The end of Japan’s balance-sheet recession | FT Alphaville

The end of Japan’s balance-sheet recession

Strong praise for the new Japan prime minister, Naoto Kan, from one Richard Koo.

In his latest note, Nomura’s chief economist thinks the former finance minister literally “saved” the Japanese economy in 1998, by agreeing to inject capital into the domestic banking system, then in the midst of its Japan premium episode. Without Kan’s acquiescence to the bailout, Koo seems to suggest, much worse could have happened. As it was, Japan entered its Lost Decade…

Koo explains:

My position was that the Japanese economy had fallen into a balance sheet recession, which results when the private sector seeks to minimize debt rather than maximize profit.

GDP cannot be maintained in such situations unless the government steps in to borrow (and spend) the surplus savings resulting from private-sector deleveraging. The question of how the government spends the savings is of secondary importance.

In a world in which damaged balance sheets leave businesses and households paying down debt and unwilling to borrow money despite zero interest rates, demand shrinks by the amount of private savings. Assuming a private savings rate of 10%, what started out as income of ¥1,000 will progressively contract to ¥900, ¥810, ¥729, and so on.

If the government stands back and does nothing to stop this process, the jobs supported by the borrowing and spending of this money will be lost, and the situation will continue to deteriorate until the private-sector deleveraging process stops.

If we accept that unemployment represents the worst possible allocation of economic resources, the government’s first priority under such circumstances should be to prevent the economy from falling into a deflationary spiral by borrowing and spending surplus private savings. In the example above, the government would need to borrow and spend the initial ¥100 in savings (10% of ¥1,000). When added to the ¥900 spent by the private sector, this would ensure that total spending remained at ¥1,000.

Under such circumstances, I argued, it was not an option for the government to stand by and do nothing because it could not find any worthwhile projects to invest in.

But now, Koo thinks Japan is nearing the end of its debt-shedding phase:

Today the situation is very different. Japan is clearly in the final stages of its balance sheet recession. Although there has been some increase in savings and debt paydowns since the Lehman crisis, the private sector has finished repairing its balance sheet, and there is little risk of the economy falling into a deflationary spiral, unlike the situation a decade ago.

“The final stages of a balance sheet recession” — after how many years?

Take note, US and UK.

Anyway, as the above should suggest, Koo is all about the stimulus:

In summary, Japan (1) faces a shortage of demand (more accurately, a shortage of external demand) and (2) is being pursued by strong economic competitors. Under such circumstances, the government’s ability to spend money on areas with future potential is critical to the economy’s future. The kind of public works projects undertaken in the coming years, therefore, will have a major bearing on the nation’s future.

And to hell with fiscal consolidation.

Yields on Japanese government bonds have been low for ages, Koo says, and there’s a reason for it:

Pushing ahead with these misguided policies risks a collapse of social and economic foundations and could even threaten the survival of democratic structures. A good example is prewar Germany’s Brüning cabinet, which insisted on fiscal retrenchment and allowed the emergence of Hitler in the 1930s. The risk is especially high in Central and Southern European countries, which have a relatively short history of democracy.

Ultimately, I think the reason so many academics and pundits do not trust current low yields on government debt and expect them to rise suddenly is that they do not trust the market economy. When a price level set by the market persists for many years, we need to realize that there is an underlying economic structure supporting those prices.

What governments—including Japan’s new administration—should be thinking about is how to find promising public works projects and implement them in order to offset the deflationary pressures from private-sector deleveraging and provide the private sector with a sense of direction.

Full note available over at Paul Kedrosky’s.

Related links:
Japan’s post-Hatoyama outlook: ‘Shades of drab’ – FT Alphaville
Is BoJ-bashing about to inflate the world? – FT Alphaville
On the edge of a deflationary precipice… – FT Alphaville
‘Japan’s brewing fiasco’ – FT Alphaville