Richard C. Koo
Chief economist, Nomura Research Institute
With the unemployment rate staying above 9% after nearly three years of zero interest rates and the $787 billion fiscal stimulus enacted in February 2009 still failing to pump-prime the economy, the American people are beginning to realise that this is no ordinary recession. With both traditional fiscal and monetary policies failing to produce results, the policy debate is running from one extreme to the other. Some are pushing for QE3 while others are calling those actions "treason". Some are pushing for smaller government while others are pushing for more fiscal stimulus. Some are calling for more regulation while others are pushing for less, and so the list goes on. This lack of consensus is making people worry even more as they fear that there may be no cure for this disease.
The same acrimonious debate was taking place in Japan 15 years ago, with no consensus on what was the right thing to do. It took those of us in Japan nearly a decade to realise that the country was suffering from a rare type of recession that happens only after the bursting of a nationwide asset-price bubble financed with debt. In this type of recession, now called balance-sheet recession, the private sector is actually minimising debt instead of maximising profits because the liabilities it incurred during the bubble days are still on the books while the assets it purchased with borrowed funds have collapsed in value, leaving its balance sheets seriously underwater and in need of repair.
When the private sector as a whole starts paying down debt, however, the economy starts losing aggregate demand equivalent to the unborrowed savings in the private sector. If left unattended, the contraction in demand will continue until the private sector has become too poor to save money. That is exactly what happened during the Great Depression when America lost 46% of GDP in just four years.
Monetary policy is largely useless in this type of recession because those with balance sheets underwater are not interested in increasing borrowings at any interest rate. There will not be many lenders either when the lenders themselves have balance-sheet problems. This explains why the Fed's and the Bank of Japan's zero interest-rate and quantitative-easing policies failed to produce economic recovery.
Since the government cannot tell the private sector not to repair its balance sheets, the only way for the government to keep the economy from collapsing is to borrow and spend the unborrowed savings in the private sector and put them back into the economy's income stream. And this stimulus must be maintained until the private sector has regained enough financial health to borrow money again. The Japanese government was basically doing that from the beginning, and that is why Japanese GDP never fell below the peak of the bubble even though commercial real estate prices fell 87% nationwide and the private sector was deleveraging to the tune of nearly 10% of GDP per year.
The American economy has been in balance-sheet recession with its usual attributes since the bursting of the real estate bubble in late 2007. Then in September 2008 Lehman Brothers collapsed, which was a financial crisis. Balance-sheet recession is a problem of borrowers, while financial crisis is a problem of lenders. For the former, monetary easing is useless and fiscal stimulus is essential; but for the latter, monetary easing in the form of liquidity injections, together with capital injections from the government, are necessary for banks to be able to lend money again.
All three policies were in place by February 2009. The V-shaped recovery since the spring of 2009, however, was largely a recovery from the Lehman shock, not from the balance-sheet recession. This is because private-sector deleveraging is still continuing and real estate prices are still weakening. The fact that deleveraging is continuing at zero interest rates, a phenomenon no business schools or economics departments have prepared us for, suggests that the American private sector is still very sick.
The recovery that started in 2009, however, led people to believe that the economy was on its way to full recovery. Not realising that the balance-sheet problems were still there, the American government refused to renew the fiscal stimulus enacted in February 2009. That fiscal package is now expiring. This means the recovery from the Lehman shock will hit a ceiling, which comes from the balance-sheet recession. It appears that the American economy has been hitting this ceiling for some time now.
Those investors who bought equities believing that QE2 would result in an increase in money supply and a stronger economy are now shocked to find that neither the economy nor the money supply is growing to support those equity prices. This realisation is behind the correction in equity prices we are seeing now.
Recovery from financial shock is relatively easy as long as the authorities inject sufficient liquidity and capital in time. Recovery from balance-sheet recession takes time because it requires the recovery of millions of private-sector balance sheets that are currently underwater. Moreover, as Keynes once said, and as was amply demonstrated in America recently, it is almost impossible to sustain fiscal stimulus in a democracy during peacetime.
When the Japanese government lost its patience and switched to fiscal consolidation in 1997 while its private sector was still deleveraging, the economy entered a horrendous double dip. GDP contracted for five quarters and the banking system went down with it. As a result, the deficit, instead of contracting, increased by a whopping 68%. It took Japan ten years to recover from this policy mistake. If the American government stays the course on fiscal consolidation while the private sector is still deleveraging, the probability of repeating Japan's mistake of 1997 is high.
http://www.economist.com/debate/days/view/737
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