The book’s title is intriguing. Has the author really found the Holy Grail of macroeconomics in lessons from Japan’s great recession of the 1990’s?

The title of the book comes from a quote from Ben Bernanke. “To understand the great depression is the Holy Grail of macroeconomics,” but that “we do not yet have our hands on the Grail by any means,” said the chairman of the US Federal Reserve. He added that, “not only did the depression give birth to macroeconomics as a distinct field of study, but the experience of the 1930s continues to influence macroeconomists’ beliefs, policy recommendations and research agendas.”

Bernanke regards the depression as “a fascinating intellectual challenge”. He notes that to this day, it has not been explained how things got so bad for so long after the October 1929 stock market crash. Author Richard Koo suggests the answer lies in the so-called “lost decade” of Japan in the 1990s which he refers to as “Japan in the past 15 years”.

Koo, chief economist of Nomura Research Institute, finds the same phenomenon at work in the US and German economies following the burst of the high-tech bubble in 2000, and the sub-prime induced financial crisis in 2007. He says the 2000 and 2007 crises have striking similarities with the great depression 70 years earlier.

Meanwhile, the Japanese experience offers a stepping stone, making it easier to see the similarities. It is especially useful because the Japanese economy has captured a wealth of data not available during the depression of the 1930s. It is also similar to the other three crises in that the Japanese economy was powerful and prosperous through the 1980s until it hit a sudden downturn that began in 1990.

Balance sheet recession

Neo-classical economics traditionally assumes profit maximisation. Koo, on the other hand, introduces the concept of “balance sheet recession”, which adds “debt reduction” to the list of motivation for companies and individuals.

So, why do companies want to retire their debt early? First, it is to reduce risk. Next, by doing so, they will have less need for capital since fewer business opportunities are available in a recession. Koo emphasises that a “balance sheet recession” is different from neo-classical economic theory, which places monetary policy in a central role. He shows that monetary policy is ineffective in a balance sheet recession; since there is little or no demand for loans, adding to the money supply - as advocated by monetarists like Milton Friedman and Anna Schwartz - is of little use.

While at odds with monetarists, most readers will note that a “balance sheet recession” is strikingly similar to Keynesian policy prescriptions, which also find monetary policy of little or no use in a severe recession. Like Koo, the Keynesian alternative advocates fiscal spending. The subtle difference between Keynes and Koo comes down to debt practices of firms and individuals. Keynes said in a depression or severe recession, dismal economic prospects means companies will not borrow and banks will not lend, even at near-zero interest rates.

According to Koo, balance sheet recession involves companies not just paying off debt as it comes due but also by retiring it early. He hypothesised that Keynes, a successful investor and a fine art collector, did not understand this debt link because of his lack of first hand experience of personal debt. “As did the monetarists and neoclassical economists, he (Keynes) failed to see that the liquidity trap was a borrowers’ phenomenon,” says Koo.

The more standard (Keynesian) view is that companies suffer from lower earnings and cash shortages in a severe recession. Many will have difficulty meeting scheduled debt payments, as well as paying their suppliers and employees. Paying off loans early is usually not a high priority and is something companies will try to stall as long as they can. In a severe recession or depression, many companies don’t even consider it.

Ultimately, the question of whether companies exhibit this behaviour is an empirical one. Unfortunately, the author did not present evidence of companies which have retired debt early during a “balance sheet recession”. It would be helpful to have an anecdote or two. Even one company which did this would provide some ray of hope that the holy grail of macroeconomics may really have been found.

Nonetheless, Koo concludes: “… Keynesian theory as it stands is critically incomplete, because it fails to see corporate debt minimisation as the key driving force behind the economic problem it has set out to explain and solve. Corporate debt minimisation, therefore, is the long-overlooked micro-foundation of Keynesian macroeconomics.”

Koo extends his theory to include households. They also respond to a severe recession by being responsible and paying down their debts. “If Keynes had recognised balance sheet concerns at firms and households as the main cause of the Great Depression, and had indicated in 1936 that fiscal stimulus is effective and essential only when the private sector is paying down debt, his followers in the 1950s and 1960s would not have pushed for aggressive fiscal stimulus. That in turn would have preserved the credibility of deficit spending as the key policy tool for fighting a balance sheet recession all the way to the 1990s,” he says.

An alternative explanation

The alternative explanation lies on the supply side. Companies do not pay down their debt willingly in severe recessions. In fact, they crave capital and risk going out of business because they can’t get enough cash. Because of this, companies are reluctant to part with their cash before they have to, and rarely pay down debts early.

Instead, it is the banks which find lending to be suddenly risky. It is their decision to cut back on loans in recessions, resulting in a supply-side phenomenon. Company and personal debt levels are lowered because banks have decided it is the safer route to take. On the consumer side, in severe recessions, we have seen mortgage financing move from 90 to 80 to 70% loans, requiring 10 to 20 to 30% equity from buyers. This is not the buyer’s choice but that of the banks.

On the corporate side, banks cut credit lines and new loans become harder to come by. Companies respond by delaying payment to suppliers - longer “days payable” become a substitute for bank loans. Today, few companies would turn down a low-interest loan if they could get one.

Koo believes the opposite to be true, based on Japan’s experience in the 1990s. “Finally, with an excess of willing lenders and a shortage of willing borrowers, market forces naturally sparked intensive price competition between the lenders,” he says.

The alternative explanation is that banks today are desperately looking for credit worthy borrowers but find few. There are plenty of willing borrowers but banks avoid them, preferring to hang onto their cash and avoid the new, higher levels of risks associated with lending to individuals and firms during a deep recession. Evidence of the latter are the sharply higher collateral requirements by banks, which one would not expect if banks were desperately trying to loan out their excess reserves, as Koo indicates.

Again, empirical evidence would be useful. Koo’s case could be made more convincing if there were even one banker who went on record to say that he looked high and low but was unable to find a company or an individual who wanted to borrow money. It also would be useful to hear from a company that actually pre-paid its loans in the depths of a recession. Even a few anecdotal stories would add believability to his theories.

Embarrassing balance sheets

Is it possible that declining asset values of firms result in negative equity? It means companies are technically bankrupt.  It can happen on a personal level too, like when home prices collapse. In Japan, home prices fell 87% between 1990 and 2007, resulting in negative equity for many Japanese households, similar to what the many American households are now experiencing. Companies go through the same curve when business slows and the value of their assets decline.

When such a situation happens, according the Koo, it is in the interests of both companies and creditors to hide the facts. “The CEO of a company with negative net worth that is struggling to pay down debt would never discuss such matters with people outside the firm,” he says.

Companies don’t want customers or even employees to find out the true (severe) situation for fear of losing both. Regarding the role of lenders in this conspiracy of silence, Koo says: “Creditors (banks) do not want to discuss these issues either. If it becomes known that a borrower is technically insolvent, loans extended to the company will become bad loans, and the lender may be forced by government regulators to cut off credit and try to collect on existing loans.”

Outside of Japan, whether or not this is true depends on specific loans covenants, which vary widely from loan to loan. It also depends on financial reporting and disclosure requirements, which vary from country to country.

The current recession, when it is over, is likely to offer more lessons for future economic historians. Meanwhile, the search for the Holy Grail continues.