The Age of Balance Sheet Recessions: What Post-2008 U.S.

, Europe and China Can Learn from Japan 1990-2005

Richard C. Koo Chief Economist Nomura Research Institute Tokyo October 2008

Exhibit 1. US Housing Price Futures Moving Closer to the Japanese Experience

(US: Jan. 2000=100, Japan: Dec. 1985=100)

Futures
Composite Index Futures (as of Sep. 19, 2007)

260 240 US: 10 Cities Composite Home Price Index 220 200 180 160 140 120 100 80 60 40 92 77 93 78 94 79 95 80 96 81 97 82 98 83 99 84 00 85 01 86 02 87 03 88 04 89 05 90 06 91 07 92 08 93 09 94 10 95 11 96 12 97 Japan: Osaka Area Condo Price 2 (per m , 5 months moving average)
Composite Index Futures (as of Oct. 23, 2008)

Japan: Tokyo Area Condo Price 2 (per m , 5 months moving average)

US Japan

Sources: Bloomberg, Real Estate Economic Institute, Japan, S&P "S&P/Case-Shiller Home Price Indices", as of Oct. 23, 2008.

Exhibit 2. Japanese Banking Crisis and US Subprime Crisis Resulting in Similar Bank Losses
(Losses in billions of U.S. dollars) 1600 40

1400

Other financials (left scale) Bank losses (left scale)

35

1200

Percent of GDP (right scale)

30

1000

25

800

20

600

15

400

10

200

0 U.S. savings and loan crisis Japan banking crisis (1990- Asia banking crisis (1998- U.S. subprime crisis (2007(1986-1995) 1999) 1999) present)
Source: IMF, Global Financial Stability Report (October 2008) , p.16

Exhibit 3. Japanese Asset Prices Collapsed after 1990

(1990=100) 140

120

TOPIX Land Prices in Six Major Cities (Commercial) Golf Course Memberships

from the peak

100

80

60

40 -95% 20

-87%

-72% -81% -95%

0
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Sources: Tokyo Stock Exchange, Japan Real Estate Institute, Nikkei Sangyo Shimbun

Exhibit 4. Cumulative Capital Losses on Shares and Land since 1990 Reached $15 Trillion or 3 Years Worth of Japans GDP
400 (Tril. yen) (Capital Gain)

Land
0

Shares

-400

-800

1,500 tril. yen

-1200

Land and Shares Combined

-1600 90 91 92 93 94 95 96

(Capital Loss) 97 98 99 00 01 02 03 04 05 06

Source: Cabinet Office, Japan "National Accounts"

Exhibit 5. Balance Sheet Problems Forced Japanese Businesses to Pay Down Debt even with Zero Interest Rates
Funds Raised by Non-Financial Corporate Sector
(% Nominal GDP, 4Q Moving Average) 25 (%) 10

CD 3M rate (right scale)

20 8

Borrowings from Financial Institutions (left scale)

15 6

Funds raised in Securities Markets (left scale)

10 4

-5

-2

-10 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Sources: Bank of Japan, Cabinet Office, Japan

-4

Exhibit 6. Japans GDP Grew even after Massive Loss of Wealth and Private Sector Rushing to Pay Down Debt
(Tril.yen, Seasonally Adjusted) 600 550 500 450 400 350 300 250 200 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Sources: Cabinet Office, Japan Real Estate Institute Land Price Index in Six Major Cities (Commercial, Right Scale) Last seen in 1973 Real GDP (Left Scale) 600 500 400 300 down 87% 200 100 0 Nominal GDP (Left Scale) 800 700 (Mar. 2000100)

Exhibit 7. Japanese Government Borrowed and Spent the Excess Savings of the Private Sector to Sustain GDP
(Tril. yen) 100 Government Spending 90

80

70

60

50

40 Bubble Collapse Tax revenue

30

20 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: Ministry of Finance, Japan Note: FY 2007 includes supplementary budget, and FY 2008 is just initial budget.

Exhibit 8. Japanese Companies Made Huge Progress in Reducing Debt Overhang

(Yen tril., Seasonally Adjusted) 450 400 350 300 250 (as a ratio to nominal GDP, %)

90
Credit Extended by the Banks to 85/4Q Corporate Sector as a Ratio to Nominal GDP (Right Scale)

80

70
200 150 100 50 0 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
Sources : Bank of Japan, "Loans and Discounts Outstanding by Sector" "Loans to Individuals", Cabinet Office, Japan "National Accounts" Notes: 1. 'Credit Extened by the Banks to Corporation' is extended to 1970 by NRI after adjustment for discontinuities in statistics in 1993 and again in 1975. 2. As a percentage of nominal GDP. For GDP statistics before 1979, 68 SNA is used.

Credit Extended by the Banks to Corporate Sector (Left Scale)

60
last seen in 1956

50

Exhibit 9. Premature Fiscal Reforms in 1997 and 2001 Weakened Economy, Reduced Tax Revenue and Increased Deficit
70
(Yen tril.) (Yen tril.) Hashimoto Koizumi (initial budget)* fiscal Obuchi-Mori fiscal fiscal reform (with supplemental budget)* reform stimulus

70

Tax Revenue 60 Budget Deficit

60

50

50

40

40

30

unnecessary deficit: 30 107 tril.

20

20

10

10

0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
(FY) Source: Ministry of Finance, Japan *: estimated by MOF

Exhibit 10. The Anatomy of Balance Sheet Recession and Its Cure
Private Sector Bought Assets with Borrowed Funds Original Money Flow Household Sector Continues to Save

The Problem The Solution

Fall in Asset Prices Vicious Cycle

Balance Sheet Problems Develop

Repair Balance Sheets

Government Procures Funds at Low Rates due to the Lack of other Borrowers Allow Private Sector to Pay down Debt Breaking the Vicious Cycle

Private Sector Moves away from Profit Maximization to Debt Minimization

Private Sector Paying Down Debt

Fall in Aggregate Demand

Keep the Aggregate Demand from Falling

No Demand for Funds

Weaker Economy and Deflation

Fiscal Stimulus

Central Bank Panics and Dramatically Eases Monetary Policy

More Defaults

Further Fall in Asset Prices

More Non Performing Loans at Banks Nothing Happens because Private Sector Is Minimizing Debt "Liquidity Trap"

Government Borrowings Help Maintain Money Supply in the Absence of Private Sector Borrowers

Source: Richard Koo, Balance Sheet Recession: Japan's Struggle with Uncharted Economics and its Global Implications , John Wiley & Sons, Singapore 2003

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Exhibit 11. Four Kinds of Banking Crises and Their Remedies

Yang
Normal demand for funds (I) Quick NPL disposal Pursue accountability (II) Slow NPL disposal Fat spread

Yin
Weak or non-existent demand for funds (III) Normal NPL disposal Pursue accountability (IV) Slow NPL disposal Capital injection

Localized Banking Crisis Systemic

Type (I): 1989 S&L crisis Type (II): 1982 Latin America debt crisis, nationwide credit crunch in the US between 1991 and 1993, and the Nordic banking crisis in the early 1990s Type (III): Japan prior to 1995 (for example, problems at two credit cooperatives) Type (IV): Japan since 1996, Taiwan since 2000, the US Great Depression of the 1930s, and US and UK subprime crisis since 2007
Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japans Great Recession, John Wiley & Sons, Singapore, 2008

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Exhibit 12. Two Capital Injections Ended the Credit Crunch in Japan
Bankers' Willingness to Lend as Seen by the Borrowers, and the Actual Credit Extended by the Banks
'Accommodative' minus 'Restrictive', %points 60 Miyazawa Proposal

Credit Crunch

Large Enterprises Left Scale

40

Bubble Burst

"Takenaka Shock"
20

Accommodative 0 Restrictive -20 Small Enterprises Left Scale

1st Capital Injection

(1.8 tril.) -40 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00

2nd Capital Injection

(7.5 tril.) 01 02 03 04 05 06 07 08

Shaded areas indicate periods of BOJ monetary tightening Source: Bank of Japan, "Tankan".

12

Exhibit 13. CDS Spreads of US Banks Have Shrunk after Capital Injection
1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Source: Bloomberg Note: As of Oct. 23, 2008. Morgan Stanley Goldman Sachs Citigroup

13

Exhibit 14. CDS Spreads of European Banks Have Shrunk after Capital Injection
800

700 Fortis 600 UBS Barclays 500 HSBC 400

300

200

100

0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Source: Bloomberg Note: As of Oct. 23, 2008.

14

Exhibit 15. Percentage of House Purchases that May Lead to Return the Key
For Houses Bought before August 2008
(millions)

50 45 40 35 30 57.0% (1) 25 20 15 28.6% (2) 10 5 0

At Present (Oct. 2008) Home Prices [-22.0%] 30% below the Peak Lowest Price in Futures Market (Nov. 2010)[-33.7%] 40% below the Peak

83.1% (1)

70.3% (1) 65.5%

(1)

41.4% (2)

23.8% (2) 15.3% (2)

Source: Nomura Research Institute estimates from the data of US Department of Commerce, National Association of Realtors, S&P "S&P/Case-Shiller Home Price Indices", and Bloomberg (as of Oct. 23, 2008). Notes: (1) Maximum share of underwater mortgages assuming that the total number of mortgages is 53 million. (2) As (1), but with a 10% downpayment.

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Exhibit 16. Japans Money Supply Has Been Kept Up by Government Borrowings (I)
16 14 12 10 8 6 4 2 0 -2 -4 -6 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Sources: Bank of Japan "Monetary Survey", "Changes in Money Stock (M2+CD), and Credit Statistics" Notes: "Credit extended to others"= (1) public sector + (2) foreign assets (net) + (3) others. (1) Public Sector = credit to the government (net) + credit to regional public sector bodies + credit to public corporations (3) Others= (money + quasi-money + CD) - (foreign assets (net) + domestic credit). Therefore, increase or decrease in "Credit extended to others" will include impact of increase/decrease in public sector debt, increase/decrease in bank debentures issued by private sector banks and deposits of financial institutions, and errors in data.
(Y/Y%)

Credit Extended to Others (Mostly Government) Credit Extended to the Private Sector Money Supply (M2+CD)

Quantitative Easing

16

Exhibit 17. Japans Money Supply Has Been Kept Up by Government Borrowings (II)
Balance Sheets of Banks in Japan
December 1998
Assets Liabilities

December 2007
Assets Liabilities

Credit Extended to the Private Sector

Money Supply (M2+CD)

Credit Extended to the Private Sector

621.5 tril.

501.8 tril. (-99.8)

Money Supply (M2+CD)

601.6 tril.

744.4 tril. (+122.9)

Credit Extended to the Public Sector

Credit Extended to the Public Sector

140.4 tril.
Foreign Assets (net)

Other Liabilities (net)

247.2 tril. (+106.8)

Foreign assets (net) Other Liabilities (net)

153.2 tril.

32.7 tril.

74.1 tril. (+41.4)

Total Assets 774.7 tril.

Source: Bank of Japan "Monetary Survey"

Total Assets 823.1 tril. (+48.4)

78.7 tril. (-74.5)

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Exhibit 18. US Money Supply Growth after 1933 Was also Made Possible by Government Borrowings
Balance Sheets of All Member Banks
June 1929
Assets Liabilities

June 1936
Assets Liabilities

Credit Extended to the Private Sector $29.63 bil.

Deposits $32.18 bil. Credit Extended to the Private Sector $15.80 bil. (-13.83) Credit Extended to the Public Sector Other $8.63 bil. Liabilities (+3.18) $6.93 bil. Other Assets $6.37 bil. (-1.65) Capital Reserves $6.35 bil. $2.24 bil. (-0.12)

June 1933
Assets Liabilities

Credit Extended to the Public Sector $5.45 bil. Other Assets $8.02 bil.

Deposits $23.36 bil. (-8.82) Credit Extended to the Public Sector $16.30 bil. (+7.67)

Credit Extended to the Private Sector $15.71 bil. (-0.09)

Deposits $34.10 bil. (+10.74) (= Money Supply)

Other Other Assets Liabilities $8.91 bil. $4.84 bil. (+2.54) (-2.09) Reserves Capital $5.61 bil. $4.84 bil. (+3.37) (-1.51)

Other Liabilities $7.19 bil. (+2.35) Capital

Reserves $2.36 bil.

$5.24 bil. (+0.40)

Total Assets $45.46 bil.

Total Assets $33.04 bil. (-12.42)

Total Assets $46.53 bil. (+13.49)

Source: Board of Governors of the Federal Reserve System (1976) Banking and Monetary Statistics 1914-1941 pp.72-79

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Exhibit 19. Monetary Aggregates Behave Totally Differently under Balance Sheet Recession
Quantitative Easing

(1990/1Q=100, Seasonally adjusted) 300 High-powered Money (Average Balance) Money Supply (M2+CD, Average Balance) 250 Credit Extended to the Private Sector

200

150

Textbook Economics (monetary policy effective)

Balance Sheet Recession (monetary policy NOT effective)

Down 37%

100

50

1990/1Q

0 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Note: Private sector borrowings seasonally adjusted by Nomura, adjustments made for discontinuities in line with BOJ's "Monetary Survey" Source: Bank of Japan

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Exhibit 20. Summary of US Policy Options Based on Japans Experience

Fiscal Policy
Economic Stimulus Capital Injection
Government spending more effective than tax cuts Must be seamless for the duration of recession Effective in ending debilitating credit crunch Politically unpopular but sooner the better

Monetary Policy

Monetary easing largely ineffective except

Until home prices fall to their Discounted Cash Flow values

Liquidity Injection

Keeps financial institutions operating Benefit: Exports encouraged, Imports discouraged

Weaker Dollar

Risks: May trigger foreign capital outflow leading to higher interest rates Accelerate imported inflation Oil price denomination in US dollar may be jeopardized, which may lead to a dollar collapse

Source: Nomura Research Institute

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Exhibit 21. As for the Accountability

All rating agencies who gave high ratings to subprime-related securities should be required to display the following notice in all of their public announcements for the next 50 years.

Warning: Subprime crisis has proven that ratings produced by this agency are sometimes worthless. Investors are therefore advised not to rely entirely on ratings produced by this agency in making investment decisions.

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Exhibit 22. EU Economic Sentiments Are Worsening

(Seasonally adjusted) 120

115

110

Euro Area Economic Sentiment

105

100

95

90 Ifo Business Climate 85

80 2000

2001

2002

2003

2004

2005

2006

2007

2008

Source: Ifo Business Survey, European Commission

22

Exhibit 23. US Interest Rates Took 30 Years to Return to Their 1920s Level
(%)
9 8 US government bond yields Prime BA, 90days US government bond yields 1920-29 average (4.09%, June 1959) Prime BA, 90days 1920-29 average (4.13%, September 1959)

7 6 5
Oct '29 NY Stock Market Crash '33 New Deal Dec '41 Pearl Harbor Attack Jun '50 Korean War

4 3 2

1 0 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60
Source: FRB, Banking and Monetary Statistics 1914-1970 Vol.1, pp.450-451 and 468-471, Vol.2, pp.674-676 and 720-727

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Exhibit 24. Yin Yang Cycle of Bubbles and Balance Sheet Recessions
China
Yin (=Shadow) Bubble Yang (=Light)

(1) Monetary policy is tightened, leading the bubble to collapse.

(9) Overconfident private sector triggers a bubble.

US Spain UK
(2) Collapse in asset prices leaves private sector with excess liabilities, forcing it into debt minimization mode. The economy falls into a balance sheet recession. (3) With everybody paying down debt, monetary policy stops working. Fiscal policy becomes the main economic tool to maintain demand. (4) Eventually private sector finishes its debt repayments, ending the balance sheet recession. But it still has a phobia about borrowing which keeps interest rates low, and the economy less than fully vibrant. Economy prone to mini-bubbles. (8) With the economy healthy, the private sector regains its vigour, and confidence returns.

India

(7) Monetary policy becomes the main economic tool, while deficit reduction becomes the top fiscal priority.

Germany Japan

(6) Private sector fund demand recovers, and monetary policy starts working again. Fiscal policy begins to crowd out private investment.

(5) Private sector phobia towards borrowing gradually disappears, and it takes a more bullish stance towards fund raising.
Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japans Great Recession , John Wiley & Sons, Singapore, April 2008 p.160.

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Exhibit 25. Contrast Between Yin and Yang Phases of a Cycle

Yang
1) Phenomenon 2) Fundamental driver 3) Corporate financial condition 4) Behavioral principle 5) Outcome 6) Monetary policy 7) Fiscal policy 8) Prices 9) Interest rates 10) Savings 11) Remedy for Banking Crisis a) Localized b) Systemic
Textbook economy Adam Smith's "invisible hand" Assets > Liabilities Profit maximization Greatest good for greatest number Effective Counterproductive (crowding-out) Inflation Normal Virtue Quick NPL disposal Pursue accountability Slow NPL disposal Fat spread

Yin
Balance sheet recession Fallacy of composition Assets < Liabilities Debt minimization Depression if left unattended Ineffective (liquidity trap) Effective Deflation Very low Vice (paradox of thrift) Normal NPL disposal Pursue accountability Slow NPL disposal Capital injection

Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japans Great Recession , John Wiley & Sons, Singapore, 2008

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