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28
Interview with Richard Koo
Chief Economist, Nomura Research Institute
A Japanese·Rx for the We
by Leslie P. Norton
RICHARD KOO HAS DRAWN WIDESPREAD
attention for his theories on why Japan's
economy has struggled for so long. In
particular, his view of that nation's "bal­
ance-sheet recession" has been exten­
sively studied by policymakers in the de­
veloped world.
Though many economists fear that
Japan's enormous debt is unsustain­
able, the nation's economy hasn't col­
lapsed. Still, the economic malaise has
punished investors in Japanese stocks,
which topped out in 1989, and some
investors fear that the same stagnation
could afflict equities in the North Amer­
ica and Europe, too.
"The most interesting question in
macroeconomics today is why Japan de­
veloped the way it did over the past 20
years," says Gifford Combs, a portfolio
manager at Dalton Investments. "What
nobody in the West wants to utter
aloud is that western economies, and
most especially the U.S., could follow
the same trajectory as Japan, essen­
tially a recovery that almost feels
worse than the disease."
Koo is well-equipped to answer ques­
tions about Japan and the West, having
served as an economist for the Federal
Reserve Bank of New York in the past
and as chief economist of Nomura Re­
search Institute now.
To learn his views, read on.
Barron's: You're visiting Washington a
lot these days.
Koo: I'm explaining to' the Americans
that the disease you've got, is the disease
we got 15 years earlier. Most Americans
are flabbergasted by the fact that the
Federal Reserve has lowered interest
rates to zero, flooded the market with
liquidity-and the economy is still going
absolutely nowhere. Unemployment is
still increasing, people are still retrench­
ing, deleveraging. When the central
bank brings rates down to zero, a lot of
things are supposed to happen, but
there's nothing happening. But that's
BARRO
what we experienced in Japan. The Bank
of Japan brought the rates down to zero,
did massive quantitative easing, with no
result whatsoever. This happens bec~use
of a balance-sheet recession.
What is that?
This happens because the private-sector
companies are no longer maximizing prof­
its; they are minimizing debt. They are
minimizing debt because all the assets
they bought with borrowed money col­
lapsed in value, but the debt is still on
their books, so their balance sheets are all
under water. If your balance sheet is un­
der water, you have to repair it. So every­
body is in balance-sheet-repair mode.
This type of recession isn't in any eco­
nomic textbook yet, and there's no name
for it. I call it the balance-sheet recession.
It took us [in Japan] a decade to figure
out. People said, ''Ab, just run the print­
ing presses, ah, structural reform, ah,
just privatize the post office, this and
that, and everything will. be fine." Noth­
ing worked. This is pneumonia, not the
common cold. When people are minimiz­
ing debt because of their balance-sheet
problems, monetary policy is largely use­
less. If your balance sheet is under wa­
ter, in negative equity, you are not going
to borrow money at any interest rate,
and no one will lend you money, either.
In an ordinary, garden-variety reces­
sion, as we learned in school, the private
sector uses money more efficiently, and a
budget deficit is considered bad. But
when the private sector is completely ab­
sent and paying down debt at zero inter­
est rates, and the government doesn't
borrow this money, what happens? Even
a child would understand the whole
thing could collapse. The only way the
government can turn this economy
around is to do the opposite of the pri­
vate sector-borrow the money the pri­
vate sector saved and spend it, which
means fiscal stimulus. That's what saved
Japan from entering a Great Depression.
Refresh our memory.
'N'S ]anuM 4, iViC

st:· Keep Spending

"The only way the u.s. can turn this economy

around is [with] fiscal stimulus. That's what saved
Japan from entering a Great Depression." RichardKoo
 January 4, 2010 BAP
Our commercial real-estate prices fell
87% from the peak, nationwide. I mean
just imagine Manhattan, San Francisco,
Chicago down by that much. But our
gross domestic product never fell below
the peak of the bubble [despite] this de­
cline in asset values. It is an unbelievable
achievement. The point is, private-sector
savings, plus the debt repayment to­
gether become the economy's "deflation
gap"-the amount of money that comes
into the banking system but is unable to
leave it because no one is borrowing.
You end up losing demand. That's how
the U.S. got into the Great Depression of
1929 to 1933 and lost half of its GDP in
'just four years. Japan could have fallen
into that deflationary spiral except for
the fact that the government was borrow­
ing and spending all that money. That's
why our GDP never fell. It was the first
country in history that managed to avoid
faIling into a depression-type outcome. If
you look at the history of this type of
recession in the past, the only way those
countries came out was through fighting
wars. Japan managed to do that without
,fighting a war. Once Americans under­
; iltand this point, they don't have to fear
the housing market collapse. If GDP isn't
'falling, people have the income to pay
down debt. At some point, your balance
sheet will be balanced again and this prob­
lem will be over.
Five years from now, a lot of people
, will be using the term balance-sheet re­
ceSsion. My task now is to get American
policymakers to understand that's how Ja­
pan suffered for 15 years. There is no
\ .. reason the U.S. has to suffer for ]5 years.
The U.S. can learn from Japan.
How far along are we in the balance­
sheet recession for the U.S., Europe and
Japan?
In Japan, we are definitely on the exit
sidE;l. We have the exit problem of trying
to convince people who became so averse
to debt to start borrowing again. If you
remember, Americans who lived through
the Great Depression, the Great Balance­
Sheet Recession, never wanted to borrow
money again. We have something
similar- I call it the debt-rejection
syndrome-after paying down debt for 15
years. But we can't repair the govern­
ment balance sheet until the private sec­
tor starts to borrow money again.
The other countries are stilI in the en­
trance part, in the U.S. and Europe ex­
Germany, because Germany never actu­
ally had a housing bubble. Germany did
liMy task now is to get
to understand how Japa
There's no reason the U.
years. The U.S. can learn
sillIer a balance-sheet recession after the
collapse of the telecom bubble. It was
smaller than Japan's, but the German
economy did poorly for a very long time.
They're mostly out of it.
In the U.S., it all depends on policy.
The economy could be shrinking quickly
if the government didn't borrow money so
the GDP would be maintained; the pri­
vate sector would have itlCome until debt
minimization is over. But suppose the gov­
ernment cut its support in the middle and
the economy collapsed one more time?
Then people would become very pessimis­
tic, and the whole. process would take
much longer. In 1997, Japan made that
stupid mistake of cutting our deficit, and
that lengthened our suffering by five
years, if not more. I see a similar danger
in the U.S. and Europe.
Has the U.S. government done enough
to offset the crisis?
They are a bit too cautious. In this type of
recession, government has to be in there
in a sustained fashion to take this entire
excess savings in the private sector and
put that back into the income stream. It
has to be sustained until private sector
deleveraging is over. Individually, every­
body is doing the right thing. I can't tell
you to stop paying down debt. But when
everybody does it at the same time, who
is going to borrow and spend? Once the
private sector starts borrowing again,
we're back to the textbook world of maxi­
mizing profits. But U.S. households and
U.S. financials are still deleveraging.
What do we need to see?
A three- to five-year program, minimum,
where President Obama comes out and
tells the American people: "Look, we
have a different type of disease now."
That kind of explanation is essential to
get Democrats and Republicans to under;:
stand why you need fiscal stimulus. I can
assure you if [the government doesn't
spend much more], your budget deficit
will continue to increase. During the past
15 years, we in Japan tried to cut the
budget deficit twice. On both occasions,
-KONS
American policymakers
n suffered fO.r 15 years.
s. must suffer for 15
from Japan."
the economy collapsed, and tax revenue
dropped. The U.S. will experience that,
. too. If you say it's political suicide [to
spend], not doing it will be an even bigger
suicide.
What's a plausible number?
That's a very difficult question to answer
because we have to see what's happened
to the deleveraging process. If deleverag­
ing isn't as large as it was in the first year,
then you need to do less. If it's bigger, you
need to do more.. The point is to tell peo­
ple about this kind of disease. And we had
a silly accident called Lehman shock,
which in my view was totally unnecessary.
The fundamental problem of the U.S.
housing market collapse is still with us.
The [first] $787 billion [in Washington's
fiscal stimulus package] had to deal with
. two problems: the housing collapse, and
then the policy mistake called the Leh­
man collapse. But we still have this one
left. So [the numberl could be $500 billion,
it could be bigger, it could be smaller. I
hope it won't be another $787 billion.
What about Obama telling the banks to
lend more?
Just telling them is not enough. There's a
wide range of things to do, but the most
important is to make sure the fiscal stimu­
lus is in place until the private-sector
deleveraging is over. On the banking side,
if you look at the Federal Reserve senior
loan officers' survey, American bankers are
still tightening lending standards, which
means the credit crunch is still With us.
The TARP [Troubled Asset Relief Pro­
gram] money was put in place to end the
credit crunch, and failed miserably. I know
it's politically difficult, but I suggest that
[Washington] put capital one more time
into the banks, and at the same time put
together a lO-year non-performing loan am­
ortization program, so give the banks 10
years to clean up the mess. That's a much
more realistic approach than rushing to
clean up, and will make them more relaxed
and lend money. The IO-year program
should be very closely supervised by the
government and one of the agencies so it
29
remains credible. The credibility of the ef­
fort is what's important, not how fast it
goes. Many banks are facing potential
losses on commercial mortgages and real
estate. They should come up with a IO-year
plan to write off problems and inject capi­
tal to keep things going.
The U.S. deficit will remain large, but
U.S. interest rates will not skyrocket.
With this much fiscal stimulus-lO% of
GDP and massive monetary stimulus­
the long bond yield is 3.4%. Under ordi­
nary circumstances it should be 8.4%.
Why? The private sector is deleveraging.
What are the other implications of the
balance-sheet recession?
Many countries will continue to run mas­
sive fiscal deficits for the foreseeable fu­
ture. There are two issues. One is how to
rate the sovereign debt of countries that
have fallen into balance-sheet recessions
and require heavy fiscal stimulus. Issuing
more government debt when an economy
isn't in a balance-sheet recession leads to
a variety of problems, including higher
interest rates, crowding out, inflation,
and inefficient distribution of resources.
Any of these would be ample justification
for a rating downgrade.
But increased issuance of government
debt during a balance-sheet recession is a
positive. Unless the government issues a
sufficient amount of debt and boosts fiscal
expenditures, the econo'my will fall into a
deflationary spiral. At such times, rating
agencies that don't understand the concept
of balance-sheet recessions can send the
wrong signal with credit downgrades, pre­
venting governments from doing what is
necessary and sparking further weakness'
in the economy. Ofthe two main U.S. rating
agencies, Moody's appears to be paying
much more attention to this issue. Stan­
dard & Poor's, on the other hand, remains
entirely indifferent and continues to apply
orthodox rating criteria in a doctrinaire
fashion.
It was the haphazard assignment of
AAA ratings to subprime CDOs by these
two organizations that enabled those in­
struments to be bought by investors
around the world, ultimately triggering
the global financial crisis. The problem of
sovereign-debt downgrades represents an­
other opportunity for these agencies to ex­
acerbate problems in the global economy.
National and international authorities ur­
gently need to pursue further regulation
and reform ofthe rating agencies as partof
their efforts to tighten regulation of the fi­
nancial sector.
RON'S January 4. 2010

What other types of collateral damage are vision, and it was that we could end this

you expecting? once the private-sector deleveraging was

The Dubai [World] default was part of it, over. But this time around, the private-sec­

and some Eastern European problems, tor deleveraging is happening outside Ja­

and we still haven't seen a U.S. commercial pan, and there is a view, pronounced at the

real-estate resolution yet-it's falling very G-20 meeting in Pittsburgh, that external

quickly, and there's no relief in sight. This imbalances should not grow too much.

will hit the U.S. banking system one more That means Japan, China, and the rest

time. Some Western European banks were of the Asia region will really have to find

more opaque than American banks, so we [their] own domestic-demand-Ied growth

might see some land mines there, too. modeL China is definitely helping; they put

Abu Dhabi is helping Dubai. For in the largest fiscal stimulus among any of

Greece, what will happen isn't clear. If this these countries in November 2008. The 4

were an ordinary recession and Greece trillion Chinese yuan package was 17% of

was going crazy spending money, we'd China's GDP. But China's consumption is a

have to tell Greece to cut its deficit. But fraction of U.S. consumption.

balance-sheet problems are at the heart of In Japan, [demand] could be stimu­

the problem, and the rest of the world lated [by] environmental projects or

shouldn't push Greece to cut it~ deficit. housing-areas where we still lag behind

the West. Unless a vision is presented,

Is Japan's recent 7.2 trillion yen ($78.3 bil­ we'll have to rely on fiscal stimulus be­

lion) stimulus enough to pull it out of its fore exports go back up. People may be

current slump?
spooked by a large deficit. We need to

It's far better than nothing, but this time say that we need fiscal stimulus to buy

around, I'd like to see a long-term vision. time, but have long-term growth strate­

which is completely missing from this gov­ gies kicking in soon. Then the bond mar­

ernment at the moment. In the past, when ket would be more relaxed because there

we ran a big budget deficit, there was a would be an exit strategy._

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