Lessons from Japan on sovereign default and balance sheet recessions


Edward wrote a piece about Japan’s government net asset value falling below zero. He thought it would make sense if I gave you an alternative view using Richard Koo’s latest thinking about the Japanese experience, especially given the parallels to the U.S. regarding balance sheet recessions.

Before I get to Koo, I should add that, for all of the talk about Japan’s "national insolvency", I still don’t see their Social Security cheques – or the Japanese equivalent – being bounced. The fact that debt issuance exceeds tax revenues only tells me that the economy remains in dire straits, not that the country is bankrupt. The latter implies a shortage of yen, which can never been the case in a country which has retained its sovereign ability to create currency.

I know Edward understands this despite his Austrian-oriented sensibilities. but it needs to be reiterated. See Edward’s piece “Russia, sovereign debt defaults, and fiat currency.”

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As for Koo, the only thing I’ve seen from Koo recently was an interview he conducted with Nomura Research Institute about 6 weeks ago.

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Koo was asked how GDP can continue to grow if the private sector are taking “massive hits to their wealth”, which is also a common theme among the debt-deflationists – that we have to take our medicine now and excoriate the debt and allow industry to suffer widespread failure as a consequence. Some people even believe you need mass unemployment to assist in this debt elimination process.

Koo rejects this "Austrian" line of thinking. An October 2009 post from Bill Mitchell explains.

… Japan’s GDP grew even after the massive loss of wealth it suffered when its real estate bubble burst … That happened even though the private sector was rushing to pay down debt all during that time. And the reason is that the government’s fiscal spending kept incomes growing enough that GDP never fell below its bubble peak, in either nominal or real terms …

And this was over a period that commercial real estate prices fell by 87 per cent from their 1990 peak – and the total wealth effect amounted to “the largest loss of wealth in human history, in peace time.” GDP kept growing because the Japanese government was “highly liberal with public spending”. Moreover, he rejects the Austrian arguments in this regard (that is, a sharp recession to clear the decks and the debt) because it would be extremely costly in human and economic terms:

… that experiment was tried from 1929 to 1933 and almost half of U.S. GDP disappeared. Unemployment rate went to 25% and bringing the economy back to full employment literally too the Japanese attack on Pearl Harbour. I don’t think that’s the way we want the world to come back to life. People who argue that zombie companies should be allow to go to hell … don’t realise that, first of all, zombie companies with no cash flow cannot pay down debt, and if they cannot pay down debt, they are actually not the source of the problem … Balance sheet recessions are caused by good companies with good cash flow paying down debt.

How fiscal policy saved the world, Bill Mitchell, billy blog, October 2009

The problem Koo notes again is that while the first wave of Japanese fiscal injection instantly worked (building roads and bridges) they considered it a temporary measure only. Unfortunately, the Obama people view deficit spending in the same way. Larry Summers talks about deficit spending being "targeted, timely and temporary" (my emphasis on the last).

Koo concludes that:

… what my work shows is that the total additional, or cyclical, deficit that the government created to sustain GDP during Japan’s balance sheet recession … took the fiscal deficit to about 63% of GDP. But I would argue that this 63% of GDP deficit represents the most successful fiscal stimulus in history.

His computation is based on the fact that GDP would have dived (perhaps by more than 46 per cent) if the stimulus was not provided. To be conservative, however, he assumes that GDP returns to its pre-bubble level of 1985 with no stimulus.

How fiscal policy saved the world, Bill Mitchell, billy blog, October 2009

There’s also some good charts that have been reproduced from Koo’s work in the cited example from Bill Mitchell’s blog.

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