The World in Balance Sheet Recession: What Post-2008 U.S.

, Europe and China Can Learn from Japan 1990-2005

Richard C. Koo Chief Economist Nomura Research Institute Tokyo November 2011

Exhibit 1. US Housing Prices Are Moving along the Japanese Experience

(US: Jan. 2000=100, Japan: Dec. 1985=100) 260 240 220 200 180 160 140

Futures

US: 10 Cities Composite Home Price Index Japan: Tokyo Area Condo Price1 Composite Index Futures

Japan: Osaka Area Condo Price1

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 13 98 14 99

US Japan

Note: per m 2, 5-month moving average Sources: Bloomberg, Real Estate Economic Institute, Japan, S&P, S&P/Case-Shiller Home Price Indices, as of Oct. 28, 2011

Exhibit 2. Drastic Liquidity Injection Failed to Increase Money Supply (I): US

320 300 280 260 240 220 200 180 160 140 120 100 80 3.0 2.5 2.0 1.5 1.0 0.5 08/1 08/4 08/7 08/10 09/1 09/4 09/7 09/10 10/1 10/4 10/7 10/10 11/1 11/4 11/7 11/10
Sources: Board of Governors of the Federal Reserve System, US Department of Commerce Note: Commercial bank loans and leases, adjustments for discontinuities made by Nomura Research Institute.

(Aug. 2008 =100, Seasonally Adjusted)

Monetary Base Money Supply (M2) Loans and Leases in Bank Credit

Down 25%

(%, yoy)

Consumer Spending Deflator (core)

Exhibit 3. Drastic Liquidity Injection Failed to Increase Money Supply (II): EU

150 (Aug. 2008 =100, Seasonally Adjusted)

Base Money
140

Money Supply (M3) Credit to Euro Area Residents

130

120

110

100

90 2.2 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 (%, yoy)

CPI core

08/1

08/4

08/7

08/10

09/1

09/4

09/7

09/10

10/1

10/4

10/7

10/10

11/1

11/4

11/7

Sources: ECB, Eurostat Note: Base money's figures are seasonally adjusted by Nomura Research Institute.

Exhibit 4. Drastic Liquidity Injection Failed to Increase Money Supply (III): UK

280 265 250 235 220 205 190 175 160 145 130 115 100 85 70 6 5 4 3 2 1 0 (Aug. 2008 =100, Seasonally Adjusted)

Reserve Balances + Notes & Coin Money Supply (M4) Bank Lending (M4)

Aug. 08' Down 17%

(%, yoy)

CPI (ex. Indirect Taxes)

07/1 07/4 07/7 07/10 08/1 08/4 08/7 08/10 09/1 09/4 09/7 09/10 10/1 10/4 10/7 10/10 11/1 11/4 11/7 Sources: Bank of England, Office for National Statisics, UK Notes: 1. Reserve Balances data are seasonally unadjusted. 2. Money supply and bank lending data exclude intermmediate financial institutions.

Exhibit 5. Drastic Liquidity Injection Failed to Produce Drastic Increase in Money Supply (IV): Japan
260 240 220 200 180 160 140 120 100 80 60 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 (y/y, %) (Oct. 97 = 100, Seasonally Adjusted)

Monetary Base Money Supply (M2) Bank Lending

Quantitative Easing

Earthquake

Oct. 97

Down 37%

CPI Core

Note: Bank lending are seasonally adjusted by Nomura Research Institute. Source: Bank of Japan

Exhibit 6. Japans De-leveraging with Zero Interest Rates Lasted for 10 Years
Funds Raised by Non-Financial Corporate Sector
(% Nominal GDP, 4Q Moving Average) 25 (%) 10

20

CD 3M rate (right scale) Borrowings from Financial Institutions (left scale)

15

Funds raised in Securities Markets (left scale)

10 4

0 Debt-financed bubble (4 years)

-5

Balance sheet recession (16 years)

-2

-10

-4

-15 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Sources: Bank of Japan, Cabinet Of f ice, Japan

-6

Exhibit 7. Japans GDP Grew in spite of Massive Loss of Wealth and Private Sector De-leveraging
(Tril.yen, Seasonally Adjusted) (Mar. 2000=100)

600

550

Nominal GDP (Left Scale) Real GDP (Left Scale)

800

700

500 600 450 500 400

Likely GDP Path w/o Government Action

Cumulative 90-05 GDP Supported by Government Action: ~ 2000 trillion

400

350

300

300

200

Last seen in 1973

250

down 87%

Land Price Index in Six Major Cities (Commercial, Right Scale)

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 09 10 11

100

200

Cumulative Loss of Wealth on Shares and Real Estate ~ 1500 trillion

Sources: Cabinet Of f ice, Japan Real Estate Institute

Exhibit 8. Japanese Government Borrowed and Spent the Unborrowed Savings of the Private Sector to Sustain GDP
(Tril. yen) 110

Government spending
100 90 80 70 60 50 40

cumulative cyclical deficit 90-05 315 trillion overall deficit 460 trillion Bubble Collapse

30 20

Tax revenue

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 09 10 11 Source: Ministry of Finance, Japan Note: FY 2011 includes 2nd supplementary budget.

Exhibit 9. Premature Fiscal Reforms in 1997 and 2001 Weakened Economy, Reduced Tax Revenue and Increased Deficit
(Yen tril.) 70 (Yen tril.) 70 Hashimoto Obuchi-Mori fiscal fiscal reform stimulus Koizumi fiscal reform Global Financial Crisis

Tax Revenue Budget Deficit

60

60

50

50

*
40 40

unnecessary increase in deficit: 103.3 tril.

30

30

20

20

10

10

0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 (FY) Source: Ministry of Finance, Japan *: estimated by MOF

Exhibit 10. Monetary Easing No Substitute for Fiscal Stimulus (I): Japans Money Supply Has Been Kept Up by Government Borrowings
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)

10

Exhibit 11. Monetary Easing No Substitute for Fiscal Stimulus (II): Post-1933 US Money Supply Growth 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 12. US in Balance Sheet Recession: US Private Sector Increased Savings Massively after the Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %, quarterly) 8

Households
6

(Financial Surplus) Rest of the World Shift from 4Q 2006 in private sector: 9.30% of GDP
Corporate: 1.40% Households: 8.22%

4 2 0 -2 -4 -6 -8 -10 -12 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Note: For the latest f igures, 4 quarter averages ending with 2Q/11' are used. Sources: FRB, US Department of Commerce

General Government Corporate Sector

(Non-Financial Sector + Financial Sector)

Shift from 4Q 2006 in public sector: 5.80% of GDP IT Bubble Housing Bubble

(Financial Deficit)

12

Exhibit 13. UK in Balance Sheet Recession: UK Private Sector Increased Savings Massively after the Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %) 9

Households
6

(Financial Surplus) Rest of the World Shift from 1Q 2007 in private sector: 8.23% of GDP
Corporate: 2.19% Households: 6.04%

-3

-6

-9

General Government (Financial Deficit)

Corporate Sector
(Non-Financial Sector + Financial Sector)

Shift from 1Q 2007 in public sector: 7.11% of GDP

-12 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Note: For the latest f igures, 4 quarter averages ending with 2Q/11' are used. Source: Of f ice f or National Statistics, UK

13

Exhibit 14. Global Bond Yields* Nearing Japanese Levels

(%) 6

England US Sweden Switzerland Japan

Japanese Bond Yield in 1997

3%
2

1.3%
1

0 2007

2008

2009

2010

2011

*Note: Excluding Eurozone. As of Oct. 28, 2011. Source: Bloomberg

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Exhibit 15. Euro-Zone Bond Yields Are Diverging Sharply

(%) 26 24 22 20

Greece Ireland Portugal

18 16 14 12 10 8 6 4 2 0 2007 Note: As of Oct. 28, 2011. Source: Bloomberg

Spain Italy France Germany

2008

2009

2010

2011

15

Exhibit 16. Euro-zone in Balance Sheet Recession: Euro-zone Private Sector Increased Savings Massively after the Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %) 6

(Financial Surplus) Households

4

Shift from 3Q 2008 in private sector: 4.09% of GDP

Corporate: 2.62% Households: 1.47%

Rest of the World

-2

-4

General Government
-6

Shift from 3Q 2008 in public sector: 4.03% of GDP

Corporate Sector
(Non-Financial Sector + Financial Sector)

(Financial Deficit)
-8 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Note: For the latest f igures, 4 quarter averages ending with 1Q/11' are used. Source: ECB

16

Exhibit 17. Spain in Balance Sheet Recession: Spanish Private Sector Increased Savings Massively after the Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %) 12

(Financial Surplus) Households

9

Rest of the World

6

Shift from 3Q 2007 in private sector: 17.95% of GDP

Corporate: 12.54% Households: 5.41%

-3

-6

Shift from 3Q 2007 in public sector: 11.93% of GDP Corporate Sector General Government
96 97 98 99 00
(Non-Financial Sector + Financial Sector)

-9

-12 01

(Financial Deficit)
02 03 04 05 06 07 08 09 10 11

Note: For the latest f igures, 4 quarter averages ending with 2Q/11' are used. Source: Banco de Espaa

17

Exhibit 18. Ireland in Balance Sheet Recession: Irish Private Sector Increased Savings Massively after the Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %) 15

Corporate Sector
10

(Financial Surplus)
Shift from 2006 in private sector: 21.55% of GDP
Corporate: 7.29% Households: 14.26%

(Non-Financial Sector + Financial Sector)

Rest of the World

5

-5

General Government

Shift from 2006 in public sector: 16.78% of GDP

-10

Households

-15 2002 2003 2004

(Financial Deficit)
2005 2006 2007 2008 2009

Sources: Eurostat, Central Statistics Of f ice, Ireland

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Exhibit 19. Exit Problem (II): German Private Sector Refused to Borrow Money after 1999-2000 Telecom Bubble
Financial Surplus or Deficit by Sector
(as a ratio to nominal GDP, %) 8

Households
6 4 2 0

(Financial Surplus)

Telecom Bubble

Shift from 2000 to 2005 in private sector: 12.06% of GDP

Corporate: 9.26% Households: 2.80%

Rest of the World

-2 -4 -6 -8 -10 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Corporate Sector (Non-Financial Sector + Financial Sector)

General Government

Shift from 2000 to 2005 in public sector: 4.62% of GDP

(Financial Deficit)

Sources: Deutsche Bundesbank, Federal Statistical Of f ice Germany Note: The assumption of Treuhand agency's debt by the Redemption Fund f or Inherited Liabilities in 1995 is adjusted.

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Exhibit 20. Recovery from Lehman Shock Is NOT Recovery from Balance Sheet Recession

Bubble Burst

Lehman Shock

Likely GDP Path without Lehman Shock

Economic weakness from private-sector (A) de-leveraging

Weaker Demand from Private Sector De-leveraging

Economic weakness from policy mistake (B) on Lehman

Actual GDP Path

Stronger Demand from Government's Fiscal Stimulus Current Location

Source: Nomura Research Institute

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Exhibit 21. Multi-Decade Cycle of Bubbles and Balance Sheet Recessions

Yin (=Balance Sheet Recession) Bubble Yang (=Textbook Economy)

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

(9) Overconfident private sector triggers a bubble.

US Entrance Problem 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.

(8) With the economy healthy, the private sector regains its vigour, and confidence returns.

(3) With everybody paying down debt, monetary policy stops working. Fiscal policy becomes the main economic tool to maintain demand.

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

Exit Problem

Japan Germany

(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.

(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 22. Euro-Zone Banks Need Low-Cost Unconditional Capital Injection to Avoid Credit Crunch
Contrast Between Yin and Yang Phases of Cycle
Behavioral principle
1) Phenomenon 2) Private sector financial condition 3) Outcome 4) Monetary policy 5) Fiscal policy 6) Prices 7) Interest rates 8) Savings a) Localized b) Systemic

Yang = Profit maximization

Textbook economy Assets > Liabilities Greatest good for greatest number Effective Counterproductive (crowding-out) Inflationary Normal Virtue Quick NPL disposal Pursue accountability Slow NPL disposal Fat spread

Yin = Debt minimization

Balance sheet recession Assets < Liabilities Depression if left unattended Ineffective (liquidity trap) Effective Deflationary Very low Vice (paradox of thrift) Normal NPL disposal Pursue accountability Slow NPL disposal Capital injection by government

9) Remedy for Banking Crisis

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

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