What Can the U.S. Learn from Japan?

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by: Cris Heaton

In this crisis, as in Japan's long recession, the problem is not that banks won't lend, but that companies won't borrow. So what to do? Cris Heaton reports.

What is a balance-sheet recession?

In a healthy economy, businesses borrow to invest in new capacity, households save, and the government alternates between borrowing and saving, depending on the point in the cycle. But if firms are no longer borrowing, a gap emerges in the economy. The money they would have borrowed piles up unused in the banks. The effect of this money falling out of circulation creates severe deflation – less money chasing the same quantity of goods means lower prices. This is well-established – for example, the Great Depression saw a 47% collapse in bank lending between 1929 and 1933. The usual explanation is that banks were refusing to lend, but Nomura economist Richard Koo argues in his new book, The Holy Grail of Macroeconomics, that the real problem was that businesses were unwilling to borrow. He calls this a 'balance-sheet recession'. That may sound like a technicality, but it has huge implications for trying to avoid a depression.

Why does this happen?

Under standard economic theory, businesses always aim to maximise profits. But during a balance-sheet recession, says Koo, they instead want to minimise debt. This is basically a matter of survival: the balance-sheet recession follows a huge bubble and bust in asset prices, which leaves firms holding lots of assets that are worth far less than they paid for them. Since these assets were purchased with debt, companies' liabilities are now far greater than their assets and they are technically insolvent, even though their cash flow may still be healthy. Long-term survival then becomes a matter of paying down debt as quickly as possible before anyone realises how much trouble they're in – because if news gets out, they'll probably be forced into bankruptcy.

What's so special about this kind of recession?

The problem is how to respond to it. If you assume that firms are always profit-maximising, there's an easy way out of slumps: cut interest rates until they begin borrowing and investing again. This is the monetarist view of how the Great Depression could have been ended much more quickly. But the profit-maximising assumption is crucial. If firms are debt-minimising because they feel they cannot live with the debt burden they already have, then even cutting interest rates to zero will not persuade them to take on more debt.

Is Koo's theory right?

The collapse in bank lending in both the Great Depression and Japan's long recession in the 1990s is very clear. The question is whether this is because banks stopped lending, or because firms weren't interested in borrowing whether banks would lend or not. Koo argues that business surveys in both slumps generally reported that firms did not feel that credit was too tight. He also points out that the monetarist solution was tried in Japan, through both zero interest rates and quantitative easing (the central bank providing huge amounts of money to banks to lend out). Neither worked: corporate lending continued to contract until 2005.

If it's true, how do we fix it?

If firms won't borrow and invest, the government has to, says Koo. While firms are repairing their balance sheets, the govern­ment must increase its borrowing to invest in infrastructure projects, and so on. He disagrees with the criticism that Japan did this and still ended up with a lengthy slump, saying that this ducks the question of what would have happened to Japan without this huge rise in government spending. In America, the slump wiped out wealth equal to around one years' worth of 1929 GDP and was followed by a huge fall in GDP. In comparison, Japan's slump wiped out three years of GDP: from that perspective, keeping GDP above the level it was at when the bubble burst – as Japan did – should be seen as a big success.

Why does all this matter?

Because we may be on the edge of another deflationary slump. In fact, Koo argues, America has already suffered a balance-sheet recession due to the tech bubble bursting in 2000-2001. The country tried to juice up housing to support the economy as firms rebuilt; but while this created a property bubble, firms refused to borrow even after repairing their balance sheets. Now, after the housing bust, we have a debt-burdened consumer as well as debt-averse firms. Flooding the economy with cheap money will probably fail, says Koo; the only way to avoid a severe slump is government spending, bank recapitalisations and perhaps a devaluation in the dollar to boost US exports.

What does this mean for the global economy?

The most sobering aspect of Koo's argument is that it implies that hugely increased government spending for several years is the only way to avert a Japan-style slump. Whether or not you agree with higher government spending, and the waste it entails, it's the route the West seems likely to take. Yet even so, a backdrop of severe deflation will make government bonds one of the best places for investors to put their money, reckons Société Générale's Albert Edwards. He expects nominal yields on ten-year bonds in America and Europe to fall below 2%. As he puts it, "we are all Japan now".

Stock position: None.