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The Escape from Balance Sheet Recession and the QE Trap


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Foreword xix About the Author xxv CHAPTER 1 Balance Sheet Recession Theory?Basic Concepts 1 GDP and Inflation Fueled by Growth in Money Supply, Not Monetary Base 5 Japan Fell into Balance Sheet Recession in 1990s 10 Plunging Asset Prices Create Balance Sheet Problems for Businesses 12 Japanese Firms Rushed to Repair Balance Sheets by Paying Down Debt 13 ?Correct? Private Sector Behavior Tipped Japan into Contractionary Equilibrium 14 Collapse of Japan?s Bubble Destroyed Y1,500 Trillion in Wealth 16 Why Japanese GDP Did Not Fall after Bubble Burst 18 Fiscal Stimulus Saved Japan?s Economy 21 ?Good? Fiscal Deficits Were Not Perceived as Such 23 Balance Sheet Recessions and the Limitations of Econometric Models 25 Fiscal Stimulus Works in Two Stages 28 FDR Made Same Mistake in 1937 28 Reactive Fiscal Stimulus Is Far Less Efficient 30 Fiscal Deficits Are Easily Financed during Balance Sheet Recessions 31 Self-Corrective Mechanism for Economies in Balance Sheet Recessions 33 Two Types of Fiscal Deficits Require Different Responses 34 Fiscal Deficits Must Be Viewed Relative to Private Savings 36 Consequences of Leaving Things Up to the Market in a Balance Sheet Recession 37 GFC Triggered by Insistence on Market Principles 40 Volcker Understood Systemic Crises 41 Little to Be Gained from Bashing Those Who Have Already Come to Their Senses 42 Recovery from Balance Sheet Recession Takes Time 43 Forward Guidance Important for Fiscal as Well as Monetary Policy 43 Fiscal Consolidation: Better Too Late Than Too Early 45 Three Points to Consider Regarding Costs for Future Generations 47 Japan Had a Shot at Full Recovery in 1996 . . . 49 Conflation of Balance Sheet and Structural Problems Extends Recession 50 Distinguishing Balance Sheet Recessions from Structural Problems and Financial Crises 53 Democracies Are Ill-Equipped for Dealing with Balance Sheet Recessions 55 Keynes Also Overlooked Private-Sector Debt Minimization 56 Those Who Prevent Crises Never Become Heroes 58 Democracy Plus Balance Sheet Recession Equals ?Secular Stagnation? 59 Appendix to Chapter 1: Summary of Yin and Yang Phases of Economy 60 CHAPTER 2 Monetary Policy and the Quantitative Easing Trap 63 Monetary Policy Impotent without Demand for Funds 64 Mechanisms for Money Supply Growth 65 Government Borrowing Drove Money Supply Growth in Japan 67 Economics Dogged by Incorrect Analysis of Great Depression 68 Japanese Monetary Policy Has Relied on Fiscal Policy for Past 20 Years 72 Balance Sheet Recessions Triggered by Borrower-Side Problems, Financial Crises Triggered by Lender- Side Problems 74 Bernanke Himself Says QE2 Unlikely to Have Major Macroeconomic Benefits 75 Real Aim of QE2: Portfolio Rebalancing Effect 75 Can Higher Share Prices under QE2 Be Justified on DCF Basis? 77 QE2 a Big Gamble for Bernanke 77 QE Undermined U.S. Leadership in G20 78 QE with No Income Effect Harms Other Countries 79 Dollar-Buying Intervention by U.S. Authorities Would Have Produced Different Outcome 80 Inward Capital Controls Help Keep Bubbles Fueled by Hot Money in Check 80 QE Represents Government Intervention in Asset Markets 81 Operation Twist Lowered Long-Term Rates, but to No Effect 81 Operation Twist Provided Only Limited Economic Boost 83 Bernanke Admits the United States Faces Same Problems as Japan 84 Fed Overestimates Impact of Quantitative Easing 84 ?Lower Long-Term Rates = Higher GDP? Formula Does Not Hold during Balance Sheet Recession 85 Fed Has Also Underestimated Costs of QE 85 Unorthodox Monetary Policy Distorts Signals from Bond Market 86 Needless QE Acts as Drag on Financial Institutions 87 Why Fed Embarked on QE3 Two Months before Presidential Election 88 Post-Bubble Wage Growth Nearly Identical in the United States and Japan 89 The ?Inconvenient Truth? of the Real Cost of Quantitative Easing 89 BOJ?s First Round of QE Was Easy to Wind Down Because It Was Conducted in Money Market 91 Redemption of Central Bank Bond Holdings Will Not Reduce Commercial Banks? Current Accounts 92 Government Issue of Refunding Bonds to Private Sector Would Absorb Excess Reserves 92 Redeeming Fed Bond Holdings Has Same Effect as Issuing Deficit Bonds 93 Strength of Private Loan Demand Different at Start and End of QE 94 Paying Interest on Excess Reserves Would Enable Rate Hikes . . . 94 But Cost Could Be Prohibitive 95 Cost of Winding Down QE Has Yet to Be Properly Analyzed 97 Debate over Winding Down QE Sparks ?Bad? Rise in Rates 98 ?QE Trap? Appears Increasingly Likely 98 Continued QE Trap More Likely Than Hyperinflation 101 BOJ Found Itself in Same Position in 2006 103 Fed Admits That Supply and Demand Matters, Too 103 Fed Changes Course Despite a 1.1 Percent Inflation Rate 104 Traditional Phillips Curve Relationship No Longer Holds 105 Upcoming Chapters in QE Saga 106 Capital Injection Could Also Be Threatened If Blame Shifts to Fed 106 Sales Should Start with Bonds Maturing Soon 107 Final Cost of QE Can Be Calculated Only at End of Fourth Chapter 108 Theoretical Debate on QE Has Focused Entirely on Benefits and Ignored Costs 108 Central Banks Should Establish a New Reaction Function to Drain Reserves 110 Emerging Markets Need Inward Capital Controls to Protect against QE 111 Japan Should Learn from Pioneers in QE Using Long-Term Bonds 112 Financial and Capital Markets during Balance Sheet Recessions 113 Balance Sheet Recession Brings Special Kind of Liquidity-Driven Market 115 Is Inflation of 1?2 Percent Too Low? 116 Does Inflation Improve People?s Standard of Living? 116 Absence of Inflation Concerns May Have Lifted Utility of Consumption in Japan 117 QE Should Not Be Pursued Any Further Given Difficulty of Winding It Down 118 QE a Problematic Byproduct of Balance Sheet Recessions 119 CHAPTER 3 The United States in Balance Sheet Recession 121 Rating Agencies Need to Be More Tightly Regulated 123 Why Was Lehman Allowed to Fail? 124 TARP Prevented Bank Failures but Also Created Turmoil 127 U.S. Authorities Changed Course with ?Pretend and Extend? 129 Fiscal Stimulus Shifts from ?Three Ts? to ?Three Ss? 131 Obama Has Yet to Disclose the Name of the Disease 132 Bernanke?s ?Fiscal Cliff? Warning Saved the U.S. Economy 134 Bernanke Declared Monetary Easing Could Not Offset Impact of Fiscal Cliff 136 Fall from Fiscal Cliff Triggered Japan?s Deflation 137 U.S. Households Still Repairing Balance Sheets 138 Nonfinancial Corporate Sector Faced Difficult Years in the Wake of GFC 140 U.S. Companies Hit Far Harder by GFC Than by Collapse of Internet Bubble 141 Can U.S. Corporate Sector Become Economic Engine? 141 Long-Term Rate ?Conundrum? Kept Housing Bubble Alive 142 Post-2007 Fed in Similar Position to BOJ in 1990s 143 Flow-of-Funds Data Suffer from Poor Accuracy 143 Bad Data Were Good for Policy Debate 145 Estimated Correctly, Private Sector Financial Surplus Continues to Shrink 146 Recovery in U.S. Private Sector Demand for Funds May Outpace Japan 148 Housing Market Strength during the First Half of 2013 May Have Contained Temporary Factors 149 Fed?s Reputation Falls to Earth 150 CHAPTER 4 The Great Potential of Abenomics 153 BOJ Already Had a Massive QE Program in Place 155 Why Didn?t Japan?s Institutional Investors Follow Their Overseas Counterparts? 157 Yen Fell and Stocks Rose Because Japan?s Institutional Investors Stayed in Bond Market 158 Honeymoon Altered Japan?s Economic Landscape 159 Bond Market Reaction Ended Abenomics?s Honeymoon 160 Private Sector Continues to Save after One Year of Abenomics 161 Japan?s Growth over Last Year Attributable to Fiscal Policy 162 Can the Abe Administration Overcome the Trauma of Balance Sheet Recession? 164 The Trauma of the Balance Sheet Recession Will Be the Last Effect to Go 166 Focus of Structural Reforms Must Shift from Lenders to Borrowers 167 Is Japan?s Slump Due to Shrinking Population or Balance Sheet Problems? 169 Slump in Domestic Demand Was Due to Balance Sheet Recession, Not Decline in Working-Age Population 170 Personal Financial Assets Have Already Been Invested Somewhere 171 Corporate Debt Pay-Downs Weighed on Consumption and Investment 171 Real Bottleneck in Japan?s Economy: Lack of Loan Demand at Private Companies 172 Balance Sheet Recession Has Taught Japanese How to Be Frugal 173 Is Japan Really Closed to Immigration? 174 Japanese Economy Would Cease to Function without Foreigners 175 Agricultural Reforms a Major Step for LDP Government 176 Structural Reforms Are Microeconomic Policies That Take Years to Work 177 Scale of Structural Reform Is Also Important 177 We Should Not Expect More Good Fortune 178 Kuroda May Be Trying to Close Gap between Expectations and Reality ? 180 BOJ and Government Must Stress That Inflation Overshoot Will Not Be Tolerated 182 BOJ Had Weapon to Prevent JGB Crash during Balance Sheet Recession 183 No One Has Criticized Japan for Currency Manipulation 184 Japan Supported Global Economy for Four Years after Lehman Collapse 185 Real Effective Exchange Rate Does Not Fully Express Japanese Firms? Pain 187 Rising Fiscal Deficits Caused by Change in Corporate Behavior 188 How Should Japan?s Tax System Be Reformed? 190 Fiscal Stimulus Introduced to Offset Consumption Tax 191 Current Corporate Earnings Based on Massive Fiscal Deficits 192 Working Down Public Debt Will Require Bold Policies to Lift Japan?s Growth Rate 192 Incentives Needed to Restore Japan?s Economic Vitality 194 More Effective Land Utilization Could Propel Growth 194 Japan Needs Bold Tax Reforms Modeled on U.S. and Hong Kong Systems 195 Policies Need to Change Perceptions of Japan at Home and Abroad 196 CHAPTER 5 Euro Crisis?Facts and Resolution 199 Euro?s Adoption Lowered Interest Rates Sharply 200 Maastricht Treaty Acted as Constraint on Credit Risk 201 Greece Was Spoiled by Euro, and Germany Reacted Violently 203 Germans Believed Structural Reforms Required a Crisis 204 German Balance Sheet Recession Eight Years before GFC Started the Crisis 205 German IT Bubble Brought about Euro Crisis 209 ECB?s Rate Cuts Create Bubbles outside Germany 210 Misunderstandings Regarding Lack of Competitiveness in Southern Europe 213 Money Supply Growth Much Lower in Germany 214 German Reforms Responsible for Only Half of Competitive Gap 214 Germany Benefited Most from Euro 216 One More Mutual Dependency between Germany and Eurozone Periphery 217 Spain?s Vicious Balance Sheet Recession 219 Ireland?s Household Sector Forced to Pick Up Pieces after Massive Housing Bubble 220 Irish Businesses Remain Net Savers 222 Portugal?s Balance Sheet Recession Began Quite Recently 224 Italy Is in Same Position as Portugal 225 Why the Polarization of Eurozone Government Bond Yields? 227 Eurozone Allows Investors to Buy Government Bonds of Member Countries with No Currency Risk 229 Eurozone-Specific Fund Flows Amplify Economic Swings 230 Meaning of ?Fiscal Space? Differs Inside and Outside Eurozone 231 Maastricht Treaty Is Defective and Should Be Revised Immediately 232 In Practice, Fiscal Stimulus Requires EU and ECB Approval 233 Ban on Buying Other Nations? Debt Ideal Way to Stabilize Eurozone 234 Efficiency Gains from Single Currency Remain Intact 235 Different Risk Weights Should Be Applied to Domestic and Foreign Government Debt 237 Next-Best Alternative to Risk Weights Already in Place? 238 Separation of Sovereign Risk and Banking Risk a Rejection of self-Corrective Mechanism 238 Joint Issue of Eurobonds Would Only Solve Half of Eurozone?s Structural Defects 240 Draghi Unaware That There Are Two Kinds of Recessions and Fiscal Deficits 241 Outside of Greece, Capital Flight Is the Problem 243 Explaining Balance Sheet Recessions to the German Public 244 Even Germans Understand Need for Fiscal Stimulus If Properly Explained 245 Excessive Focus on Fiscal Deficits While Ignoring Growth in Private Savings 246 Lack of Private Loan Demand Biggest Problem for Germany 247 Germany Unlikely to Announce Stimulus Package 247 Disadvantages of Euro Exit for Greece 248 Argentina?s Experience Also Suggests Euro Exit Would Have Few Merits for Greece 249 Germany?s Competitive Gap with Other Countries Will Also Disappear in a Few Years 251 Draghi?s LTROs Prevented Collapse of Eurozone Financial System 252 ?Grand Bargain? with ECB Is an Empty Promise 254 Double-Dip Recessions and the Eurozone?s Bad Loan Problem 255 EBA?s Lack of Understanding of Systemic Crises Leads to Rash Actions 256 Cypriot Bank Resolution Could Worsen Financial System Jitters 257 Vicious Cycle of Creating New Bubbles to Paper over Old Ones 258 EU Election Results the Result of Economic Policy Errors 259 European Policymakers Mistake Balance Sheet Problems for Structural Problems 260 Policymakers Need to Ask Why Eurosceptics Made Such Gains 262 Disappointment with Established Parties Led to Rise of Nazis and World War II 262 Continued Disregard for People?s Voice Puts Democracy in Jeopardy 263 U.S. Voters Had Policy Choices, Unlike Their European Counterparts 263 The Euro Can Be Saved with Two Repairs 264 CHAPTER 6 China?s Economic Challenges 267 China?s Local Governments Began Borrowing en Masse 268 Decoupling Would Not Have Been Possible in Ordinary Democracy 269 China?s Remaining Problems Include Overcapacity and Income Inequality 270 China Understands Political Ramifications of Inflation 270 China?s Shadow Banking Sector: Misunderstandings and Realities 272 Problem: Sharp Growth in Lending to Local Governments Post-Lehman 273 Decoupling of China and Developed Economies to Continue 274 Problems Facing China?s Economy 274 China Has Already Passed the Lewis Turning Point 276 Rapid Economic Growth Continues until Lewis Turning Point 277 U.S.-Led Free Trade Regime Enabled the Emergence of Asia 278 Economy Starts to Mature Only after Passing the Lewis Turning Point 279 Local and Global Lewis Turning Points and Inequality 280 China Increasingly Tolerant of RMB Appreciation as Transition to Consumption-Led Economy Proceeds 281 The West Is Conflating Problems of Trade Imbalance and Financial Crisis 282 Liberalized Financial Sector and Capital Flows Could Weaken RMB 283 China Could Fall into the ?Middle-Income Trap? If It Neglects to Advance Its Industrial Base 284 Japan, Korea, and Taiwan Escaped from Middle-Income Trap 284 Labor Disputes Increase Sharply after the Lewis Turning Point Is Reached 287 The Dilemma of Patriotism with an External Enemy 289 Working-Age Population Peaked Just as the Lewis Turning Point Was Reached 290 Will China Grow Old before It Grows Rich? 291 The Next 15 to 20 Years Are Critical 292 Uncertainty Due to Corruption and Lack of Legal Infrastructure Must Be Removed . . . 293 Appealing to Patriotism without Creating External Enemies 294 China Could Become a World-Class Nation for the First Time in Two Centuries 295 Chinese Ambition and Industry Must Be Steered in Right Direction 296 Afterword 299 Bibliography 301 Index 305

About the Author

RICHARD C. KOO is the Chief Economist of Nomura Research Institute, a research arm of Nomura Securities, the leading securities house in Japan. Best known for developing the concept of balance sheet recession, which is now used widely around the world, he has also advised successive prime ministers on how best to deal with Japan's economic and banking problems. Consistently voted as one of the most reliable economists by Japanese market participants for over a decade, he was a Doctoral Fellow of the Board of Governors of the Federal Reserve System and an economist with the Federal Reserve Bank of New York prior to joining Nomura.


Praise for The Escape from Balance Sheet Recession and the QE Trap ?Richard Koo has been a pioneer in recasting macroeconomics for the current era of financial crisis and potential deflation. This book presents his latest thinking in a clear and powerful way. Agree or disagree his work deserves close study if the next decade in the industrial world is going to be better than the last.? ? Lawrence Summers, President Emeritus and Charles W. Eliot University Professor, Harvard University; former U.S. Secretary of the Treasury ?This is an important, stimulating, exciting and timely book. Guided by the ideas in this book, growing numbers of experts are appreciating the parallels between the current world-wide crisis and the crisis Japan experienced 15 years ago. The basic insight ? that in the presence of persistent liabilities, the private sector minimizes debt ? is one that needs to be fully appreciated in order for appropriate policies to be devised. This is a must-read for all those seeking to respond to the current economic malaise.? ? Dennis J. Snower, President, Kiel Institute for the World Economy; Professor of Economics, Christian-Alberchts University, Kiel ?Koo?s The Escape from Balance Sheet Recession and the QE Trap provides the most insightful guide to current macroeconomic policy available today. Koo?s concept of ?balance sheet recession? adds depth and detail to observations of the ?liquidity trap? and ?zero lower bound? of interest rates. He explains what needs to be done now and how long it could take. Everyone concerned with macroeconomic policy needs to read this analysis to learn how the world economy can be revived.? ? Peter Temin, Elisha Gray II Professor Emeritus of Economics, Massachusetts Institute of Technology ?I have always liked the Richard Koo style ? succinct theories, razor-sharp points, self-sustaining logic, and, more importantly, a set of workable solutions. It?s definitely a worthy read.? ? Gao Xiqing, Professor, School of Law, Tsinghua University; former Vice Chairman and President, China Investment Corporation. ?In the wake of the financial crisis of 2008, governments and financial institutions have instituted a wide range of changes in such areas as risk management, regulation, market organization, and fiscal and monetary policy. Unfortunately, however, these measures have suffered from a lack of a unified recognition of the fundamental problem. In a clear, engaging and penetrating way, Richard Koo has diagnosed the core nature of the challenge and the appropriate response. The Escape from Balance Sheet Recession and the QE Trap is an essential guide for anyone interested in the future of the global economy.? ? Jeffrey E. Garten, Juan Trippe professor of international trade and finance and former Dean, Yale School of Management; former Undersecretary of Commerce ?When the history of this depression is written, policymakers who ignore Koo?s finding will be judged harshly for imposing unnecessary suffering on their societies.? ? Richard Duncan, Author, The Dollar Crisis

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