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December 25, 2002

Preemptive Strike to Deal with Balance-Sheet Recession

Richard Koo (Chief Economist, Nomura Research Institute)

Mistaken Priorities

One year and a half have passed since the Koizumi Administration was inaugurated with the slogan of structural reform. Having observed their management of the economy, I think it is clear that there is no hope for economic recovery under this administration. The reason is because the "illness" that they are trying to cure is completely different from the one that the Japanese economy is actually suffering.

Currently, the Japanese economy is inflicted with two illnesses, one is "pneumonia" and the other is "diabetes," so to speak. It is needless to say that we should put our priority on the treatment of "pneumonia" to save the patient's life first and then deal with "diabetes" later. While the Koizumi government is trying to treat diabetes, that is, "structural problems including the problem of non-performing loans," there seems to be no recognition on the part of the government that the Japanese economy is dying of pneumonia, that is, "balance-sheet recession," which should be regarded as the fundamental cause for the current economic stagnation.

Seriousness of Balance-Sheet Recession

Let me emphasize the seriousness of this balance-sheet recession. Normally, corporations would borrow money and invest for maximization of profit or market share, but in present-day Japan, they not only stopped borrowing money to invest, but are now paying back debt to their banks. More concretely, Japanese corporations as a whole are paying back as much as 20 trillion yen a year or 4% of GDP.

On the other hand, the household sector is still saving 20 to 30 trillion yen a year, which should have been borrowed and invested by corporations for their business expansion. Instead, however, corporations are paying back money themselves even at the zero interest rate. No economic or business textbook has ever talked about such a situation. This is indeed a horrible and dangerous situation.

The cause for this peculiar balance-sheet recession is the collapse of the bubble in 1990, when asset prices such as land values and stock prices declined sharply. For instance, commercial land values have dropped by 85% on the national average, and there are actually many cases where land values have become one tenth or one twentieth their peak levels. The problem is that these assets were purchased by borrowing money and, therefore, corporations have been suffering from debt overhang since the collapse of asset prices.

As a result, corporations are trying their best in repaying debt out of their current cash flow. While the corporate sector is doing the right thing by trying to repair their balance sheets, the household sector is still saving as before. With the corporate sector no longer borrowing, this means the entire household savings is turning into the deflationary gap. In this sense, Japan is facing the "fallacy of composition," a situation in which the overall result proves wrong even if everyone does the right thing.

Ineffective Monetary Policy

In the case of a balance-sheet recession, everyone tries to repay debt and the economy tends to stagnate. Then, asset prices will fall, and that will increase the amount of debt overhang that everyone has to repay. This is the vicious circle of the balance-sheet recession.

What to do is quite clear. The government cannot force corporations to stop paying down their debt. The government, therefore, should take action to fill the gap. This is the lesson human race have learned from the experience of the Great Depression in the 1930s.

The important thing is that the government should stimulate the economy in order to create the environment where corporations can earn profits and repay their debt as quickly as possible. If the government borrows and spends money that the household sector saved but the corporate sector did not borrow, the economy will be stabilized and the vicious circle will be stopped.

Normally, there exist two ways to fill the gap, namely, fiscal policy and monetary policy. Unfortunately, monetary policy is ineffective in the case of a balance sheet recession. Most of the corporations that are desperately repaying their debt would not start borrowing money even if interest rates are reduced to the near zero level.

In fact, monetary policy was not effective at all during the Great Depression era, as many people were busy repaying their debt. The word, "the liquidity trap," was coined at that time. The current situation is very similar to the situation then.

There are lists of 30 or 50 troubled companies circulated nowadays, and some in the Cabinet talk as though the bulk of the problem of non-performing loans would be resolved if those troubled companies went bankrupt. However, that is wrong, because the remaining millions of companies would not stop repaying their debt, even if those 30 or 50 companies go under. Even worse, the remaining companies might well accelerate their debt repayment schedule in an attempt to escape from creditors desperate to get their money back. As a result, the recession would get worse.

Preemptive Strike by Fiscal Policy

If neither the disposition of non-performing loans nor monetary policy is effective, the remaining policy that helps corporations clear their balance-sheet with minimum cost is nothing but fiscal policy. The government should borrow money to fill the gap between household savings and corporate investment. This is the only option left in the case where corporations are trying to repay their debt in spite of zero interest rates.

If Prime Minister Koizumi's structural reform approach was supported by the market, then the stocks of those companies that have pushed reform themselves should have been bought. But that was not the case when almost all stock prices dropped sharply in response to the "fiscal revival plan" announced by Mr. Takenaka the other day. This is because investors became seriously concerned about the future of the Japanese economy, as the Koizumi Administration has announced that "no demand-side policy will be taken."

Yet, there are strong objections to such fiscal policy. Some say that "more than 30 trillion yen has been spent by the government with no effect on the economy." That may be true, but the point is how to spend it. In a balance sheet recession, it is important to use it as a "preemptive strike." It would be less costly to behave "proactively" before the damage is done.

In contrast, the Koizumi government is doing just the opposite, as its deflation policy was adopted after the damage was done. If the government adopted stimulative fiscal policy last year, the economy would have been in a much better shape now and the sharp declines in stock prices would have been avoided.

We can learn about this kind of "preemptive strikes" from the U.S. in the aftermath of the September 11 attacks. FRB Chairman Greenspan and former Treasury Secretary Rubin argued for fiscal spending as a "preemptive attack," to stop the vicious circle of the economic decline. Thanks to such a policy, the U.S. economy has escaped a serious damage. Learning from such an experience in the U.S., the Japanese government must spend enough money to have the effect of a preemptive strike to the current recession.

How to Create Excess Demand Condition

Furthermore, we need to think of how to improve the effectiveness of fiscal spending. For example, we might shorten the delivery time for public works in order to create excess demand situation. If we freeze all the public works, as some in the Cabinet seem to be suggesting we would incur a tremendous amount of losses, given the huge amount of past investment. Instead, it may be a good idea to shorten the completion time for selected public works.

For instance, we could cut the budget for about 20 percent of planned highway construction with the lowest levels of projected usage, and the remaining 80 percent would be fully funded given the condition that the completion time be cut in half. Such requirement will create shortages everywhere. Then, public works would be accelerated and become quite stimulative, just like war-time government spending. This might well redirect the economy from a vicious cycle to a virtuous cycle.

Then, the government should start spending money on next-generation projects as much as possible, again with half the order period that is currently planned, and keep it going at least for three to four years. Hopefully, this will lead to much desired inflation for the economy as a whole.

This might be regarded as a radical proposal, but we need a bold idea to create a world of excess-demand and full mobilization of resources. That is much better than the current situation with excess supply and underutilization of resources in our economy. It is only after the balance sheet problems of businesses are corrected that the government should go after the diabetes which should include everything from resolving the infamous "land problem" to pushing the deregulation and privatization.

Richard Koo, "Koizumi seiken niwa zetsubo shita," Voice, December, 2002

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