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The Holy Grail of Macroeconomics: Lessons…

The Holy Grail of Macroeconomics: Lessons from Japan's Great… (edition 2009)

by Richard C. Koo (Author)

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The revised edition of this highly acclaimed work presents crucial lessons from Japan's recession that could aid the US and other economies as they struggle to recover from the current financial crisis. This book is about Japan's 15-year long recession and how it affected current theoretical thinking about its causes and cures. It has a detailed explanation on what happened to Japan, but the discoveries made are so far-reaching that a large portion of economics literature will have to be modified to accommodate another half to the macroeconomic spectrum of possibilities that conventional theorists have overlooked. The author developed the idea of yin and yang business cycles where the conventional world of profit maximization is the yang and the world of balance sheet recession, where companies are minimizing debt, is the yin. Once so divided, many varied theories developed in macro economics since the 1930s can be nicely categorized into a single comprehensive theory- The Holy Grail of Macro Economics… (more)
Title:The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession
Authors:Richard C. Koo (Author)
Info:Wiley (2009), Edition: Revised, 352 pages
Collections:Your library

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The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession by Richard C. Koo

  1. 00
    Dogs and Demons: Tales from the Dark Side of Japan by Alex Kerr (mercure)
    mercure: Richard Koo discusses the Need for Japan's government spending in the aftermath of the bubble. Alex Kerr reports about the consequences of Japan's government spending for Japan's culture and environment. The costs were not just financial.

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Good take on the main reason for the prolonged crisis, private sector deleveraging, but practically nothing said about the influence of the demographic transformation, globalization, ... and after the first half the book pretty much keeps on hammering the same points again and again. ( )
  emed0s | Feb 6, 2021 |
A well-written quick read that solves the puzzle why the Japanese economy took so long to recover from its burst real estate bubble in the early 1990s. Koo offers a good explanation about why liquidity traps occur and firms pay-down their debts in a low-interest environment. Balance sheet recession is his name for the Kabuki dance firms perform when their assets are worth less than their liabilities. If the situation would be handled according to the laws in place, these underwater but not insolvent firms would be placed in receivership and reorganized. This is, however, not what happens in the real world of oligarchy power.

Politics and regulators pretend not to notice the underwater situation of these firms led by their buddies, prop them up by fake "stress tests" and capital assistance. This unwillingness to cure the patient by surgery (removing incompetent managers, wiping out the old shareholders) condemns an economy to an exceedingly slow recovery as these firms pretend to do business as usual, while they effectively can't. This is my problem with Koo's book. He is one of the insiders, a Davos man, a protector of the status quo with a believe in the system that I barely understandable. He writes - in 2008 (p. 179): "Large asset-price bubbles have occurred elsewhere - witness the U.S. housing and Chinese stock market/real estate bubbles. When these bubbles eventually burst, it is comforting to know that Japan's recent experience has clearly demonstrated what sort of policy is required to deal with their aftermath." Granted that Koo could not expect the level of incompetence of both the Bush and Obama administrations. He fails to look for the root of these problems: Most of these bubbles (from Tulipomania, the South Sea craze to the dotcom bubble) are driven by oligarchies that have more money than sense, investing in foolish adventures. When the bubble bursts, the oligarchy's political power prevents a clean resolution. Koo clearly sides with the oligarchy. Thus, he is shocked about Paul Krugman's quip of disappropriating it via inflation.

His Japanese "hammer" might not work well in a US situation where, the financial industry apart, the debt problem is not one of enterprises but consumers, as Elizabeth Warren has so clearly shown. Overall, he offers a good account and explanation of the Japanese case which, with modifications, is useful in looking at other countries. Koo also shows that local expertise is the key to understanding. US economists with limited knowledge about Japan are perhaps not the best consultants to listen to. Likewise, Koo is not the best person to offer macroeconomic advice on Germany and Europe, as the bolt-on chapters on the US, China and Germany demonstrate. ( )
2 vote jcbrunner | Jun 25, 2011 |
Will the U.S. be like Japan? Many fear the U.S. GDP will plateau, as Japan's has for over a decade. Interested in learning more about the Japanese episode, I picked up "The Holy Grail of Macro-Economics", by Richard Koo.

The book had much that I was looking for on Japan: about the conditions of their corporations, the levels of indebtedness, and the ways in which their government tried to deal with it.

In addition, it turned out to be a more ambitious book than I expected. Koo talks about the slow down of growth in Germany, and about the Great Depression of the 1930's, and he tries to tie these together to address some fundamental questions in economics.

Koo's thesis is that:
Some recessions are special (they're "balance sheet recessions") and are marked by some fundamental behavioral changes because people go into "balance sheet repair mode" for a while.
These changes in motivation and behavior, can make it seem as though certain laws of economics are temporarily suspended. For instance, monetary policy does not have its normal effect (e.g. even with rates at zero people could be unwilling to borrow)
Fiscal policy can have an impact by spending wealth based on promises of repayment by future generations. He contends this it worked in Japan, and the stagnation that resulted was a good thing; otherwise the country would have seen some years of falling GDP and painful readjustments

Koo terms a balance-sheet recession as the "Yin" phase of an economy, and says it is marked by a drive to strengthen one's balance sheet even allowing possible profit opportunities to slip by (with "Yang" being the typical profit-maximization phase of an economy). He says: "in this phase, monetary policy is ineffective, because firms are all rushing to pay down debt, and private sector demand for funds is essentially non existent."

The notion of a business cycle characterized by over-indebtedness, ending in a crash, followed by deflation is not new. Monetarist Irving Fisher presented it in the 1930's. Among conventional economists, the monetarists advocate "printing" more money as a solution. However, Koo (primarily Keynesian) stresses the futility of monetary policy in the context of a credit-based economy. In such an economy, the central bank can inflate "narrow/core/high-powered money", but the broader credit money-alternatives can continue to deflate while borrowers remain in "balance-sheet repair" mode.

Monetarist economists stress the supply-side of money and credit, giving very little importance to the demand side. The simplified versions of the quantity theory of money assume that demand for money is stable. This works most of the time; however, when people are uncertain about the economic future, the demand for money and credit changes. Creating more money has little effect, because most of it is deployed into the safest asset and and does not "multiply" into business credit expansion. In this narrow area, Koo, the Keynesian would actually find agreement from von Mises who criticized the Quantity Theory of money for excessive focus on the supply of money, and for paying too little attention to demand, addressing it only indirectly via the "velocity of circulation".

Keynes propounded a situation called a "liquidity trap", where monetary policy is ineffective. While the phenomena that Koo describes is very similar, there are crucial differences. Koo says: "Keynes, ... had to argue that it was a decline in the marginal efficiency of capital that induced corporations to stop investing. But he never convincingly explained why the marginal efficiency of capital should suddenly fall."

I interpret this in the following way: Keynes suggested that an economy might face a shortage of investment, but did not explain how this could happen. The mistake Keynes was making is that he was proposing this as a general theory. The type of situation Keynes described can occur, but only in the special and rare case of a balance-sheet recession. In other words Keynes was wrong to think that what he saw was an intermittent "natural" occurrence in a free-economy; rather, it was caused by a large number of people shifting into "balance-sheet repair" mode in the aftermath of a bust in a credit-driven boom.

Be warned that Koo's solution is Keynesian. He wants governments to borrow to the hilt and is comfortable leaving twice or thrice our current debt to the next generation. If you're not willing to read through those types of recommendations don't pick up the book. I will say that Koo is a clear writer, so at least he does not hide his recommendations in obfuscation and throw an epistemological load on the reader. Though many Keynesians see their recommendations as part of a general theory, and would like to see an economic "fine tuning" czar, Koo's book gives it a different spin. If one thinks a mixed economy is legitimate, and if one thinks the government ought to redistribute wealth, then -- in that special case -- there are times when fiscal spending can accomplish the redistribution and can "work" in the sense this its advocates think it ought.

Koo tries to relegate Keynesian prescriptions to a special case, arguing that monetary means at better for regular "fine tuning" by our economic Gods! Of course, as some skeptic note: for Keynesians temporary means forever!

The free-market solution to balance sheet crises is intelligent private-sector driven liquidation and readjustment. If one does not believe in government redistribution, this is also the fair way. In the longer scheme of things, it is also the more efficient way, because the sharper readjustment morphs into a faster turn-around and because it does not build long-term "moral hazard' into the system.

Despite his faulty recommendations, I found Koo's book to be useful. I learnt about recent Japanese economic history. In addition, Koo is an articulate champion for his variant of Keynesianism and it is useful to understand his point of view if one is going to argue against it. ( )
2 vote realistTheorist | Feb 4, 2011 |
Eastern Wisdom for the Great Deleveraging

Japan’s Great Recession that started in the late 1980’s has some important similarities to the Great Depression and the credit crisis that started in earnest in 2008. In this book, Richard Koo’s looks a these crises from a new angle. Both the analysis and the recommendations are quite different from the standard approach that is often rooted in the work of neoclassical economists like Milton Friedman (this does not stop the author from using data from Friedman’s work with Anna Schwartz, however).

Mr. Koo did not develop his theory in the ivory towers of academia, but after using the input he received from the clients of his employer Nomura. By looking at Japan’s Great Recession, he has access to much more data than we have about the Great Depression. As a consequence, he uses the Great Depression more for validations of his theory. Unfortunately, other equivalent crises, e.g. the Asian Currency Crisis and the various economic disasters in Latin America, are not really included. Much of the book’s focus is on Japan and the United States only.

Marketing his theory like a true consultant, Mr. Koo divides the economy between Yang and Yin Cycles. Most of the time the economy is in a Yang Cycle. In the Yang Cycle the economy is in good health, and economic actors try to maximise profits. Monetary policy, i.e. increasing or reducing the money supply, is now the most important tool of a central bank to manage the economy. Economic actors will react as expected to changes in interest rates by increasing or reducing their investments. Government borrowing and subsequent government investment may be counterproductive. Governments can crowd out the private sector, and government investment is overall less efficient than investment by the corporate sector. Hence government saving is a virtue in many cases. The private sector will save for tougher times or a nest egg. In the Yang Cycle recessions and banking crises may occur. In case of a localised problem, a quick disposal of non-performing loans and an improvement in accountability may solve the problem. In case of systemic problems in the banking sector, banks may be allowed to dispose of non-performing loans slowly, while accepting a “fat spread” between their market rates and central bank borrowing.

Only very occasionally may the economy move into a Yin Cycle, a situation where economic textbook solutions do not apply. This is the case after a major asset bubble has burst. Economic actors with a healthy cash flow may be hurt by large unrealised losses on their balance sheets because of fallen asset prices. This is what Mr. Koo calls a Balance Sheet Recession. In this case corporates will not respond to stimulus from quantitative easing and lower interest rates, no matter how low the interest rate goes. Corporates do not want to borrow, but will concentrate on paying down existing debt to clean up their balance sheets. This will continue until the value of their assets is larger again than their liabilities. During Balance Sheet Recessions (i.e. not credit crunches that can be countered by government policies like injections in banks and borrowing of bank assets by Central Banks) banks are often willing to lend, but they find few borrowers. As corporates are mainly busy paying off existing debt, the money supply in the economy can reduce quickly, and investments can dry up, resulting in deflating prices. This poisonous mix has a negative multiplier, and may lead to a depression until the private sector is too impoverished to save money. That is, unless the government fills the gap by issuing bonds (i.e. soaking up the excess liquidity within the banking sector) and spending the monies in the economy. Government saving, e.g. because of falling tax income, will only increase the problem. Localised banking crises may be countered by the standard measures for writing of non-performing loans. Systemic crisis require capital injections into banks and a slow disposal of non-performing loans. Yin Cycles have a strong impact on economic actors and may reduce the willingness to borrow for profit maximisation for many years. People only want to live a Balance Sheet Recession once in their working life, and will accept lower growth of their companies and of the economy in general as an outcome. Consequently, it took 60 years for the next Balance Sheet Recession to materialise after the Great Depression.

Mr. Koo’s analysis may look Keynesian, but that is only the case at a superficial level. Keynes looked at the marginal utility of labour in the case of a liquidity trap and not at debt reduction as the main driver of corporate behaviour. Keynes perceived companies as always willing to borrow for investment, an assumption he shared with neoclassical economists. Mr. Koo’s analysis seems rather straightforward given the process he describes. Hence it seems baffling that it took so long for someone to develop this theory. However, neither banks nor CFO’s have much interest in revealing the dirty secret of a company’s indebtedness as long as cash flows are healthy, and corporates can repay loans: openness may only lead to problems. Balance sheet issues are a problem time can solve for the benefit of all stakeholders. What may have also helped in the past is that mark-to-marked accounting was not mandatory or allowed. Corporate balance sheets are simply not included in macro economic theories, they are always assumed to be healthy.

Mr. Koo uses Japan’s 15-year recession to proof of his theory. During this recession Japan lost 3 times its GDP in asset devaluation, with land prices losing up to 87% of their value at the height of the bubble. Various remedies were used to counter the recession, among others the ones described in the paragraph about the Yin Cycle. According to the author, this has saved Japan from a depression. During Japan’s rise to become an economic superpower, Japan had enjoyed no material inflation, a strong currency, and no labour unrest, and managed to improve its products and export them worldwide. During these years, Japanese companies were much more leveraged than western companies. This did not matter so much as long as the economy was developing rapidly. In 1989 at the height of the bubble, Japan's companies were borrowing 9% of GDP. The first response after bubble burst was a reduction in savings by households and fiscal stimulus from the government. As a consequence, the GDP did not fall initially. The slump continued longer than initially expected, because of the significant change in corporate spending. Companies that basically still had a healthy cash flow (mark-to-market accounting was only required after 2001) turned to saving by paying down debt on credit. Government borrowing and spending stabilised GDP at above peak levels, at the expense of national debt. The state also guaranteed the deposits in banks, who took most of the brunt of asset devaluation. On the other hand, the devaluation of the Yen made little sense, as Japan’s high quality output still guaranteed a trade surplus.

In 2003 corporates were net savers of up to 9% of GDP. According to the author Japan’s money supply could have shrunk with 37 % if the government had not sold bonds to banks and spent the amount in the real economy. This is not much different from the USA during the Great Depression (33% between 1929 and 1932). Japanese GDP could have fallen with 30-50%, as did the GNP in US after 1929 (46%). There were certainly no signs of crowding out of private sector borrowing because of government borrowing. During Japan’s 15 year recession, supply side adjustments had been tried by 2 Japanese governments, but had no positive effect. The same applies for monetary stimulation and fiscal consolidation. In general too much fiscal stimulus is better than too little. Besides Japan, fiscal stimulation also worked successfully during the New Deal in the United States and in Nazi Germany. According to the author government borrowing and subsequent spending is even better than no fiscal stimulus for government debt, as it stabilises the economy and tax income. This happened in 2003 (page 55), but also in the United States during the Great Depression (page 116). Still, for me, this is still the weakest part of the theory, as Mr. Koo gives little detailed analysis. Japan paid a high price for stabilisation. In a time when Japan’s population is rapidly aging, national debt is now 200 % of GDP, which is much higher than Greece’s. It is only sustainable, because Japan manages to borrow mainly domestically from private savings with no interest to speak off. Once Japan’s population will reduce its savings for retirement income, Japan’s problems may increase materially.

Besides his theory of the Balance Sheet Recession, Mr. Koo informs us about the acceptance of his theories with influential economists, rating agencies, and the IMF. He is very critical of the IMF, that came down during the recession with standard solutions that did not match Japan’s specific situation. Equally, rating agencies do not understand that fiscal expansion is better than budget balancing in this kind of economic situation. British and American journalists also get a bashing. They take the moral high ground by overvaluing structural reforms where fiscal stimulus is more important. He is however most critical of Ben Bernanke and Paul Krugman. Both seem to think that monetary stimulus always works. Krugman claimed that it is not important to understand the causes of deflation. He advocated 300 % inflation for Japan, which would have wiped out people’s savings. The author also gives qualitative arguments. Helicopter money would not be trusted if it is not backed by gold, and producers may cease selling if they would get such a currency in return.

When looking at the world in 2009, there are many signs of a Balance Sheet Recession. The FED has created bubble after bubble, with lastly the housing bubble, the sector of the economy that is most sensitive to low interest rates. Low interest rates however also they tend to correlate with lax lending standards. The money supply itself was not the best indicator of the bubble status, but as usual, the increased velocity of money was. Capital injections were given to banks around the world during the weeks of the systemic crisis. Particularly in America this was politically difficult. In such a case all the government can do is wait until it gets painful enough. The costs of saving banks are always low in the end, and market solutions do not work times of systemic crises. Tax cuts are definitely not the solution for Balance Sheet Recessions. Other remedies that Mr. Koo advocates will be more difficult for some countries, particularly in Euroland, where the Maastricht Treaty basically makes fiscal stimulus impossible (the same applies to recent changes in the German constitution), although exceptions are allowed.

In the case of the US, targeting a lower exchange rate is legitimate, given the US current account deficit. This solution worked well for Asian countries in the aftermath of the Asian Currency Crisis. Mr. Koo estimates that the trade imbalances with Asia can be met by a coordinated increase in Asian exchange rates of about 15%. Asian spending can be stimulated by setting up much need social security in China, which would reduce the need for China’s extraordinary savings rate. Japan could easily stimulate domestic spending by increasing workers holidays or improving home construction. Houses are now written off in 15 years and require reconstruction every 30 years, which reduces Japan’s wealth. As far as government spending is concerned, this can best be directed to education and research and development, given globalisation and the rise of China. If you would follow Mr. Koo’s argumentation, the rise of China could be seen as devaluation of human capital in the field of industrial labour.

Interest rate strategies have become ineffective in a world of open financial markets where currency markets are no longer the by-product of trade flows. Interest rate reduction makes money moves overseas to countries with higher rates of return. It could actually lead to a reduction of lending facilities in the country that reduced the interest rate, and bubbles in the country that receives the capital inflow. Also, America should not take the trust in the dollar lightly. FED chairman Ben Bernanke has stated it would only have modest effects when Japan and China would cease buying dollar assets. However, dollar flight happened before, after the 1985 Plaza Accord. At that time US interest rates rose from 7.5 to 9 percent, as the USD fell 10% (pagina 214).

I greatly enjoyed Mr. Koo’s book. However, you get the idea that it is the product of a technocrat. Mr. Koo advocates effective and efficient policies without looking at things like moral hazard, let alone at the ideological constraints you find particularly in the Anglo-Saxon world. The book is rambling in content, with many repetitions of earlier themes (and consequently I would recommend skipping the chapters 2 and 3, as they do not contain much new information). This is a pity, because otherwise the author expresses his findings very clearly. The book is easy to read as it uses charts for quantitative explanations, and lacks all math. The theory has been discussed in fora like Davos and with the likes of Paul Krugman, and Mr. Koo found an interested audience with the authorities in Canberra, Frankfurt, London, and The Hague. You will find few books that can clarify you so well about the difference between monetary and fiscal measures to improve the economy. It also gives a brief but interesting overview of the Japanese model in raising economic development, that is copied so enthusiastically by the likes of Korea, Taiwan, and China.

With “Helicopter Ben” Bernanke’s Quantitative Easing 2 starting we may soon be able to verify or falsify Mr. Koo’s theory. Given the negative effects that the FED’s policies can have globally, you would almost hope that Mr. Koo will be proven wrong.

Recommended for anyone with an interest in understanding macro economics. You may find an introduction here, but the book guides you through his theory more easily. ( )
2 vote mercure | Nov 2, 2010 |
Showing 4 of 4
It’s one of the few books out there that talks about what you should do in the aftermath of a burst bubble — almost everyone else obsesses on the causes of the bubble, and possibly on how to prevent the next bubble, neither of which is the clear and present issue.
added by mercure | editNew York Times, Paul Krugman (Aug 17, 2010)
Japan’s policymakers, Koo writes, actually did a lot more right than any of the world’s assembled economists gave them credit for, and that was to pour in huge amounts of public sector spending.
What has Japan's "lost decade" to teach us? Even a year ago, this seemed an absurd question. The general consensus of informed opinion was that the US, the UK and other heavily indebted western economies could not suffer as Japan had done. Now the question is changing to whether these countries will manage as well as Japan did. Welcome to the world of balance-sheet deflation.

As I have noted before , the best analysis of what happened to Japan is by Richard Koo of the Nomura Research Institute. His big point, though simple, is ignored by conventional economics: balance sheets matter. Threatened with bankruptcy, the overborrowed will struggle to pay down their debts. A collapse in asset prices purchased through debt will have a far more devastating impact than the same collapse accompanied by little debt.

Most of the decline in Japanese private spending and borrowing in the 1990s was, argues Mr Koo, due not to the state of the banks, but to that of their borrowers. This was a situation in which, in the words of John Maynard Keynes, low interest rates - and Japan's were, for years, as low as could be - were "pushing on a string". Debtors kept paying down their loans.

How far, then, does this viewpoint inform us of the plight we are now in? A great deal, is the answer.
added by mercure | editFinancial Times, Martin Wolf (Feb 18, 2009)
These broader problems of debt and deleveraging arguably explain why the successful stabilization of the financial industry has done no more than pull the economy back from the brink, without producing a strong recovery. The economy is hamstrung—still crippled by a debt overhang. That is, the simultaneous efforts of so many people to pay down debt at the same time are keeping the economy depressed.
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The revised edition of this highly acclaimed work presents crucial lessons from Japan's recession that could aid the US and other economies as they struggle to recover from the current financial crisis. This book is about Japan's 15-year long recession and how it affected current theoretical thinking about its causes and cures. It has a detailed explanation on what happened to Japan, but the discoveries made are so far-reaching that a large portion of economics literature will have to be modified to accommodate another half to the macroeconomic spectrum of possibilities that conventional theorists have overlooked. The author developed the idea of yin and yang business cycles where the conventional world of profit maximization is the yang and the world of balance sheet recession, where companies are minimizing debt, is the yin. Once so divided, many varied theories developed in macro economics since the 1930s can be nicely categorized into a single comprehensive theory- The Holy Grail of Macro Economics

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