Monday, April 9

Lessons from Japan's Great Recession

I have been enjoying Richard C Koo’s, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, published in 2008 by John Wiley and Sons. Book reviews can be found here, here, here, here, here and here.

Koo's thesis is simple: there are two types of recession. In your standard 'credit crunch' recession the problem is an insufficient money supply. The solution for a credit crunch is applying monetary policy to create more liquidity in the banking system. Koo argues there is another type of recession, which he calls a 'balance sheet recession'. In a balance sheet recession, firms find themselves with troubled balance sheets following an asset-class price deflation. In response, firms change their overriding purpose from profit maximisation to debt reduction; each firm's survival depends on it. As a result, the problem is not money supply. It is the reduced demand for money (and the reduced appetite for debt). According to Koo,
When companies that should be raising funds to expand their operations stop doing so en masse, and instead begin paying down existing debt, the economy loses demand in two ways: businesses are not reinvesting their cash flow, and the corporate sector is no longer borrowing and spending the savings by the household sector. This contraction in aggregate demand causes the economy to fall into recession.
When no one is borrowing money, and all firms are striving to reduce debt, the fundamental mechanism for channeling household savings into corporate investment breaks down. Koo calculates that aggregate demand (ie. GDP) would shrink by an amount equal to the sum of net household savings plus net debt repayment by firms.

Koo makes a couple of observations that might be relevant to the current fiscal policy debate in Australia. He argues that while monetary policy is the best tool of response to a credit crunch recession, fiscal policy is the best tool of response for a balance sheet recession. Expansionary fiscal policy saved Japan from a deflationary spiral like the one experienced by the US during the Great Depression. In Japan, Government borrowing replaced private borrowing.

Koo also notes that government revenues collapse under a balance sheet recession. There is an incentive for firms to sell lower valued assets and realise the loss to offset profits (and consequently tax liabilities).  Furthermore, at the end of this process, when all losses have been realised, tax revenues from firms rise quickly but at the expense of aggregate demand/GDP.

The big question in my mind is whether Koo's thesis is applicable to Australia. While we are not in recession, we have been experiencing an extended period of sub-trend GDP growth.The red line in the next chart is the decadal Henderson moving average. The trend prior to the GFC is marked in orange. The trend since the GFC is marked in purple.

We have also seen some (albeit limited) asset price deflation (especially in real estate). And there appears to be a much more cautious approach to debt. Households are saving more and businesses are borrowing less.

For the sake of the argument, if we assume that at least to some extent we are in (perhaps at the end stage of) a balance-sheet downturn in Australia, the Government's commitment to contractionary fiscal policy in the 2012-13 Budget could have a double negative impact on aggregate demand (ie. GDP).

If company tax revenues are picking up in the last six months as a result of firms exhausting the process of loss realisation, some of these extra revenues could be taking money from the economy.

Any such subtraction from GDP would be in addition to any reductions in spending or additional taxes the government might be planning to bring the budget into surplus in 2012-13. This would be especially the case if business borrowing does not replace government borrowing. Such a double whammy might be sufficient to contract the economy.

It is not just the government that needs to be cautious. The Reserve Bank is being heckled into lower interest rates. If Koo's thesis applies to Australia, there is the broad risk that lower interest rates will  prove ineffective in stimulating investment, but prove effective in fueling inflation. If firms are resolved to pay down debt, or just to eschew debt, lower interest rates may not contribute significantly to business investment (perhaps with the exception of the mining sector).

Another risk for the central bank is that the only thing lower rates would stimulate is further asset price growth in the housing sector, sowing seeds for a housing price deflation and balance sheet recession.

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