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The Age of Balance Sheet Recessions: What Post-2008 U.S., Europe and China Can Learn from Japan 1990-2005 Richard C. Koo Chief Economist Nomura Research Institute Tokyo March 2009

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Nomura economist Richard Koo talking about balance sheet recessions.

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Page 1: Richard Koo Presentation

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

Richard C. KooChief Economist

Nomura Research InstituteTokyo

March 2009

Page 2: Richard Koo Presentation

1

Exhibit 1. US Economy Is Deteriorating Rapidly

70

72

74

76

78

80

82

84

86

98 99 00 01 02 03 04 05 06 07 08 09

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

Capacity Utilization(left Scale)

(%, Seasonally adjusted, inverted)

Unemployment Rate(right scale)

Sources: US Department of Labor, FRB

(%, Seasonally adjusted)

Page 3: Richard Koo Presentation

2

Exhibit 2. EU Economic Sentiments Are Worsening

65

70

75

80

85

90

95

100

105

110

115

120

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

(Seasonally adjusted)

Source: Ifo Business Survey, European Commission

Ifo Business Climate

Euro Area Economic Sentiment

Page 4: Richard Koo Presentation

3

Exhibit 3. Exports and House Prices Are Falling in China

-20

-15

-10

-5

0

5

10

15

20

25

03 04 05 06 07 08 0920

40

60

80

100

120

140(y/y%)

House price in Shenzhen (left scale)

($ bil., Seasonally Adjusted)

China's exports ($ bil., right scale)

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.

Page 5: Richard Koo Presentation

4

Exhibit 4. Japan’s Industrial Production and Employments Are also Weakening

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

2000 2001 2002 2003 2004 2005 2006 2007 2008 200965

70

75

80

85

90

95

100

105

110

115

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

Job offers to applicants ratio (left scale)

(Seasonally adjusted, 2005=100)(Seasonally adjusted)

Industrial production (right scale) forecast

Page 6: Richard Koo Presentation

5

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

0

1

2

3

4

5

6

7

8

2003 2004 2005 2006 2007 2008 2009

(%)

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

Australia

EU

US

UK

Japan

Page 7: Richard Koo Presentation

6

Exhibit 6. Features of Balance Sheet Recession

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. In order to repair their balance sheets, private sector moves away from profit maximization to debt minimization.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.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).In this type of recession, the economy will not enter self-sustaining growth until private sector balance sheets are repaired.

Page 8: Richard Koo Presentation

7

Exhibit 7. US Demand for Funds Is Falling Sharply

-50

-40

-30

-20

-10

0

10

20

30

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

(D.I.)

stronger demand for funds

weaker demand for funds

large and middle-market firms

small firms

housingbubble

collapseIT bubblecollapse

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 changedover the past three months?"D.I. = ("Substantially stronger" + "Moderately stronger"×0.5) - ("Moderately weaker"×0.5 + "Substantially weaker")

Page 9: Richard Koo Presentation

8

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

40

60

80

100

120

140

160

180

200

220

240

260

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

US: 10 Cities Composite Home Price Index

(US: Jan. 2000=100, Japan: Dec. 1985=100)

Sources: Bloomberg, Real Estate Economic Institute, Japan, S&P "S&P/Case-Shiller® Home Price Indices", as of Mar. 18, 2009.

Composite Index Futures(as of Mar. 18, 2009)

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

77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98

Japan: Osaka Area Condo Price(per m2, 5 months moving average)

Futures

Composite Index Futures(as of Sep. 19, 2007)

A fall in actual prices to the bottom forfuture prices would bring house prices

back to level of Dec. 2002

US

Japan

Page 10: Richard Koo Presentation

9

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

0

50

100

150

200

250

75 7677 7879 808182 8384 8586 8788 8990 919293 9495 9697 9899 0001 020304 0506 0708 0910 11

?

(91/1Q=100, Seasonally Adjusted)

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

Rents

House prices

A 21% decline would bring houseprices back to level of 2003 Q4

21%

Page 11: Richard Koo Presentation

10

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

-40

-20

0

20

40

60

80

100

120

95 96 97 98 99 00 01 02 03 04 05 06 07 08-2

-1

0

1

2

3

4

5

6

Saving rate (right scale)

($bn, seasonally adjusted)

Actual savings (left scale)

Amount needed to lift savingsto 4%* (left scale)

(%)

Note: Average savings rate for US households in1997-98.Source: Nomura Research Institute, based on US Department of Commerce data.

Savings shortfall = $1,544bn

4.5years atthis rate

Page 12: Richard Koo Presentation

11

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

0

100

200

300

400

500

600

700

800

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 08200

250

300

350

400

450

500

550

600(Tril.yen, Seasonally Adjusted)

Real GDP(Right Scale)

Land Price Index in Six Major Cities(Commercial, Right Scale)

(Mar. 2000=100)

Sources: Cabinet Office, Japan Real Estate Institute

Nominal GDP(Right Scale)

Last seenin 1973

down87%

Page 13: Richard Koo Presentation

12

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

-1600

-1200

-800

-400

0

400

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

Land Shares

Source: Cabinet Office, Japan "National Accounts"

(Tril. yen)

Land and SharesCombined

(Capital Loss)

(Capital Gain)

¥1,500trillion

Equivalentto $45

trillion lossin the US

Page 14: Richard Koo Presentation

13

Exhibit 13. Balance Sheet Problems Forced Japanese Businesses to Pay Down Debt even with Zero Interest Rates

Funds Raised by Non-Financial Corporate Sector

-10

-5

0

5

10

15

20

25

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08-4

-2

0

2

4

6

8

10

Borrowings from Financial Institutions (left scale)

Funds raised in Securities Markets (left scale)

CD 3M rate(right scale)

(% Nominal GDP, 4Q Moving Average) (%)

Sources: Bank of Japan, Cabinet Office, Japan

Page 15: Richard Koo Presentation

14

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

20

30

40

50

60

70

80

90

100

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, JapanNote: FY 2008 includes supplementary budget, and FY 2009 is just initial budget.

Government Spending

Tax revenueBubble Collapse

(Tril. yen)

totaladditional

deficit 90-05¥315 trillion

Page 16: Richard Koo Presentation

15

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

0

20

40

60

80

100

120

140

160

180

83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 080

1

2

3

4

5

6

7

8

9

Balance Sheet Recession

(%)(% of GDP)

Japanese Government Debt as Percentage of GDP (left scale)

Yields on 10year JGB (right scale)

* Household savings plus corporate debt repaymentSources: Cabinet Off ice, Japan, Japan Bond Trading Co., Japan Securities Dealers Association

Page 17: Richard Koo Presentation

16

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

0

50

100

150

200

250

300

350

400

450

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 0850

60

70

80

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

Credit Extended by the Banks to Corporate Sector

(Left Scale)

Credit Extended by the Banks toCorporate Sector

as a Ratio to Nominal GDP(Right Scale)

85/4Q

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.

last seenin 1956

Page 18: Richard Koo Presentation

17

Exhibit 17. Japanese Corporate Leverage Came Down Sharply

0

1

2

3

4

5

6

7

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

(Times)

Japan

US

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

Page 19: Richard Koo Presentation

18

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

0

10

20

30

40

50

60

70

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 090

10

20

30

40

50

60

70Tax Revenue

Budget Deficit

Hashimotofiscal

reformObuchi-Mori

fiscalstimulus

Koizumifiscal

reform

(Yen tril.) (Yen tril.)

(FY)

(with supplemental budget)*

(initial budget)*

Source: Ministry of Finance, Japan*: estimated by MOF

unnecessarydeficit:

¥97.6 tril.

Page 20: Richard Koo Presentation

19

Exhibit 19. Four Kinds of Banking Crises and Their Remedies

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 Great Depression of the 1930s, and US and UK subprime crisis since 2007

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

YangNormal demand for

funds

YinWeak or non-existent

demand for funds

Localized(I)

Quick NPL disposalPursue accountability

(III)Normal NPL disposalPursue accountability

Systemic(II)

Slow NPL disposalFat spread

(IV)Slow NPL disposal

Capital injection

BankingCrisis

Page 21: Richard Koo Presentation

20

Exhibit 20. Two Capital Injections Ended the Credit Crunch in Japan

-120

-100

-80

-60

-40

-20

0

20

40

60

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08-9

-6

-3

0

3

6

9

12

15

18

21

24

27

30

33

(Shaded areas indicate periods of BOJ monetary tightening)Sources : "Tankan", "Loans and Discounts Outstanding by Sector", BOJ

Bankers' Willingness to Lend as Seen by the Borrowers, and the Actual Credit Extended by the Banks

Accommodative

Credit Extended by the Banks(right scale)

Large Enterprises(Left Scale)

Restrictive

Small Enterprises(Left Scale)

('Accommodative' minus 'Restrictive', %points) (Y/Y%)

1st Capital Injection(¥1.8 tril.) 2nd Capital Injection

(¥7.5 tril.)

Miyazawa Proposal

Bubble Burst

Credit Crunch

"Takenaka Shock"(rushed NPL disposal)

GlobalFinancial

Crisis

Page 22: Richard Koo Presentation

21

Exhibit 21. Percentage of House Purchases that May Lead to “Return the Key”

For Houses Bought before January 2009

0

5

10

15

20

25

30

35

40

45

50

At Present (Mar. 2009) Home Prices[-30.2%]

Lowest Price in Futures Market (Nov. 2010) [-37.3%]

40% below the Peak

(millions)

46.3% (2)

41.1% (2)

28.7% (2)

88.0% (1)

82.9% (1)

70.4% (1)

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.

Page 23: Richard Koo Presentation

22

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

Source: Nomura Research Institute

FiscalPolicy

MonetaryPolicy

Economic Stimulus

Capital Injection

Monetary easinglargely ineffective

except

Liquidity Injection

Weaker Dollar

• Government spending more effective than tax cuts• Must be fast acting and seamless for the duration of recession

• Effective in ending debilitating credit crunch• Politically unpopular but sooner and bigger the better

Keeps financial institutions operating

Benefit: Exports encouraged, Imports discouraged

Risks: • May trigger foreign capital outflow leading to higher interest rates • Accelerate imported inflation

Credit Easing(Asset Purchases)

Benefit: • Help financial institutions deleverage • May help unclog some markets if the Fed's presence is viewed as permanent

Risk: May saddle Fed's balance sheet with distressed assets and lead to a serious loss of trust in the Fed and the dollar

Page 24: Richard Koo Presentation

23

Exhibit 23. US Trade Deficit Is Still Enormous

-80000

-70000

-60000

-50000

-40000

-30000

-20000

-10000

0

10000

20000

30000

40000

50000

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

($ mil., SA)

Japan's trade surplus

US trade deficit with ChinaUS trade deficit with Japan

US trade deficit(Census Basis)

China's trade balance

US RunningFederalBudget

Surpluses

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.

Page 25: Richard Koo Presentation

24

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

0

50

100

150

200

250

300

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

High-powered Money (Average Balance)

Money Supply (M2+CD, Average Balance)

Credit Extended to the Private Sector

1990/1Q

TextbookEconomics

(monetary policyeffective)

Balance SheetRecession(monetary policyNOT effective)

(1990/1Q=100, Seasonally adjusted)

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

Down37%

QuantitativeEasing

Page 26: Richard Koo Presentation

25

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

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.

-6

-4

-2

0

2

4

6

8

10

12

14

16

9 0 9 1 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9 0 0 0 1 0 2 0 3 0 4 0 5 0 6 0 7

Credit Extended to Others (Mostly Government)

Credit Extended to the Private Sector

Money Supply (M2+CD)

(Y/Y%)

QuantitativeEasing

Page 27: Richard Koo Presentation

26

Exhibit 26. Japan’s Money Supply Has Been Kept Up by Government Borrowings (II)

CreditExtended tothe Private

Sector¥601.6 tril.

CreditExtended to thePublic Sector¥247.2 tril.

(+106.8)

Foreign assets(net)

¥74.1 tril.(+41.4)

Foreign Assets(net)

¥32.7 tril.

Credit Extendedto the Public

Sector¥140.4 tril.

Money Supply(M2+CD)

¥621.5 tril.

CreditExtended tothe Private

Sector¥501.8 tril.

(-99.8)

Other Liabilities(net)

¥78.7 tril.(-74.5)

Other Liabilities(net)

¥153.2 tril.

Money Supply(M2+CD)

¥744.4 tril.(+122.9)

Balance Sheets of Banks in Japan

December 2007

Total Assets ¥823.1 tril. (+48.4)Total Assets ¥774.7 tril.

December 1998Assets

AssetsLiabilities

Liabilities

Source: Bank of Japan "Monetary Survey"

Page 28: Richard Koo Presentation

27

Exhibit 27. US Money Supply Growth after 1933 Was also Made Possible by Government Borrowings

Balance Sheets of All Member Banks

CreditExtended tothe Private

Sector$29.63 bil.

Deposits$32.18 bil.

CreditExtended tothe Public

Sector$5.45 bil.

Other Assets$8.02 bil.

Reserves$2.36 bil.

Capital$6.35 bil.

OtherLiabilities$6.93 bil.

June 1929 Assets Liabilities

Total Assets $45.46 bil. Total Assets $33.04 bil. (-12.42) Total Assets $46.53 bil. (+13.49)

CreditExtended

to thePrivateSector

$15.71 bil.(-0.09)Credit

Extended tothe Private

Sector$15.80 bil.

(-13.83)

June 1936 Assets Liabilities

June 1933 Assets Liabilities

Deposits$23.36 bil.

(-8.82)

Deposits$34.10 bil.(+10.74)

CreditExtended

to thePublicSector

$8.63 bil.(+3.18)

CreditExtended

to thePublicSector

$16.30 bil.(+7.67)

OtherAssets

$6.37 bil.(-1.65)

OtherAssets

$8.91 bil.(+2.54)

Reserves$2.24 bil.

(-0.12)

Reserves$5.61 bil.(+3.37)

OtherLiabilities$4.84 bil.

(-2.09)

OtherLiabilities$7.19 bil.(+2.35)

Capital$4.84 bil.

(-1.51)

Capital$5.24 bil.(+0.40)

(= Money Supply)

Source: Board of Governors of the Federal Reserve System (1976) Banking and Monetary Statistics 1914-1941 pp.72-79

Page 29: Richard Koo Presentation

28

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

-4000

-2000

0

2000

4000

6000

8000

10000

12000

14000

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

-4

0

4

8

12

16

20

24

28($ mn, June)

Revenue (left scale)

Expenditures (left scale)

Budget deficit as % of GNP(right scale)

(%)

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

Unemployment rate(right scale)

New Deal policies

Page 30: Richard Koo Presentation

29

Exhibit 29. German fiscal stimulus reduced unemployment dramatically

-10

-5

0

5

10

15

20

25

30

35

1930 1931 1932 1933 1934 1935 1936 1937 1938-10

-5

0

5

10

15

20

25

30

35

Unemployment rate(right scale)

(DM bn) (%)

Governmentrevenue

(left scale)

Governmentexpenditure(left scale)

Fiscal deficit as %of GDP

(right scale)

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

Nazis come topower

N.A. N.A.

Page 31: Richard Koo Presentation

30

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

0

1

2

3

4

5

6

7

8

9

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

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

Oct '29 NY StockMarket Crash

Jun '50 Korean War

Dec '41 PearlHarbor Attack

(%)

'33~New Deal

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

Page 32: Richard Koo Presentation

31

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

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

Repair Balance Sheets

Private Sector Bought Assetswith Borrowed Funds

Fall in Asset Prices

Private Sector Moves away from Profit Maximization to Debt Minimization

Central Bank Panics andDramatically Eases MonetaryPolicy

Balance Sheet Problems Develop

Fall in Aggregate DemandPrivate Sector Paying Down Debt

Nothing Happens because Private Sector Is Minimizing Debt

No Demand for Funds Weaker Economy and Deflation

The Problem

The Solution

Vicious Cycle

Private Sector SavingsOriginal Money Flow

"Liquidity Trap"

Breaking theVicious Cycle

Allow Private Sector toPay down Debt

Keep AggregateDemand from Falling

Further Fall in Asset Prices

Fiscal Stimulus

Government ProcuresFunds at Low Rates due tothe Lack of Private SectorBorrowers

Government Borrowings HelpMaintain Money Supply in the Absenceof Private Sector Borrowers

More Defaults

More Non-Performing Loans at Banks

Page 33: Richard Koo Presentation

32

Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession , John Wiley & Sons, Singapore, April 2008 p.160.

(1) Monetary policy is tightened, leading the bubble to collapse.

(5) Private sector phobia towards borrowing gradually disappears,and it takes a more bullish stance towards fund raising.

(8) With the economy healthy,the private sector regains its vigour,

and confidence returns.

(9) Overconfident private sector triggers a bubble.

(7) Monetary policy becomes the maineconomic tool, while deficit reduction

becomes the top fiscal priority.

(6) Private sector fund demand recovers,and monetary policy starts working again.

Fiscal policy begins to crowd out private investment.

(4) Eventually private sector finishes its debt repayments,ending the balance sheet recession.

But it still has a phobia about borrowing which keepsinterest rates low, and the economy less than fully vibrant.

Economy prone to mini-bubbles.

(3) With everybody paying down debt,monetary policy stops working.

Fiscal policy becomes the main economic toolto maintain demand.

(2) Collapse in asset prices leaves private sectorwith excess liabilities,

forcing it into debt minimization mode.The economy falls into a balance sheet recession.

BubbleYin (=Shadow) Yang (=Light)

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

Germany

Japan

US

India

China

UK

Spain

Page 34: Richard Koo Presentation

33

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

Yang YinTextbook economy Balance sheet recession

Adam Smith's "invisible hand" Fallacy of composition

Assets > Liabilities Assets < Liabilities

Profit maximization Debt minimization

Greatest good for greatest number Depression if left unattended

Effective Ineffective (liquidity trap)

Counterproductive (crowding-out) Effective

Inflation Deflation

Normal Very low

Virtue Vice (paradox of thrift)

a) Localized Quick NPL disposalPursue accountability

Normal NPL disposalPursue accountability

b) Systemic Slow NPL disposalFat spread

Slow NPL disposalCapital injection

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

5) Outcome

6) Monetary policy

7) Fiscal policy

1) Phenomenon

2) Fundamental driver

3) Corporate financial condition

4) Behavioral principle

8) Prices

9) Interest rates

10) Savings

11) Remedy forBanking Crisis