Why Governments Haven't Learned The Lessons Of Japan

Tracy Alloway (0:12)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:17)

And I'm Joe Weisenthal.

Tracy Alloway (0:19)

Joe, do you think everyone knows what a balance sheet recession is by now?

Joe Weisenthal (0:23)

I don't think so. Only the cool people know what a balance sheet recession is.

Only the real nerds who are reading up on this stuff, pre and post-crisis, were into that. But I think for the vast majority of people, including, I would say, the vast majority of economists, unfortunately, I don't think that concept is one that's really in their language or their terminology, typically.

Tracy Alloway (0:44)

Yeah, I kind of have to remind myself of this because I got into financial journalism right after the 2008 financial crisis, and balance sheet recession was sort of the hot thing then. It was the parallel that everyone was reaching for to explain what was happening to the US at the time.

But of course, it's still a relatively new concept, and it's still a relatively rare type of recession, I guess.

Joe Weisenthal (1:10)

Right, and you know, again, this sort of one of the questions that developed market economies are dealing with right now is, why have the traditional tools that governments and central banks use to stimulate the economy not been effective? Why have lower interest rates not caused faster growth and more rapid inflation?

Why don't we see more rapid growth and inflation thanks to budget deficits that are essentially near their highest levels of all time in places like the US and elsewhere? And so it kind of in keeping things we've talked about a long time, like, well, what is really wrong with the framework? And is there a different way to think about the malaise that we see across so much of the world's economies?

Tracy Alloway (1:56)

Right, and I think we are seeing more and more policymakers who are arguing that fiscal stimulus is the way forward or that fiscal is the new monetary policy. And a lot of that thinking stems from the balance sheet recession idea. So why don't we go ahead and dig into it? I'm really happy to say that our guest on today's episode is Richard Koo, the chief economist of Nomura Research Institute and the man who the term balance sheet recession is actually attributed to. So Richard, thank you so much for coming on.

So why don't we start with the obvious question, what exactly is a balance sheet recession and how did you come to start thinking about recessions in that way?

Richard Koo (2:42)

I have to first disclose my geography because I've been in Japan for the last 36 years.

Starting around 1990, of course, Japan fell into this, what I call, balance sheet recession. And BOJ brought rates down to almost zero, tried to stimulate the economy, and nothing seemed to work.

And it took me about seven years to figure out that perhaps we have to come out of our ordinary, you know, private sector always maximizing profits kind of framework to understand what's going on. And one day I stumbled upon the chart that indicated the Japanese companies are not borrowing money at all. They're actually paying down debt. And then it came to me that why would a private sector company willing to pay down debt when interest rates are zero?

And then, of course, the only reason that can happen is that they have financial problems of some sort, perhaps balance it under water. And then when I start thinking in those terms, everything kind of fell in place. That is to say, during the bubble days, people typically leverage themselves up, thinking that they're going to make lots of money very quickly. When the bubble burst, asset prices collapsed, perhaps all that liabilities remained, their balance sheets under water, and people all start paying down debt at the same time. And paying down debt, it becomes kind of a survival issue for them, because if people outside the company, for example, finds out that your company is actually in a negative equity, they will stop trading you on credit, they demand everything to be settled in cash, your best employee could leave, because realizing that this company might be under water for many years to come, when all these things come to surface, you're basically dead.

So people inside the companies who understand the actual situation keep their mouths shut, tell investors, shareholders, whatever they want to hear, they try to repair the balances as quickly and quietly as possible.

And that's, of course, on an individual level, the right thing to do. If I were running one of those companies, I would be doing it. Many of the people listening to this podcast in the same situation will probably do the same, because if you have a cash flow, and in the Japanese case, a lot of companies still had cash flow. Japan was running the largest trade surplus in the world. People wanted to buy Japanese products all over the world. So the main line of business was okay. They had a cash flow, but their balance sheets were horribly underwater. So all these people start paying down debt to repair their balance sheets, and that way you don't have to tell your shareholders. It's not, the shares are all a piece of paper now. You don't have to tell your bankers. It's all non-performing loans. And most importantly, you don't have to tell your workers. There are no more jobs tomorrow. So for all the stakeholders involved, using the cash flow to pay down debt is the right thing to do. But when everybody does it at the same time, we fall into this fallacy of composition problems in that even though everybody is doing the right things, collectively you get the wrong result, and you get this wrong result because in a national economy, if someone is saving money or paying down debt, someone else has to be borrowing those money and putting them back into the income stream. If everybody is saving money or paying down debt, then no one is borrowing money. And the economy will just implode. When all these people start paying down debt, the economy will begin to decelerate and the situation got worse and worse and worse.