Bubbles and Balance Sheet Recessions in the Global Economy

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

Exhibit 1. US Housing Bubble Lasted Two Years Longer than Greenspan Expected
(y/y %) 20 (%) 8

yield on 10-year treasury notes (Right scale)

15

Medium existing-home price (Left scale)

6 10

0 2 -5

FF rate (Right scale)

-10 2000 2001 2002 2003 2004

unexpected bubble
0 2005 2006 2007 2008

Sources: FRB, National Association of Realtors

Exhibit 2. Delinquency Rates on Adjustable Rate Mortgages Are Rising Sharply

(%) 6.0 (%) 21 20 19 5.0 Prime (left scale) 18 17 16 15 3.5 14 13 12 11 10 9 2002 2003 2004 2005 2006 2007

5.5

4.5

4.0

3.0

2.5 Subprime (right scale) 2.0

1.5 Sources: MBA, Bloomberg

Exhibit 3. Turmoil Seen So far Is Just Half the Story

The Amount of ARMs Facing Interest Rate Reset
Loans with payment shock (bil. $) 45 40 35 30 25 20 15 10 5 0 2007 2008 2009 2010 2011 Source: Silver Street Capital present

Timing of initial rate adjustment

Source: Financial Times Weekly Review of the Fund Management Industry Aug. 6, 2007. Watch out for another wobble

Exhibit 4. 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): the 1989 S&L crisis Type (II): the Latin America debt crisis of 1982, the 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, April 2008 (forthcoming).

Exhibit 5. 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 i j 60 Miyazawa Proposal

Credit Crunch

Large Enterprises L i eft Scale j

40

Bubble Burst

"Takenaka Shock"
20

Accommodative 0 Restrictive -20 Small Enterprises L eft Scale i j

1st Capital Injection

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

2nd Capital Injection

(7.5 tril.) 00 01 02 03 0 4 05 06 07

S i haded areas indicate periods of BOJ monetary tightening j Source: Bank of Japan, "Tankan".

Exhibit 6. Capital Injection Is Politically Difficult when the US Economy Is Doing Well
(%, Seasonally adjusted) 86 (%, Seasonally adjusted, inverted) 3.5

84

Capacity Utilization (left Scale)

4.0

82 4.5 80 5.0 78 5.5 76

74

Unemployment Rate (right scale)

6.0

72 98 99 00 01 02 03 04 05 06 07 08 Sources: US Department of Labor, FRB

6.5

Exhibit 7. 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 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Japan: Osaka Area Condo Price (per m2, 5 months moving average)
Composite Index Futures (as of May. 22, 2008)

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

US Japan

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

Sources: Bloomberg, Real Estate Economic Institute, Japan, S&P "S&P/Case-Shiller Home Price Indices", as of May. 22, 2008.

Exhibit 8. US Housing Sales Are Collapsing

(1000, Seasonally adjusted annual rate) 1400 1300 7000 1200 1100 New home sales (Left scale) 6500 (1000, Seasonally adjusted annual rate) 7500

1000 6000 900 800 5500

700 600 500 1999 2000 2001 2002

Existing home sales (Right scale)

5000

4500 2003 2004 2005 2006 2007 2008

Sources: Bloomberg, National Association of Realtors, US Department of Commerce

Exhibit 9. US Home Inventory and Inventory Ratios Are at Record Levels

(months) 12

11

10 New home inventory ratios 9

8 Existing home inventory ratios 7

3 99 00 01 02 03 04 05 06 07 08

Sources: National Association of Realtors, Bloomberg

Exhibit 10. Summary of US Policy Options Based on Japans Experience

Economic Stimulus Capital Injection Monetary easing largely ineffective for the real economy except Liquidity 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

Fiscal Policy

Monetary Policy

Until home prices fall to their DCF values

Keeps financial institutions operating Benefit: Exports encouraged, Imports discouraged

Weaker Dollar

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

Source: Nomura Research Institute

10

Exhibit 11. US Trade Deficit Is Still Enormous

($ mil., SA)

40000 30000 20000 10000 0 -10000 -20000 -30000 -40000 -50000 -60000 -70000 -80000
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

China's trade balance

Japan's trade surplus

US trade deficit with China US trade deficit with Japan US trade deficit (Census Basis) US Running Federal Budget Surpluses

Sources: US Department of Commerce, US Department of Treasury, Ministry of Finance Japan National Bureau of Statistics of China These data are seasonally adjusted by Nomura Research Institute.

11

Exhibit 12. Japanese Companies Had Been Paying 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

12

Exhibit 13. Debt Repayment Prompted by Collapse in Asset Prices

(1990=100) 140

120

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

from the peak

100

80

60

-53%

40 -95% 20

-87%

-81% -94%

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

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

13

Exhibit 14. Cumulative Capital Losses on Shares and Land since End-1989 Reached 1,500 Trillion Yen
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"

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Exhibit 15. Japans GDP Grew even after the Bursting of the Bubble
(Tril.yen, Seasonally Adjusted) 600 Nominal GDP (Left Scale) 800 (Mar. 2000 100)

550

700 500 Real GDP (Left Scale) 450 500 400 Land Price Index in Six Major Cities (Commercial, Right Scale) 400 600

350 Last seen in 1973

300 200

300

250

100 0 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

200

Sources: Cabinet Office, Japan Real Estate Institute

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Exhibit 16. Government Fiscal Stimulus Largely Neutralized Corporate Debt Repayment
Financial Surplus or Deficit by Sector
15

(as a ratio to nominal GDP, %) (Financial Surplus)

10

Households

-5

Rest of the World Corporate Sector

(Non-Financial Sector + Financial Sector)

loss in corporate demand equivalent to over 20% of GDP

General Government

-10

(Financial Deficit)

-15 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 Sources: Bank of Japan, Flow of Funds Accounts , and Government of Japan, Cabinet Office, National Accounts Note: For fiscal 07' figures, 4 quarter averages ending with 4Q/07' are used.

(FY)

16

Exhibit 17. 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 Extened by the Banks to Corporate Sector as a Ratio to Nominal GDP (Right Scale)

85/4Q

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 Extened by the Banks to Corporate Sector (Left Scale)

60
last seen in 1956

50

17

Exhibit 18. Japanese Corporate Leverage Came Down Sharply

(Times)

Japan

3 US 2

0 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

Sources: Ministry of Finance, Japan, US Depertment of Commerce

18

Exhibit 19. Japanese Companies Have Finished Debt Repayments, and Are Now Rebuilding Financial Assets
30
(as a ratio to nominal GDP, %) (as a ratio to nominal GDP, %)

-30

Left Scale

Financial Assets

20

Balance Sheet Recession

-20

10

-10

-10

10

-20
Financial Liabilities Right Scale

20

-30
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
Sources: Bank of Japan, Flow of Funds Accounts, and Government of Japan, Cabinet Office, National Accounts Note: For fiscal 07' figures, 4 quarter averages ending w ith 4Q/07' are used.

30

19

Exhibit 20. Japanese Household Savings Are also Recovering

(as a ratio to nominal GDP, %) (as a ratio to nominal GDP, %)

25 20 15 10 5 0 -5 -10 -15

-25 -20 -15 -10 -5 0 5

Left Scale

Financial Assets

Balance Sheet Recession

Financial Liabilities

Right Scale

10 15

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
Sources: Bank of Japan, Flow of Funds Accounts, and Government of Japan, Cabinet Office, National Accounts Note: For fiscal 07' figures, 4 quarter averages ending w ith 4Q/07' are used.

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Exhibit 21. Premature Fiscal Reforms in 1997 and 2001 Actually Reduced Tax Revenue and Increased Deficit
70
(Yen tril.) (Yen tril.)

Tax Revenue 60 Budget Deficit

Hashimoto (initial budget)* Koizumi fiscal Obuchi-Mori fiscal reform fiscal (with supplemental budget)* reform stimulus

70

60

50

50

40

40

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
(FY) Source: Ministry of Finance, Japan *: estimated by MOF

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Exhibit 22. Money Supply Is 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

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Exhibit 23. Money Supply Is 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 24. Monetary Aggregates Behave Totally Differently under Balance Sheet Recession
(1990/1Q=100, Seasonally adjusted) 300 High-powered Money (Average Balance) Money Supply (M2+CD, Average Balance) 250 Credit Extended to the Private Sector

Quantitative Easing

200

150

Textbook Economics (monetary policy effective)

Balance Sheet Recession (monetary policy NOT effective)

Down 30%

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 25. Yin Yang Cycle of Bubbles and Balance Sheet Recessions

Yin (=Shadow)

Bubble

Yang (=Light)

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

(9) Overconfident private sector triggers a bubble.

(2) Collapse in asset prices leaves businesses with excess liabilities, forcing them 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 companies finish their debt repayments, ending the balance sheet recession. But they still have a phobia about borrowing which keeps interest rates low, and the economy less than fully vibrant. Economy prone to mini-bubbles.

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

India

(7) Monetary policy replaces fiscal policy as the main economic tool.

Germany Japan US

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

(5) Corporate phobia towards borrowing gradually disappears, and companies take a more bullish stance towards fund raising.

Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japans Great Recession , op.cit.

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Exhibit 26. 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: Compiled by Nomura Research Institute based on Eizo Kinoshita, Keizai wo shihai suru futatsu no housoku, Denki Shoin, p. 92.

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