDP
Supported by
450
500
Government
Action:
Likely GDP Path ~ ¥2000 trillion
400
w/o Government Action 400

350
300

300 200
down Cumulative
Last seen in 1973 Loss of
87%
250 Wealth on
100
Land Price Index in Six Major Cities Shares and
(Commercial, Right Scale) Real Estate
200 0 ~ ¥1500 trillion
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 11

Sources: Cabinet Of f ice, Japan Real Estate Institute

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 Exhibit 8. Japanese Government Borrowed and Spent
the Unborrowed Savings of the Private Sector to Sustain GDP
(Tril. yen)
110

Government spending
100

90

80 cumulative
cyclical
deficit
70
90-05
¥315 trillion
60
overall
50 deficit
¥460
trillion
40
Bubble Collapse
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 11
Source: Ministry of Finance, Japan
Note: FY 2011 includes 2nd supplementary budget.

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Exhibit 9. Premature Fiscal Reforms in 1997 and 2001 Weakened
Economy, Reduced Tax Revenue and Increased Deficit
(Yen tril.) (Yen tril.)
70 70
Tax Revenue Hashimoto Koizumi Global
fiscal Obuchi-Mori Financial
Budget Deficit fiscal fiscal
reform reform Crisis
60 stimulus 60

50 50
*
unnecessary
40 40
increase in
deficit:
¥103.3 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 11
(FY)
Source: Ministry of Finance, Japan
*: estimated by MOF

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 Exhibit 10. Monetary Easing No Substitute for Fiscal Stimulus (I):
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)

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 tril. Total Assets ¥823.1 tril. (+48.4)

Source: Bank of Japan "Monetary Survey"

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Exhibit 11. Monetary Easing No Substitute for Fiscal Stimulus (II): Post-1933 US
Money Supply Growth 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.
the Private $15.71 bil.
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 Liabilities
$6.93 bil. $8.91 bil.
$4.84 bil. $7.19 bil.
Other (+2.54)
(-2.09) (+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

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 Exhibit 12. US in Balance Sheet Recession: US Private Sector
Increased Savings Massively after the Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %, quarterly)
8
Households (Financial Surplus)
6 Shift from
Rest of the World 4Q 2006 in
4 private sector:
9.30% of GDP
Corporate: 1.40%
2 Households:
8.22%
0

-2

-4
Shift from
-6 4Q 2006 in
General public sector:
-8 Government 5.80% of GDP
Corporate Sector
(Non-Financial Sector +
-10 Financial Sector) IT Bubble Housing
Bubble
(Financial Deficit)
-12
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 11

Note: For the latest f igures, 4 quarter averages ending with 2Q/11' are used.
Sources: FRB, US Department of Commerce

12
 Exhibit 13. UK in Balance Sheet Recession: UK Private Sector
Increased Savings Massively after the Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
9
Households (Financial Surplus)

6 Rest of the World

Shift from
1Q 2007 in
private sector:
3 8.23% of GDP
Corporate: 2.19%
Households: 6.04%
0

-3

Shift from
-6 1Q 2007 in
public sector:
General Corporate Sector 7.11% of GDP
(Non-Financial Sector +
-9 Government Financial Sector)

(Financial Deficit)
-12
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Note: For the latest f igures, 4 quarter averages ending with 2Q/11' are used.
Source: Of f ice f or National Statistics, UK

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 Exhibit 14. Global Bond Yields* Nearing Japanese Levels
(%)
6

England
US
5 Sweden
Switzerland
Japan
Japanese
4 Bond Yield
in 1997

3%
2

1.3%

0
2007 2008 2009 2010 2011

*Note: Excluding Eurozone. As of Oct. 28, 2011.

Source: Bloomberg

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 Exhibit 15. Euro-Zone Bond Yields Are Diverging Sharply
(%)
26

24
Greece
22
Ireland
20
Portugal
18
Spain
16 Italy
14 France

12 Germany

10

0
2007 2008 2009 2010 2011

Note: As of Oct. 28, 2011.

Source: Bloomberg

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Exhibit 16. Euro-zone in Balance Sheet Recession: Euro-zone Private Sector
Increased Savings Massively after the Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
6
(Financial Surplus)
Households Shift from
4 3Q 2008 in
private sector:
4.09% of GDP
Rest of the World Corporate: 2.62%
2
Households: 1.47%

-2
Shift from
3Q 2008 in
public sector:
-4 4.03% of GDP
General
Government
Corporate Sector
-6 (Non-Financial Sector + Financial Sector)

(Financial Deficit)
-8
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Note: For the latest f igures, 4 quarter averages ending with 1Q/11' are used.
Source: ECB

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Exhibit 17. Spain in Balance Sheet Recession: Spanish Private Sector
Increased Savings Massively after the Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
12
(Financial Surplus)
Households
9
Rest of the World Shift from
3Q 2007 in
private sector:
6
17.95% of GDP
Corporate: 12.54%
Households: 5.41%
3

-3 Shift from
3Q 2007 in
public sector:
-6 11.93% of GDP
Corporate Sector
-9 (Non-Financial Sector + Financial Sector)
General
Government
(Financial Deficit)
-12
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Note: For the latest f igures, 4 quarter averages ending with 2Q/11' are used.
Source: Banco de España

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 Exhibit 18. Ireland in Balance Sheet Recession: Irish Private Sector
Increased Savings Massively after the Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
15
Corporate Sector
(Financial Surplus)
(Non-Financial Sector + Financial Sector)
10 Shift from 2006
Rest of the World in private sector:
21.55% of GDP
5 Corporate: 7.29%
Households: 14.26%

General Shift from 2006

-5 Government in public sector:
16.78% of GDP

-10
Households

(Financial Deficit)
-15
2002 2003 2004 2005 2006 2007 2008 2009

Sources: Eurostat, Central Statistics Of f ice, Ireland

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 Exhibit 19. Exit Problem (II): German Private Sector Refused to
Borrow Money after 1999-2000 Telecom Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %)
8
Households (Financial Surplus) Shift from 2000
6 to 2005
Telecom Bubble
in private sector:
4 12.06% of GDP
Corporate: 9.26%
Households: 2.80%
2

0
Rest of the World
-2

-4 Shift from 2000

to 2005
-6 General in public sector:
Corporate Sector Government 4.62% of GDP
-8 (Non-Financial Sector +
Financial Sector) (Financial Deficit)
-10
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Sources: Deutsche Bundesbank, Federal Statistical Of f ice Germany

Note: The assumption of Treuhand agency's debt by the Redemption Fund f or Inherited Liabilities in 1995 is adjusted.

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 Exhibit 20. Recovery from Lehman Shock Is NOT Recovery from
Balance Sheet Recession

Bubble Lehman Shock

Likely 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 GDP from Government's
Path Fiscal Stimulus
Current Location
Source: Nomura Research Institute

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 Exhibit 21. Multi-Decade Cycle of Bubbles and Balance Sheet Recessions

Yin (=Balance Sheet Recession) Bubble Yang (=Textbook Economy)

(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

US with excess liabilities, (8) With the economy healthy,
the private sector regains its vigour,
Entrance forcing it into debt minimization mode.
The economy falls into a balance sheet recession. and confidence returns.
Problem Spain
UK (3) With everybody paying down debt,
monetary policy stops working. (7) Monetary policy becomes the main economic
Fiscal policy becomes the main economic tool tool, while deficit reduction becomes the top
to maintain demand. 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.
Exit Japan Economy prone to mini-bubbles.

Problem Germany
(5) Private sector phobia towards borrowing gradually disappears,
and it takes a more bullish stance towards fund raising.

Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession , John Wiley & Sons, Singapore, April 2008 p.160.

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Exhibit 22. Euro-Zone Banks Need Low-Cost Unconditional Capital
Injection to Avoid Credit Crunch
Contrast Between Yin and Yang Phases of Cycle

Yang Yin
Behavioral principle
= Profit maximization = Debt minimization
1) Phenomenon Textbook economy Balance sheet recession

2) Private sector financial condition Assets > Liabilities Assets < Liabilities

3) Outcome Greatest good for greatest number Depression if left unattended

4) Monetary policy Effective Ineffective (liquidity trap)

5) Fiscal policy Counterproductive (crowding-out) Effective

6) Prices Inflationary Deflationary

7) Interest rates Normal Very low

8) Savings Virtue Vice (paradox of thrift)

Quick NPL disposal Normal NPL disposal
a) Localized
9) Remedy for Pursue accountability Pursue accountability
Banking Crisis Slow NPL disposal Slow NPL disposal
b) Systemic
Fat spread Capital injection by government
Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession ,
John Wiley & Sons, Singapore, 2008

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