21 Jul 2012

Japan has Seen it all Before, and We're Getting it Wrong

Nomura Research Institute's Richard Koo says that what the world is experiencing right now, a "balance sheet recession," is different from traditional recessions.

"This is no ordinary recession." 


"People were no longer maximising profits they were minimising debt. And even with zero interest rates people were paying down debt. And no economics text book or business school anywhere in the world has suggested that such a think should take place."

Corporate debt repayment occurred for 10 years. Equivalent to nett 6% of GDP for that period.

More debts than assets = bankrupt.  But can be bankrupt with cash-flow or without. Without cash-flow it's game over. With cash-flow the best thing to do is pay down debt. Best for all stakeholders: shares retain some value, banks get repaid, workers keep jobs. The right thing to do is to use cashflow to pay down det, and you'll eventually get back in business.

However when everyone does it the aggregate effect is that the economy shrinks. Even when interest rates are zero and people still don't borrow. Because if you are bankrupt "you are not going to borrow money at any interest rates; and no one is going to lend you money either!"

"The Great Depression in the US was exactly this pattern. US lost half of it's GDP in just 4 years... because everyone was paying down debt."

In Japan this continued for 10 years.

"In this type of situation monetary policy is largely dead in the water."

"The only thing the government can do is the opposite - borrow and spend."

"That's basically what we realised what was happening in Japan."

Govern stimulus improved things briefly, but then they cut the deficit and it crashed again--because the private sector was still deleveraging. And they repeated this cycle, for a full 15 years.

"And because this is not in the economic textbooks, because it's not supposed to happen, no one gave us the right direction, until we discovered it ourselves, that this is a different disease... fiscal stimulus was maintained we finally climbed out 2005, the whole thing took 15 years."

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