The Age of Balance Sheet : What Post-2008 U.S., Europe and China Can Learn from Japan 1990-2005

Richard C. Koo Chief Nomura Research Institute Tokyo March 2009 Exhibit 1. US Economy Is Deteriorating Rapidly

(%, Seasonally adjusted) (%, Seasonally adjusted, inverted) 86 3.5

4.0 84 Unemployment Rate (right scale) 4.5 82 5.0

80 5.5

78 6.0

6.5 76

7.0 74 7.5 Capacity Utilization 72 (left Scale) 8.0

70 8.5 98 99 00 01 02 03 04 05 06 07 08 09 Sources: US Department of Labor, FRB

1 Exhibit 2. EU Economic Sentiments Are Worsening

(Seasonally adjusted) 120

115 Euro Area Economic Sentiment 110

105

100

95

90

85

80 Ifo Business Climate

75

70

65 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Ifo Business Survey, European Commission

2 Exhibit 3. Exports and House Prices Are Falling in China

(y/y%) ($ bil., Seasonally Adjusted) 25 140

20 House price in Shenzhen (left scale) 120 15

10 100

5 80 0

-5 60

-10 40 -15 China's exports ($ bil., right scale) -20 20 03 04 05 06 07 08 09 Note: Seasonal adjustment by Nomura Research Institute. Sources: Nomura Research Institute, based on National Bureau of Statistics of China, National Development and Reform Commission (NDRC), People’s Republic of China, and Bloomberg.

3 Exhibit 4. Japan’s Industrial Production and Employments Are also Weakening (Seasonally adjusted) (Seasonally adjusted, 2005=100) 1.2 115

Industrial production (right scale) forecast 110 1.1

105 1.0 100

0.9 95

0.8 90

85 0.7

80 Job offers to applicants ratio (left scale) 0.6 75

0.5 70

0.4 65 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Note: The forecasts are calculated from METI's survey on planned production. Sources: Ministry of Economy, Trade and Industry (METI), and Ministry of Health, Labour and Welfare

4 Exhibit 5. Low Interest Rates Have Failed to Revive Economies or Asset Prices

(%) 8

Aus tralia 7

UK 6

5

4

EU 3

US 2 Japan

1

0 2003 2004 2005 2006 2007 2008 2009

Sources: BOJ, FRB, ECB, BOE and RMB Australia. As of Mar. 18, 2009.

5 Exhibit 6. Features of Balance Sheet

z A balance sheet recession emerges after the bursting of a nationwide asset price bubble that leaves a large number of private-sector balance sheets with more liabilities than assets. z In order to repair their balance sheets, private sector moves away from profit maximization to debt minimization. z With the private sector de-leveraging, even at zero interest rates, newly generated savings and debt repayments enter the banking system but cannot leave the system due to the lack of borrowers. The sum of savings and debt repayments end up becoming the leakage to the income stream. z The deflationary gap created by the above leakage will continue to push the economy toward a contractionary equilibrium until the private sector is too impoverished to save any money (=depression). z In this type of recession, the economy will not enter self- sustaining growth until private sector balance sheets are repaired.

6 Exhibit 7. US Demand for Funds Is Falling Sharply

(D.I.) 30

housing 20 IT bubble small firms bubble collapse collapse 10

0

-10

large and middle- firms -20

-30 stronger demand for funds

-40 weaker demand for funds

-50 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Nomura Research Institute, based on FRB, Senior Loan Officer Opinion Survey on Bank Lending Practices . Note: D.I. are calculated from the answers to the question, "Apart from normal seasonal variation, how has demand for C&I loans changed over the past three months?" D.I. = ("Substantially stronger" + "Moderately stronger"×0.5) - ("Moderately weaker"×0.5 + "Substantially weaker")

7 Exhibit 8. US Housing Price Futures Moving Closer to the Japanese Experience

(US: Jan. 2000=100, Japan: Dec. 1985=100) Futures 260 Composite Index Futures US: 10 Cities Composite Home Price Index 240 (as of Sep. 19, 2007)

220 Japan: Tokyo Area Condo Price (per m2, 5 months moving average) 200

180

160 Japan: Osaka Area Condo Price 140 (per m2, 5 months moving average) 120 Composite Index Futures (as of Mar. 18, 2009) 100

80 A fall in actual prices to the bottom for future prices would bring house prices 60 back to level of Dec. 2002

40 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 US 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 Japan Sources: Bloomberg, Real Estate Economic Institute, Japan, S&P "S&P/Case-Shiller® Home Price Indices", as of Mar. 18, 2009.

8 Exhibit 9. House Prices and Rents Diverged substantially during Housing Bubble

(91/1Q=100, Seasonally Adjusted) 250

200 21% House prices ?

150

100 Rents

50 A 21% decline would bring house prices back to level of 2003 Q4

0 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 09 10 11 Note: Seasonal adjustment by Nomura Research Institute. Source: Nomura Research Institute, based on Office of Federal Housing Enterprise Oversight (OFHEO) house price index and US Department of Labor CPI.

9 Exhibit 10. Americans Spent $1.5trn that Should Have Been Saved

Savings shortfall = $1,544bn

($bn, seasonally adjusted) (%) 120 6 Saving rate (right scale) 100 5

80 4 Amount needed to lift savings to 4%* (left scale) 4.5 60 3 years at this rate 40 2

20 Actual savings (left scale) 1

0 0

-20 -1

-40 -2 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Note: Average savings rate for US households in1997-98. Source: Nomura Research Institute, based on US Department of Commerce data.

10 Exhibit 11. Japan’s GDP Grew even after Massive Loss of Wealth and Private Sector Rushing to Pay Down Debt

(Mar. 2000＝100) (Tril.yen, Seasonally Adjusted) 600 800 Nominal GDP (Right Scale) 550 700 500 600 Real GDP (Right Scale) 450 500

400 400 Land Price Index in Six Major Cities (Commercial, Right Scale) 350 300 down 87% Last seen 300 200 in 1973

100 250

0 200 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: Cabinet Office, Japan Real Estate Institute

11 Exhibit 12. Cumulative Capital Losses on Shares and Land since 1990 Reached $15 Trillion or 3 Years Worth of Japan’s GDP

(Tril. yen) 400 (Capital Gain) Land Shares

0

-400 Equivalent ¥1,500 to $45 trillion trillion loss -800 in the US

-1200

Land and Shares Combined (Capital Loss) -1600 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Source: Cabinet Office, Japan ""

12 Exhibit 13. Balance Sheet Problems Forced Japanese Businesses to Pay 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

0 0

-5 -2

-10 -4 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, Cabinet Office, Japan

13 Exhibit 14. Japanese Government Borrowed and Spent the Excess Savings of the Private Sector to Sustain GDP

(Tril. yen) 100

Government Spending 90

80 total additional 70 deficit 90-05 ¥315 trillion 60

50

40 Tax revenue Bubble Collapse 30

20 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 Source: Ministry of Finance, Japan Note: FY 2008 includes supplementary budget, and FY 2009 is just initial budget.

14 Exhibit 15. With Government Borrowing and Spending the Increase in Private Sector Savings*, Large Deficit Does Not Mean Higher Interest Rates

(% of GDP) (%) 180 9 Balance Sheet Recession 160 8 Japanese Government Debt as Percentage of GDP (left scale)

140 7 Yields on 10year JGB (right scale)

120 6

100 5

80 4

60 3

40 2

20 1

0 0 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 * Household savings plus corporate debt repayment Sources: Cabinet Office, Japan, Japan Bond Trading Co., Japan Securities Dealers Association

15 Exhibit 16. Japanese Companies Made Huge Progress in Reducing Debt Overhang

(Yen tril., Seasonally Adjusted) (as a ratio to nominal GDP, %) 450 90

400 Credit Extended by the Banks to 85/4Q Corporate Sector 350 as a Ratio to Nominal GDP (Right Scale) 80

300

250 70 200

150 Credit Extended by the Banks to Corporate Sector 60 100 (Left Scale) last seen in 1956 50

0 50 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.

16 Exhibit 17. Japanese Corporate Leverage Came Down Sharply

(Times) 7

6 Japan

5

4

3 US

2

1

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

17 Exhibit 18. Premature Fiscal Reforms in 1997 and 2001 Weakened Economy, Reduced Tax Revenue and Increased Deficit

(Yen tril.) (Yen tril.) 70 70 Hashimoto Koizumi Tax Revenue (initial budget)* fiscal Obuchi-Mori fiscal Budget Deficit reform fiscal reform (with supplemental budget)* 60 stimulus 60

50 50

40 40 unnecessary deficit: 30 30 ¥97.6 tril.

20 20

10 10

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

18 Exhibit 19. Four Kinds of Banking Crises and Their Remedies

Yang Yin Normal demand for Weak or non-existent funds demand for funds

(I) (III) Localized Quick NPL disposal Normal NPL disposal Banking Pursue accountability Pursue accountability Crisis (II) (IV) Systemic Slow NPL disposal Slow NPL disposal Fat spread Capital injection

Type (I): 1989 S&L crisis

Type (II): 1982 Latin America debt crisis, 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 of the 1930s, and US and UK subprime crisis since 2007

Source: Richard Koo, The Holy Grail of : Lessons from Japan’s , John Wiley & Sons, Singapore, 2008 19 Exhibit 20. 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） (Y/Y%） 60 33 Bubble Burst Large Enterprises Global 30 40 Miyazawa Proposal （Left Scale） Financial Crisis 27

20 24

Accommodative 21 0 18

15 -20 Restrictive Credit Crunch 12 -40 Small Enterprises "Takenaka " 9 （Left Scale） (rushed NPL disposal) 1st Capital Injection 6 -60 (¥1.8 tril.) 2nd Capital Injection 3 (¥7.5 tril.) -80 0

-3 -100 Credit Extended by the Banks -6 （right scale） -120 -9 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 （Shaded areas indicate periods of BOJ monetary tightening） Sources : "Tankan", "Loans and Discounts Outstanding by Sector", BOJ

20 Exhibit 21. Percentage of House Purchases that May Lead to “Return the Key” For Houses Bought before January 2009 (millions) 50

45 88.0% (1) 40 82.9% (1)

35 70.4% (1) 30

25

20 46.3% (2) 41.1% (2) 15

28.7% (2) 10

5

0 At Present (Mar. 2009) Home Prices Lowest Price in Futures Market 40% below the Peak [-30.2%] (Nov. 2010) [-37.3%]

Source: Nomura Research Institute estimates from the data of US Department of Commerce, National Association of Realtors, S&P "S&P/Case-Shiller® Home Price Indices", and Bloomberg (as of Mar. 18, 2009). Notes: (1) Maximum share of underwater mortgages assuming that the total number of mortgages is 53 million. (2) As (1), but with a 10% downpayment.

21 Exhibit 22. Summary of US Policy Options Based on Japan’s Experience

• Government spending more effective than tax cuts Economic Stimulus Fiscal • Must be fast acting and seamless for the duration of recession Policy • Effective in ending debilitating credit crunch Capital Injection • Politically unpopular but sooner and bigger the better

Monetary Monetary easing Policy largely ineffective except

Benefit: • Help financial institutions deleverage • May help unclog some markets if the Fed's presence is viewed as permanent Credit Easing (Asset Purchases) Risk: May saddle Fed's balance sheet with distressed assets and lead to a serious loss of trust in the Fed and the dollar

Liquidity Injection Keeps financial institutions operating

Benefit: Exports encouraged, Imports discouraged

Weaker Dollar Risks: • May trigger foreign capital outflow leading to higher interest rates • Accelerate imported Source: Nomura Research Institute

22 Exhibit 23. US Trade Deficit Is Still Enormous

($ mil., SA) 50000

Japan's trade surplus 40000 China's trade balance 30000

20000

10000

0

-10000

-20000

-30000 US trade deficit with China -40000 US trade deficit with Japan US Running US trade deficit -50000 Federal (Census Basis) -60000 Budget Surpluses -70000

-80000 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

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.

23 Exhibit 24. Monetary Aggregates Behave Totally Differently under Balance Sheet Recession

Quantitative (1990/1Q=100, Seasonally adjusted) Easing 300 High-powered Money (Average Balance) Money Supply (M2+CD, Average Balance) 250 Credit Extended to the Private Sector

Textbook Balance Sheet 200 Economics Recession Down (monetary policy (monetary policy 37% effective) NOT effective) 150

100

1990/1Q 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 Note: Private sector borrowings seasonally adjusted by Nomura, adjustments made for discontinuities in line with BOJ's "Monetary Survey" Source: Bank of Japan

24 Exhibit 25. Japan’s Money Supply Has Been Kept Up by Government Borrowings (I)

(Y/Y%) 16

14 Credit Extended to Others (Mostly Government)

12 Credit Extended to the Private Sector Quantitative Easing 10 Money Supply (M2+CD)

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.

25 Exhibit 26. Japan’s Money Supply Has Been Kept Up by Government Borrowings (II) Balance Sheets of Banks in Japan

December 1998 December 2007 Assets Liabilities Assets Liabilities

Credit Extended to the Private Credit Sector Money Supply Extended to ¥501.8 tril. Money Supply (M2+CD) the Private (-99.8) (M2+CD) Sector ¥621.5 tril. ¥744.4 tril. ¥601.6 tril. (+122.9)

Credit Extended to the Credit Extended to the Public Public Sector Sector ¥247.2 tril. (+106.8) ¥140.4 tril. Other Liabilities (net) Foreign assets Foreign Assets Other Liabilities ¥153.2 tril. (net) (net) (net) ¥74.1 tril. ¥32.7 tril. ¥78.7 tril. (+41.4) (-74.5) Total Assets ¥774.7 tril. Total Assets ¥823.1 tril. (+48.4)

Source: Bank of Japan "Monetary Survey"

26 Exhibit 27. US Money Supply Growth after 1933 Was also Made Possible by Government Borrowings Balance Sheets of All Member Banks

June 1929 June 1936 Assets Liabilities Assets Liabilities

Credit Extended to the Deposits Private Credit $32.18 bil. June 1933 Sector Deposits Extended to Assets Liabilities $15.71 bil. $34.10 bil. the Private Credit (-0.09) (+10.74) Sector Deposits Extended to (= Money Supply) $29.63 bil. the Private $23.36 bil. Sector (-8.82) Credit $15.80 bil. Extended (-13.83) to the Public Credit Sector Extended $16.30 bil. Credit to the (+7.67) Extended to Public the Public Sector Other Other Sector $8.63 bil. Other Other Liabilities Assets $5.45 bil. (+3.18) Liabilities Liabilities $6.93 bil. $8.91 bil. $4.84 bil. $7.19 bil. Other (+2.54) (-2.09) (+2.35) Other Assets Assets $8.02 bil. $6.37 bil. Reserves (-1.65) Capital Capital $5.61 bil. Capital Reserves $4.84 bil. $5.24 bil. (+3.37) Reserves $6.35 bil. $2.24 bil. (-1.51) (+0.40) $2.36 bil. (-0.12) 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

27 Exhibit 28. New Deal policies doubled fiscal expenditures without increasing the budget deficit

($ mn, June) (%) 14000 28 New Deal policies 12000 24 Unemployment rate Expenditures (left scale) (right scale) 10000 20

8000 16

6000 12

4000 8

2000 Revenue (left scale) 4

0 0

Budget deficit as % of GNP -2000 -4 (right scale)

-4000 -8 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

Source: Board of Governors of the Federal Reserve System (1976), Vol. 1, p. 513; US Bureau of the Census (1975), p. 229.

28 Exhibit 29. German fiscal stimulus reduced unemployment dramatically

(DM bn) （%） 35 35 Nazis come to Government power 30 expenditure 30 (left scale) 25 25

20 Unemployment rate 20 (right scale) 15 15 Government Fiscal deficit as % 10 10 of GDP revenue (right scale) (left scale) 5 5

0 0 N.A. N.A. -5 -5

-10 -10 1930 1931 1932 1933 1934 1935 1936 1937 1938

Source: Mitchell (1975), p. 170; Flora et al. (1987), p. 350; Deutsche Bundesbank (1976).

29 Exhibit 30. Debt Rejection Syndrome Can Last a Long Time: US Interest Rates Took 30 Years to Return to Their 1920s Level

(%) 9 US government bond yields 8 Prime BA, 90days US government bond yields 1920-29 average (4.09%, June 1959) Prime BA, 90days 1920-29 average (4.13%, September 1959) 7

Oct '29 NY Stock Dec '41 Pearl Jun '50 Korean 6 Mar ket Cr as h Harbor Attack War

'33～ 5 New Deal

4

3

2

1

0 1920 21 2223 24 2526 27 2829 30 3132 33 3435 36 3738 39 4041 42 4344 45 4647 48 4950 51 5253 54 5556 57 5859 60

Source: FRB, Banking and Monetary Statistics 1914-1970 Vol.1, pp.450-451 and 468-471, Vol.2, pp.674-676 and 720-727

30 Exhibit 31. The Anatomy of Balance Sheet Recession and Its Cure

Private Sector Bought Assets Original Money Flow The Problem Private Sector Savings with Borrowed Funds The Solution

Fall in Asset Prices Vicious Cycle

Balance Sheet Problems Develop Repair Balance Sheets Government Procures Funds at Low Rates due to the Lack of Private Sector Borrowers Allow Private Sector to Private Sector Moves away from Profit Maximization to Debt Minimization Pay down Debt

Breaking the Vicious Cycle Keep Aggregate Private Sector Paying Down Debt Fall in Aggregate Demand Demand from Falling

No Demand for Funds Weaker Economy and Fiscal Stimulus

Central Bank Panics and More Defaults Further Fall in Asset Prices Dramatically Eases Monetary Policy

More Non-Performing Loans at Banks Government Borrowings Help Maintain Money Supply in the Absence Nothing Happens because Private Sector Is Minimizing Debt "Liquidity Trap" of Private Sector Borrowers

Source: Richard Koo, Balance Sheet Recession: Japan's Struggle with Uncharted Economics and its Global Implications , John Wiley & Sons, Singapore 2003

31 Exhibit 32. Yin Yang Cycle of Bubbles and Balance Sheet Recessions

China Yin (=Shadow) Bubble Yang (=Light)

(1) Monetary policy is tightened, leading the bubble to collapse. (9) Overconfident private sector triggers a bubble.

US (2) Collapse in asset prices leaves private sector (8) With the economy healthy, with excess liabilities, the private sector regains its vigour, Spain forcing it into debt minimization mode. India and confidence returns. The economy falls into a balance sheet recession. UK (3) With everybody paying down debt, monetary policy stops working. (7) Monetary policy becomes the main Fiscal policy becomes the main economic tool economic tool, while deficit reduction to maintain demand. becomes the top fiscal priority.

(4) Eventually private sector finishes its debt repayments, ending the balance sheet recession. (6) Private sector fund demand recovers, Germany But it still has a phobia about borrowing which keeps and monetary policy starts working again. interest rates low, and the economy less than fully vibrant. Fiscal policy begins to crowd out private investment. Economy prone to mini-bubbles. Japan

(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 Japan’s Great Recession , John Wiley & Sons, Singapore, April 2008 p.160.

32 Exhibit 33. Contrast Between Yin and Yang Phases of a Cycle

Yang Yin 1) Phenomenon Textbook economy Balance sheet recession 2) Fundamental driver 's "invisible hand" Fallacy of composition 3) Corporate financial condition Assets > Liabilities Assets < Liabilities 4) Behavioral principle Profit maximization Debt minimization 5) Outcome Greatest good for greatest number Depression if left unattended 6) Monetary policy Effective Ineffective (liquidity trap) 7) Fiscal policy Counterproductive (crowding-out) Effective 8) Prices Inflation Deflation 9) Interest rates Normal Very low 10) Savings Virtue Vice (paradox of thrift) Quick NPL disposal Normal NPL disposal a) Localized 11) Remedy for Pursue accountability Pursue accountability Banking Crisis Slow NPL disposal Slow NPL disposal b) Systemic Fat spread Capital injection

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

33