Mr Koo, tell me something new

Two years ago I stumbled across an amazing explanation of Japans recession after its property bubble, the so-called “Heisei bubble”, went bust at the end of the 1980’s.
Stories of Japans dwindling economic miracle and skyrocketing governmental debt had hit the front pages and economists had turned themselves loose on the phenomenon of zombie banks.
Sarcastic folks even called Japan a “loser’s paradise”.

But how do such judgments fit into the picture that the Japanese economy has actually not tanked despite a “lost decade”?

Richard Koo, chief economist at Nomura Research, provided the missing link by rendering a “Balance Sheet Recession” in Japan.
You may read the long story at welling@weeden.

So, how does it work?
Part 1
When the Heisei property speculation came to a halt most borrowers found that the book value of their mortgage – denoted at previous boom price – was not covered by the property’s actual market value.
Having their balance sheets suddenly under water by more debt than real property value, borrowers moved from profit-maximization through investments through loan-taking to debt-minimization through loan-repayment. As a result, credit demand rather than supply declined. While Japanese companies still had profitable operations(!) and thus cash flows(!) they “saved face” by paying off debt using their cash flows and deposits.
The Bank of Japan (BoJ) stepped in with monetary stimulus by decreasing the interest rate repeatedly. Their move could not stop the “deleveraging” and the entailed “deflationary spiral” of declining property prices, weakening investment activity and thus shrinking balance sheets.Part 2:
Since there is a lender to any borrower, Japanese banks were dragged into the deleveraging while they sat on imploded collateral and idle cash.
In other words, the lender’s business model did not work any more. It had taken more than ten years until the Japanese government launched a mix of financial and monetary stimulus by selling bonds at low interest rates to their banks which were desperate to repair their own balance sheets with new income and safe collateral.
The gains of this move were poured into public projects to spur the economy.
Mr Koo argues that this financial wizardry of 325 trillion Yen in government debts bought the Japanese economy a “2,000 trillion Yen GDP equivalent”.The vicious circle of deleveraging was finally broken when the BoJ finally turned to “Quantitative Easing” in 2000 which allowed banks to deposit riskier securities and collateralized loans for loans.
Slowing productivity, an increasing and grinding capital employment to sustain revenues while simultaneously paying off “yesterday’s obligations” and shunning new loans, depressed profit margins and dragged Japan into the “lost decade.”

In 2009, amidst the ongoing financial crisis, Mr Koos explanation intrigued me and I wondered whether Japans “lost decade” provides lessons to be learnt for Germany and what’s looming ahead since Germany and Japan share some economic grounds, say, mercantilism by Zaibatsu (“Japan AG”) and Germans industrial families (“Deutschland AG”).
Mr Koo has turned into the major advocates of Japanese lessons to the shaky world of finance and politics since 2009 as one could see from the list of his talks.

Richard Koo – A “Balance Sheet Recession”

With regards to the European Union as whole however, Mr Koos intriguing but simple formula might be insufficient medicine.
The reason is a different diagnosis.
So, here’s why.

1) Crisis origin: The nation of Japan dealt with an internal leverage problem while its businesses still had healthy cash flows.
The EU as a compound of nations deals with an internal and an internalized leverage problem since the sub prime crunch spilled from the US into its member’s banking sectors. Some EU members became financially distressed while rescuing their local banking sector from their exposure to the toxic assets of the sub prime crunch or an internal credit bust. Other EU members had an unbalanced budget regime; see next point.

2) Budget structure: Most of Japans businesses still had a working business model and cash flows coming in.
The expenses of some EU members are not fully met by (tax) revenues. For them, the sell-off of national assets or debt relief is not the solution on the first place, it’s rather a fixture of local business models and budget structure.

3) Coordination: While Japan had the Ministry of International Trade and Industry (MITI) coordinating the resources of Japanese companies into promising business areas until 2001 and the financial sector supported such companies with the necessary wherewithal, the EU has no such central institutions with strong coordinating or authoritative power. Plus, the EU’s budget is not to be stretched beyond their member contributions, i.e. the EU is not allowed to underwrite debentures and is subject to coordination with multiple power centers.

4) Monetary policy: Japan has the Bank of Japan to depreciate the national currency in order to spur export revenues, extend profits and thus shorten the period of deleveraging. Any member of the European Union is left to financial stimulus while the monetary stimulus belongs to all EU members through the European Central Bank. So, there are little chances for one member to support its local businesses by virtually cheapening the local products on the world market through a devalued currency.

Japans saving ratio from 1962 - 1998

Japans saving ratio from 1962 – 1998

5) Savings: For the part of monetary policy, any credit issued by a financial mediator has to be underpinned by saving accounts. Japan was known for their saving prowess until 1998 with rates ranging from 12-15%.
That way, Japans government could afford a spending spree trough debt since the Japanese debt is held primarily by its citizens.
Savings in the EU vary across its member states from -2% to 15% in 2007 which means that one EU country’s leverage is linked to the savings of other EU members or international financiers.
Tricky enough, those external savers and priority claimants are not allowed to interfer into the national affairs of their borrowers which leaves little space for good solutions.

6) Banking system: Japans banking system was strictly segmented and geographically fragmented in the late 1980s. The “Big Three” Nomura Securities, Daiwa Securities, and Nikko Cordial Securities underwrote security offerings and trusts were a source of long-term credit to large companies. Subsidiaries of the five major “city banks” and many regional banks catered their customers with commercial banking except consumer lending. Since trusts were an extension of Japans city banks they made Japan famous for “relationship banking”, the keiretsu.
Unsecured loans, such as credit cards or consumer-shopping credits, as well as loan guarantees and secured loans for property to consumers are still a domain of nonbank companies, called Shinpan kaisha. Shinpans have been unique in the world and are not to be mistaken with structured investment vehicles as they issue and manage loans on own and third-party account. Whenever a third-party debenture goes sour the Shinpan pays off the external creditor and takes over the contract.
Whereas the Japanese banking system followed the Anglo-Saxon model, Europe is known for its universal banking system. Hence, the interconnection between debt and savings may take down a universal bank much faster. Plus, local banks are regulated by their national central bank.

7) Fiscal competition: Japans uniform tax code and budget is valid across Japan, whereas each member of the European Union maintains its own tax code and budget. That way, EU member states compete for investments and economic growth through tax rates and/or productivity.

8) Dual economy: Scholars coined the term “dual economy” to describe the strip line between Japans effective export sector and its closed internal economy. This strip line goes back to the Meiji restoration in 1868 when Japan embarked on political and modernization, mainly influenced by the German school of “economic nationalism” famed as mercantilism. Such lock-up of the internal market in favour to exports may at constant productivity work well as long as wages do not rise or when capital employment deepens, i.e. machines replace workers. That happened in Japan at the end of the 1980s: workweek length was cut, total  factor  productivity  declined and capital-output ratio through deepened capital employment rose. Kanban and Kaizen at its best — see the point?
While all major export companies off-shored some of their operations, Japans internal economy was detached from growth. That way, Japans massive money injections into public projects and Quantitative Easing makes sense.

But Europe is not mercantilistic at all.

9) Culture: Finally, and despite my dislike for the ubiquitous “culture” judgment, Japanese tend to be more reliable and solemn when it comes to meeting obligations.  The Japanese delinquency rate is lower and incurs later than in Western countries. So, lenders can expect to be paid off and bankruptcy proceedings are opened later and in rarer cases than in other countries.

To sum it up, Japan is not Europe.
The European Union is a compound of many power houses and cultures when it comes to budgeting, coordinating and monetary policing.An unwanted by-effect of Japans monetary policy by keeping interest rates low are carry trades. They enable financial investors to move credit from low-interest countries into high-interest countries in order to earn the interest margin. Such schemes can turn out into a development program of countries where credit is scarce but also support malfunctioning regimes.

The interconnection between debt and savings were not solved along the Japanese way:
→ Solution 1: Debt-restructuring by internalizing the debt in order to pay off external savers. Impossible as there are no internal savings and new credit lines are harder to obtain.
→ Solution 2: Debt-refinancing by swapping the credit from existing to new lenders. Tough as contemporary history shows while trust dwindles and interest rates rise.
→ Solution 3: Debt-waiving by reimbursing only a part of the debt to external savers (“hair cut”) and finding new lenders for the remaining debt. Tough, since it annoys existing lenders foremost from Germany and Switzerland and does not prevent rising interest rates.
→ Solution 4: Debt-aggregation by paying off external savers and transfering most of the debt to a “meta lender” which stays silent by holding and issuing new debt. That’s the solution of the EU, known as European Stability Mechanism (ESM), not the best, but better than any other even for Germany.

The Japanese solution does not provide clear solution on how regulate across multiple sovereigns or how to alleviate fiscal competition.

That said, I however fully agree with Mr Koo and Mr Flassbeck that Germany needs a fiscal stimulus to prop up its internal economy although for different reasons, namely mercantilism.
While Mr Koo assumes a governmental spending spree and Quantitative Easing the right medicine for mercantilism the picture might be different for the EU.

Hence, Mr Koo, tell me something new.


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