Some lessons from Japan’s burst bubble

by Anthony Fensom

HOLY GRAIL OF MACROECONOMICS: Lessons from Japan’s Great Recession, by Richard C. Koo. John Wiley & Sons (Asia) Pte. Ltd., 2008, 296 pp., $34.95 (cloth)

Hit by a devastating housing slump, billions of dollars of subprime losses and rising oil prices, the U.S. economy appears headed for recession, taking Japan down with it. It’s a situation tailor-made for economists to prove their mettle, but will they rise to the challenge?

Only time will tell, but they might stand a chance if they heed the advice of Nomura Research Institute’s chief economist Richard C. Koo in his latest book, “The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession.” Following up from his groundbreaking 2003 work, “Balance Sheet Recession,” Koo shows how fiscal stimulus — primarily government spending — can help prevent economies from falling into the type of deflationary trap Japan endured in the 1990s.

Readers who like their economics light and frothy should stick to works like the best-selling “Freakonomics” (Levitt & Dubner, 2005). For this self-admitted “quasi-academic book” by the awarded American economist is written more for a business audience than for lay readers, and contains its fair share of jargon.

Nevertheless, this should not deter those with an interest in the quest for what U.S. Federal Reserve Chairman Ben Bernanke has described as the “holy grail of macroeconomics” — the causes of the 1930s Great Depression. This quest may lack Indiana Jones, but Koo attempts to get his hands on the prize by setting out a theory of “yin” and “yang” economic cycles.

In a “yang” economic cycle, corporate balance sheets are healthy, firms seek to maximize profits, monetary policy is highly effective and fiscal policy “crowds out” private investment. According to Koo, this is the basis of all economic theory since John Maynard Keynes’ “General Theory” of 1936.

However, in a “yin” phase, the status quo is reversed: corporate balance sheets are in a mess and firms slash debt rather than seek profits, making monetary policy ineffective and causing an economic downturn. In this scenario of balance sheet recession, fiscal policy is the only tool at the government’s disposal in boosting the economy, and public borrowing supports private investment.

“In simplest policy terms, the Grail tells us to determine which phase the economy is in, and implement policies that are appropriate for the phase,” Koo writes. Avoiding economic downturns in a yin phase requires fiscal stimulus, while interest rate cuts are the correct solution in a yang phase.

A Japan resident for a decade, Koo bases his theory on this country’s 1980s boom and subsequent bust, in which falling stock and land prices wiped out an estimated ¥1,500 trillion of national wealth — the equivalent of three years of gross domestic product and “the greatest economic loss ever experienced by a nation in peacetime.”

Koo argues the drop in asset prices made many firms technically bankrupt and forced them to focus on debt minimization, thereby causing a liquidity trap in which the Bank of Japan was impotent. Bizarrely for the theorists, even official interest rates of zero percent failed to spark corporate borrowing or growth in asset prices.

This situation sparked intense debate among economists, with proposed solutions including tax cuts, structural reform and inflation targeting. Koo discredits all of these, instead calling the government policymakers “heroes” for injecting ¥140 trillion worth of fiscal stimulus into the economy.

While the net result of the government’s binge was a debt burden that has hit 180 percent of GDP and anemic economic growth of an average of 0.9 percent from 1992-2002 (OECD average was 2.6 percent), Koo asserts that without the government spending the economy would have shrunk by as much as one-third. By taking the role of “borrower of last resort,” the government counteracted the fall in private demand for credit, making money supply growth dependent on government borrowing.

The author’s support of government pump-priming and defense of the BOJ may well be expected given Nomura’s position as Japan’s top brokerage and Koo’s advisory roles to recent Japanese prime ministers. But his blanket support for government spending during a balance sheet recession, even on a military buildup, is highly debatable.

Giving lawmakers a license to spend is akin to giving rum chocolates to an alcoholic; getting them off their “medicine” is going to be near impossible even when the ailment has been ostensibly cured. Similarly, the moral hazard of writing banks a blank check to run up bad loans is not addressed by Koo, and the squandering of billions of yen by government bodies fails to inspire confidence in the use of such funds.

But regardless of whether he has truly found the economic holy grail, Koo makes an important contribution to the debate in showing that fiscal policy has an equally important role to play with monetary policy in managing business cycles, and that public debt is not always bad. It can only be hoped that the U.S. authorities are listening.