The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession

When do banks and businesses not seek to maximize profits? When they've fallen into a state of negative net worth, such as after the bursting of an asset bubble. In this situation, it doesn't matter how cheap money is -- the usual monetarist response to a recession -- because, survival taking precedence, businesses opt to pay down debt instead. Author Richard Koo calls this situation a balance-sheet recession. He discovered it while working on the long Japanese recession of the 90s that extended into the 2000s. He particularly noted the beneficial effect of a fiscal stimulus, versus monetary policy, or worse, an attempt to balance the budget. The same conclusions can be drawn about the Great Depression in the 1930s US, where the economy would improve as long as FDR kept up government spending, but would fall back into recession when he let programs lapse or when pressured to adhere to conventional neo-classical economics, such as trying to balance the budget in 1937.We can see the same thing happening today in the US, where the Fed has reduced the bank loan rate to almost zero, handed out hundreds of billions of dollars to banks, only to find out that banks have used the money to pay down debt and strengthen their balance sheets, rather than make new loans. It's the old "pushing on a string" analogy. And so much for Ben Bernanke's helicopter.Koo sees the concept of a balance-sheet recession as something that is missing from both neo-classical and Keynesian economics. He asserts that there's an economic cycle of upturn (yang) and downturn (yin) and what works in the yang environment, like monetary stimulus, fails in the yin environment.I have a personal quibble here with Koo's concept that neo-classical economics ever works, even in the yang phase.... That is, the thirst for profits in the yang phase inevitably produces a growing disparity of income, where the investor class takes an ever-larger share of the profits, which goes back into ever more investments. But if the income of the salaried middle-class stagnates, as it did in the 1920s and again in the 1990s-2000s, then the middle-class can't afford to buy what business is producing. Business then responds by encouraging the increased use of credit in order to maintain rising sales, necessary for rising stock prices. Eventually this produces both an asset bubble and a credit bubble, finally collapsing into the yin phase where the taxpayers have to bail out the system.In this work, Koo concentrates on the yin balance-sheet recession phase, fortunately. (Though he does make some solid criticisms of neo-classical theory.) His experience in Japan has given him a good insight into what works and doesn't work. Even though Japan struggled for some 14 years, until 2005, and is now struggling along with the rest of us in this global downturn as their exports have crumbled, Koo notes that it could have been much worse. After all those years, they finally figured it out -- and their experience should be a lesson for the US, if we're paying attention.Koo also adds an interesting appendix on money, Walras, and macroeconomics. Basically, why neoclassical economics fails to understand what money really is, and the results of that failure.Hopefully, Pres Obama's economic advisors will take Koo's recommendations to heart. (According to a blurb on the book cover, Larry Summers has at least read it, though he seems non-committal as to whether or not he agrees with it.) As physicist Max Planck once noted, new ideas may only get accepted when the supporters of the old ideas die off.The book is not a difficult read for the layman, though not a quick read either. It does tend to get repetitious at times. But it's a solid contribution to our understanding of how a market economy actually works, and so not to be missed by anyone interested in macroeconomics. As for those of you who are macroeconomists by profession, working in the shadow of St. Milton, read this book and come into the light. :-)

This book is a good account of the phenomenon of debt aversion. The thesis of the book is pretty straightforward and is that, after asset bubbles burst and businesses are technically insolvent through liquidation analysis, they are likely to pay down debt irrespective of monetary policy. The fact that the businesses are technically insolvent despite market prices is described as being a function of information asymmetry and bank incentives.This realization is deemed to be the missing link to complete economist's understanding of how to bridge fiscal macroeconomic thought and monetary economic thought and the solutions required in the aftermath of a burst asset bubble. Discussing the shortfalls of Friedman's positions on the demand function for money to be a function of nominal interest rates, it is argued that when one is in the position of being insolvent yet operational, the focus shifts from using lending lines to maximise ROE to using free cashflow to minimize the debt that is causing this insolvency. When this market regime is upon us, it is the need of the government to use fiscal policy to fund the output gap.I think this is pretty accurate as an analysis of the problems that arise in monetary policy when the world is in fear of the phenomenon that hurt them (being burdened with debt that is greater relative to the asset base one had assumed would back it) and this aversion has macroeconomic repurcussions. My only criticism is, I dont think this is as obscure a result as is described. Most ecnomists realize how output gaps can arise, how debt aversion can form. Richard Posner, who is a judge, talks about debt aversion off-hand as though its well known. So all in all i think its a god perscriptive piece on a very real phenomenon we deal with but its not revolutionary and this phenomenon is discussed by others (though few have gone in to as much detail about it).

An superb book introducing the concept of a balance sheet recession. Simply put: When the people and business of a nation are paying down debt when there are close to zero interest rates rather than borrowing cheap money, the nation is in a balance sheet recession. The reason people and businesses would do this is their assets have dropped in value, following the collapse of an asset bubble, which itself was fuelled by excessive bank borrowing. The effect of the assets price collapse means for an otherwise healthy profitable business or say and individual with a good income with neither having any difficulty in servicing their repayments they are faced with a situation where their borrowings are in excess of their assets. In accounting terms they are technically insolvent, bankrupt.This shock causes them to stop spending and borrowing and direct their space cash-flow to repaying their debts. This is sensible from the individuals point of view, but, when most individuals and businesses are facing the same problem the bottom drops out of the economy, a deflation results. With borrowings built up over years and only spare can flow to pay back with (assets have dropped) its a long way back...The examples in the book explain the mechanism and the correct policy responses and how the incorrect responses such as those in the US following the Wall Street Crash of 1929 brought about the great depression of the 30's.In 2008 the global financial crisis was just getting underway, the Author was right on the money and correctly explained what was coming next. I disagree with the reviewer who said the text lacked academic rigour, it is convincing from a simple mathematical basis.I'm not an economist but an individual whose interested in asset economies and the seemingly endless rise in house prices in the UK during my lifetime, 70's, 80's, 90's 00's. I was shocked when I saw what happened in Japan to property prices following the bursting of the assets bubble and the 90% collapse in proper prices subsequently. Not all at once but "death by sandpapering", my worry, could this happen in the UK? What would happen to the nation if it did?The author explains how the Japanese property crash came about over a long period of time and the policy errors which were made.Rather than a peculiar Japanese experience the same things could happen anywhere. What's particularly optimistic is how eventually the problem was solved and how relevant the solution is to the problems facing the western world today. Whats really heartening is how great depressions have been solved in 5 years or so with the correct policy, read the book to find out what.Read thus book first before going onto his 2nd book the QE Trap, you'll get much more out of reading the two books.

I very much enjoyed this book and as everyday passes it seems to grow with relevance. It is very interesting and informative and offers some insightful contrarian views on the nature of modern recessions/depressions.While I have rated it 5 stars it does have some flaws. As one of the other reviewers have commented the data and the quality of the charts are rather lacking. It would have been nice to have more detail and some of the underlying data.While the author might be right; his approach lacks some academic rigour. The book doesn't sufficiently test alternative hypothesises and eliminate them as possible explanations. Rather the author immediately moves onto his theory as the only possible explanation.Stylistically, it could have been shorter, a little less repetitive and more concise. Though these are minor complaints.

This book is very repetitive, he probably repeats his point over 50 times and makes a very good case for it too. Though perhaps he reveres this theory excessively as if having solved all the problems between macroeconomics. Nonetheless good book with good evidence of the theory and then explanation of why it matter in economic debates.

Top notch, sound knowledge of economics, very in depth.

This book makes a clear case with plenty of evidence for the core reasons behind the Japanese stagnation of the last 20 year or so. Required reading for anyone with an interest in Japan.