Richard Koo’s Holy Grail summary

Won’t go deep into it, but essentially: Japan in 90’s was in what he terms a ‘balance sheet’ recession, where corporates have damaged balance sheets due to asset price plunging, but nominal debt remains the same. So they redirect all their free cash flow (this is contingent on the ability to keep selling goods, as Japan was through the 90s) to paying down their debt and repairing balance sheet. This means monetary policy is ineffective; further, and more controversially (to me) it means that Japan’s problems stemmed not from a zombie banking sector but by lack of demand for funds in the first place. Thus, he argues that despite the criticism (e.g. from Krugman, Bernanke, etc) Japan did the right thing through the 90s — using fiscal policy to sustain GDP and incomes, enabling corporates to slowly repair their balance sheets, up to the point where they get over their debt aversion and start borrowing again. He calls this an ‘yin’ phase, where firms focus on paying down debt, compared to the ‘yang’ phase, where firms focus on maximising profits, and where all our conventional arguments about fiscal/monetary policy play out.

It’s very interesting because:
(i) he claims to synthesise the fiscal vs monetary debate by recognizing that both sides are right, depending on what stage of the cycle an economy is at;
(ii) more disturbing from a market perspective, he argues that what happened in Japan was not a worst but a best case scenario. This runs counter to what many experts (professional/academic economists, journalists, etc) regard as conventional wisdom that Japan’s zombie banks held Japan back through the 90s and if only they’d cleaned ‘em up sooner it would’ve recovered faster.

Koo’s evidence in refuting the zombie bank theory is (i) size of Japan corporate bond market, (ii) foreign bank lending in Japan, (iii) lending rate of Jap banks. Basically, lending rates of Jap banks fell, however, it wasn’t due to banks’ refusal/inability to lend (in accordance with zombie bank theory) but because demand for funds wasn’t there – reflected in that corp bond market shrank, nor did foreign banks step in to fill the gap, as they could have. (Charts are on p8 of the book, I don’t have a scanner unfortunately. Dr Koo also apparently presented his ideas in March-09, I didn’t attend but found this slide deck on this website — . The relevant initial charts are not there, but others I cite next are.)

Anyhow, he argues that both Japan in the 1990s and the US in the 1930s suffered from balance sheet recessions, a bigger whopper than the usual kind, and caused by many years of excess liquidity in the years/decades preceding, and triggered by extremely sharp falls in asset prices, which decimate balance sheets and require firms/households to spend many years slowly repairing them and getting over the resultant debt-aversion. His evidence for this is found in Slides 13, 15, 16 of the above slide deck, where he argues that despite ZIRP in Japan, corporates still focused on paying down debt, and had actually managed to repair their BS by 2005, after which corporate lending did start to increase a bit. In the interim, Japan relied in increasing govt debt, and drawdown of household savings (which fortunately had been high) to sustain GDP.

One key observation is that Japan suffered wealth destruction of 1,500 trillion Yen from 1990-2005, equivalent of 3 years of GDP. Dr Koo notes that the GD wiped out (only?) one year’s worth of pre-GD US GDP. From estimates of wealth destruction due to the GFC, I think I’ve seen figures like US$11t in the US alone, just for households (which could be more if we include corporate balance sheets), and US GDP in 2007 was ~US$13.84t so its in the range of damage that would lead to a long-lasting balance sheet recession.

So, in the final chapter, Dr Koo argues (book published March 08, last chapter is analysis of the GFC) that what the US govt did in allowing banks to survive is right — you can’t push for rapid NPL disposal, because a lack of buyers leads to a crash in asset prices. (Slide 19 shows his categorization of recessions and the appropriate policy response.) I’m not fully convinced at this point – he’d be more convincing if he more fully addressed Japan’s banking sector in depth and how zombie banks’ awful BS helped prolong the crisis, even if they weren’t the proximate source of anemic fund demand – don’t know enough myself to comment.

He also makes the point that you can’t expect banks to earn their way out of insolvency, because the underlying economy is so weak and no one wants to borrow. Thus recap is necessary, fiscal policy is critical, and the national debt be damned (for the time being).

Of course, the specific drivers, macro context and industrial structures are different. To me:

(i) US exporters are fundamentally weaker than Japanese corporates were, and b/c we Asians can’t immediately make up for US consumption, US firms may not be able to generate the requisite free cash flow to pay down debt, as did the Japs.
(ii) Damage to Jap balance sheets could’ve been due to high cross-holding structures of Jap corporates, leading to sharply reduced assets when share prices fell. US firms may own less of each others’ shares. And in the US at least, the damage is really to the household balance sheets, at least as much as to the corporates. So corporates may still want to borrow, and monetary policy may be more effective in the GFC than Dr Koo argues it was in Japan.
(iii) Japan could, due to its socio-political structures, push through deficit funded fiscal programs; also its households had high savings stock that they could draw down. These two may not apply in the US today.
The first point suggests tracking of US exports and FCF generation by US firms. The second and third could perhaps be addressed by looking at corporate bond and lending rates, and anecdotal evidence from corporate banker friends on demand for funds… I don’t have the requisite data, but Slide 7 suggests falling demand for funds in the US, consistent with the BS recession thesis.

If Dr Koo’s analysis of Japan is right, and the read-through to the GFC is appropriate, it seems to me to point (rather conventionally after all that) to a long-term deleveraging (not inconsistent with US inflation due to weak dollar) and a slow recovery. But I’d very much like to know what others think of the whole BS recession concept…

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