Richard Koo: Debts, Deficits, and Global Financial Stability

Richard Koo reflecting on the Japanese economic situation and our own.

Richard Koo reflecting on how we’re following on the same lost decades path as Japan. And for many reasons this is merely a repeat of what Japan has tried and has failed.

Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications – Richard Koo via John Wiley & Sons.

The book sets out a theoretical explanation for the demise of Japan in the 1990s. At the time, there were two conflicting theories about why Japan went into economic decline in the 1990s. First, the neo-liberal supply-side argument claimed that Japanese institutions (banking, industry etc) were necrotic and required substantial microeconomic reform – privatization, deregulation and elimination of bureaucratic interference.

Second, demand-side explanations argued that there was a need for expanded public works spending to overcome the severe spending gap that emerged from the rising saving desires of the private sector. Some demand-side theories were not opposed to the micro reform agenda proposed but said that the urgency was for fiscal and monetary expansion.

Koo’s balance sheet recession idea is somewhat different again. He argues that the structural rigidities in Japan were present during the strong growth period and did not just emerge in the 1990s.

Koo prefers to focus on the debt build up that began in the 1970s and accelerated during the 1980s. The asset price boom that was fueled by the debt accumulation (primarily tied to land) was ultimately terminated by contractionary Bank of Japan monetary policy. The subsequent crash in asset values and the resulting balance sheet adjustments that followed give rise to the term – “balance sheet recession”.

Koo says that during this process of balance sheet restructuring the priority is to pay off debt rather than pursue profit. In turn, this suppresses aggregate demand as investment plunges. The downturn reinforces the pessimism and credit-worthy borrowers dry up and bankruptcies rise. The circuit breaker has to be fiscal policy because the economy gets caught in a liquidity trap.

The following diagram is taken from his 2003 book named above. It is essentially an expanded circular flow model used in introductory text books to show the relationship between income and expenditure and output. The flow diagram captures the basis of his balance sheet recession concept.

Koo Balance Sheet Recession

• The private sector builds up massive debt levels to buy property and speculative assets.  (This also occurred during the late 1800′s with speculation on the railroads.))
• The asset prices rise as demand rises but then eventually the bubble bursts and the private sector is left with declining wealth but huge debt.
• The private sector then start restructuring their balance sheets – and stop borrowing – no matter how low interest rates go.
• All effort is devoted to paying back debt (de-leveraging) and households increase their saving and reduced spending because they become pessimistic about the future.
• A credit crunch emerges – not because there is enough funds but because banks cannot find credit-worthy borrowers to lend to.
• Attempts at pumping liquidity into the banks will fail because they are not reserve-constrained. They are not lending because no-one worthy wants to borrow.
• The faltering spending causes the macroeconomy to melt.
• With this private contraction (reducing debt, saving) the only way out of the “balance sheet recession” is via public sector deficit spending.

GDP growth in Japan has been very low for the last 15 years and neo-liberals argue that this is evidence that the deficits were wasteful.  But Koo says that the only thing keeping the economy from falling into a deep depression was the deficits. His work categorically shows that when the neo-liberal lobby started to gain traction and government net spending was reduced the Japanese economy went backwards again. But interestingly, these attempted cut-backs only increased the deficits – via the automatic stabilizers.

But don’t get the idea that Koo is a Keynesian although both advocated using fiscal policy to stimulate aggregate demand. and to thus ensure that production capacity is fully utilised. The difference though is in how they understand a recession. In the General Theory, Keynes argued that recession originated from a decline in investment driven by pessimistic profit expectations by business. The pessimism promotes an saving and aggregate demand drops.

However, Koo sees the private sector using loose credit to underwrite expansion of spending which results in the increased precariousness of private balance sheets. The reaction to this credit binge is that the private sector starts to save more and will not borrow even though interest rates are low. So monetary policy will not stimulate investment.

It’s my personal observation that debt and speculation is not the problem, but merely a symptom of the actual mechanism.  I’ll publish that mechanism in future posts.

For the most part, this current environment was predictable 20 years ago and should have been allowed to happen in the mid 1990′s.   It’s my belief that we’re in an analogous situation to the late 1800′s depressions.  However, I’m not sure of the changes in the taxing mechanisms they had at that time.

Since there were no income taxes as that time,  there is no history to look at for the current debt induced depression where consumers’ ability to save to pay off the debt will be severely bled by an increase immense increase in taxes.   In California alone, the pension systems for the state are shy $500 Billion and that number is the floor to the deficit, not the ceiling.

Past performance is no indication of future returns especially when more and more retirees are going to draw from the system:

“In 1999 California passed Senate Bill 400 (SB400), substantially raising benefit factors and lowering retirement ages for public employees (see Table 3). Based on a National Institute on Retirement Security report, average monthly public pension benefits in California were $2,008 in 2006, the eighth highest nationwide.”

Now that $2,008 monthly benefit does not factor in additional healthcare benefits which cost a lot and are also provided as benefits.  Just do the quick math, let us assume someone retires at 55 and lives to 85 and receives that $2,008 monthly benefit:

$2,008 x 12 = $48,192 x 30 = $1,445,760 in total paid out

We are also assuming no COLA adjustments which some of these plans have.  We aren’t adding the added healthcare cost which an older retiree will be using up.  Something tells me that a state worker did not even come close to putting in $1.4 million over their working career.  And you wonder why these pension funds combined are projected to have a $500 billion shortfall?  And good luck if the stock market turns lower or simply remains stagnant for years.  California is only one example of many.  For cities their are police and firemen which can draw the same type of retirement after only 20 years of service and they get  90% of their pay.  I’m guessing that’s a whole lot more than $2,000 a month.

There has been money set aside for pensions, but the returns are nowhere near what they need to be to adequately pay out the projected funds they’ll need to pay out. Needless to say, we’ll have some interesting times ahead when people realize that there this in no money for pensions.

Calpers Annual Returns

Alan

Total Miles Driven is Dropping

The Department of Transportation keeps track of total vehicle miles driven.  As might be expected when gas prices go up, miles driven drops.  And when gas prices go down, miles driven goes up.  As oil prices have started to raise again from their recent lows, the drag on miles driven has sure started.

According to the Department of Transportation, the total miles driven is already rolling over. Total vehicle miles this January were actually below last year and last year the stock market was very unpredictable – as was the economy.  What’ s interesting is the extreme sensitivity to rising prices.  In light of some of the other charts, I’ve shown below.  Is there something else happening?

Oil Price and Vehicle Miles Driven

Oil Prices and Vehicle Miles Driven

New Indicator is Pointing to Renewed Economic Weakness

Two private-sector analysts (Jan Hatzius of Goldman Sachs and Peter Hooper of Deutsche Bank) have recently teamed up with three academics (Rick Mishkin of Columbia, Kermit Schoenholtz of NYU, and Mark Watson of Princeton) to produce a new financial conditions index that attempts to combine the information of 44 separate series including those mentioned above along with a great number of others. One of the differences between their approach and previous work is that HHMSW seek to isolate the separate information of the financial indicators from aggregate business cycle movements by looking at the residuals from a regression of each indicator on lags of inflation and real GDP growth rates. The researchers then extracted a variable similar to a principal component from the residuals across the 44 indicators. HHMSW demonstrate that the resulting series can be quite helpful for predicting real GDP growth, though there is evidence that these predictive relations may change over time.

Source: Hatzius, et. al.

Of particular interest at the moment is the fact that the HHMSW index, unlike most other indicators, shows a renewed deterioration subsequent to the initial recovery in the first part of 2009, a somewhat surprising result given the current steeply-sloping yield curve, low TED spread, and booming stock market. The surprising contrary inference from the HHMSW index appears to be due to two factors. First, the HHMSW index is based on the deviation of the financial indicators from what one would have predicted given recent economic conditions. Many indicators have not improved as much as one would have expected given the return to GDP growth, and the departure from a typical recovery pattern is viewed by the index as a highly pessimistic development. Second, the HHMSW index makes use not just of the yields themselves but also of the quantities of various assets, and many of these show little improvement so far. For example, issuance of new asset-backed securities remains quite low.

Will real GDP follow the HHMSW index back down?

Why We’re Trapped into a Cheap Money FED Policy

Government Securities vs Commercial And Industrial Loans

As you can see, since the beginning of the recession, banks have bought close to $300 billion of Treasuries and reduced commercial and industrial loans by roughly $350 billion. Foreign purchases as of January were still running at a $60 billion monthly rate in January–about $195 billion during the last three months for which we have data. That’s an annual rate of nearly $800 billion, or about half the Treasury’s annual borrowing requirement.

That demand came not from foreign central banks, but rather from “other foreigners.” Most of this indicates use of the carry trade by foreign banks, or hedge funds, who are doing exactly what the American banks are doing.

They are borrowing funds at 0.25% from central banks and lending it back to the US government at rates of from 1% to 2%. The demand isn’t coming from the mideast oil exporters. Those sources appear to now be net sellers. From a geographic standpoint, the main buyers are listed as United Kingdom and the Caribbean. It’s coming from banks and hedge funds.

The carry trade will come crashing down should the Fed need to raise rates. With 1 Trillion dollars in buying needed, so does the Treasury market and the mortgage market and the US economy probably goe down with the crash.

The Fed is addicted to a loose money policy just as the Bank of Japan was during the 1990s. We’re stuck in the lame liquidity trap. One of our stimulus tools is completely wiped out. That only leaves government deficit spending – and that tool is starting to get pretty long in the tooth. Out creditors funding that spending are eventually going to cry uncle.

Only our best,

Alan

Alan Kauth
Commercial, Residential, Land
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Intero Real Estate Services
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