My plan to save the world: leading economist Richard Koo of Nomura Research Institute sat down with TIE founder and editor David Smick to discuss balance sheet recessions and what policymakers need to do to rescue their economies.



Smick: Your 2008 book, The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession, was a very important work. What's the difference between that effort and your most recent book, The Escape from Balance Sheet Recession and the QE Trap: A Hazardous Road for the World Economy What did you need to say that you hadn't already said?

Koo: The purpose of The Holy Grail was to make sure the United States would not make the same economic policy mistakes Japan had made, and would avoid suffering from the disease I call "balance sheet recession." Against the advice of then-U.S. Treasury Secretary Larry Summers, Japan made a terrible mistake in 1997 in adopting a policy of fiscal austerity. The result was five consecutive quarters of negative growth and a complete breakdown of the banking system. It took Japan ten years to recover from that mistake. Although the United States avoided the mistake, the Europeans walked right into it, which is one reason I had to write the new book.

Smick: You mentioned something about New York Times columnist Paul Krugman?

Koo: Even though Paul later came to appreciate the need for fiscal stimulus, at the beginning he was still very much in favor of action on the monetary side. But such a recession--what I call a balance sheet recession, where the private sector got itself involved in a bubble, the bubble burst, liabilities remained, asset prices collapsed, and everyone had to repair their balance sheets--only happens once every several decades, but when it happens, monetary policy is largely useless. The second part of The Holy Grail warns readers that relying on monetary policy won't work. Inflation will not pick up. The economy will not begin to move.

My new book has two parts. The first part looks at the U.S. experience with quantitative easing. I didn't think QE was a good way to go, but since the United States did it, now we need to consider how to come out of it. My thinking suggests that this process is going to be very bumpy and very difficult, and I want to warn that it could result in some very nasty surprises. And we have been experiencing this bumpy ride in the markets since last year. I also want to save Europe. My first book helped the United States in a small way, but it didn't address the problems Europeans were facing. So I devoted a chapter to advice on basically how to save Europe.

Smick: A lot of people say U.S. policymakers were surprised when, in response to the 2008 financial crisis and despite a trillion dollars of combined Bush and Obama fiscal stimulus, the American people said "Now we're going to repair our balance sheets. We're not going to spend." At the same time, European corporations became obsessed with their balance sheets. Do you get the sense that in both the United States and Europe, individual decision makers reacted in a way that made the stimulus less effective?

Koo: The private sector has to minimize debt when its balance sheets are underwater. If the United States had not enacted that massive stimulus package, the situation would have been even more catastrophic. As soon as the Lehman crisis hit, the U.S. private sector started saving something close to 10 percent of GDP, despite zero interest rates. At zero interest rates, Americans are supposed to be borrowing money, not saving money! But because the bursting of the bubble left them with lots of debt but no assets to show for it, the U.S. private sector went from being massive borrowers to the tune of 5 percent of GDP to massive savers. Something like 15 percent of GDP was lost literally overnight when people changed their behavior.

But in the national economy, when someone is saving money, someone else needs to be borrowing money to keep the economy going. I'm glad people in the Obama Administration understood that. The government became the borrower of last resort and that's what kept the economy going.

Europeans, on the other hand, misunderstood the Japanese experience. They convinced themselves that Japan was suffering from its long recession because of a lack of structural reform and banking cleanup. Some American opinion leaders spouted similar nonsense. Japan did have those problems, but they don't explain the sudden collapse of the Japanese economy after 1990 and why it stayed so weak for so long. Thus, when the Europeans got themselves into a similar problem, they thought they had to do structural reform and clean up the banking system as quickly as possible. But when you have a balance sheet problem, those are the wrong things to do. As a result, the state of Europe's economy remains very poor.

Much of what happened in Europe was perfectly predictable. In 2003, in my first English-language book, Balance Sheet Recession: Japan's Struggle with Uncharted Economics and Its Global Implications, I clearly said that when Europe enters a balance sheet recession, the European Union should allow member governments to borrow more than 3 percent of GDP, because the private sector could be saving 7-10 percent of GDP. And that's basically what happened. In The Holy Grail, my second book, I mentioned that if the government fails to act, there will be a crisis of democracy because the people become desperate. And desperate people will start voting for populists, national socialists, and those kinds of parties, similar to what happened in Germany in 1933. I really want to warn the Europeans that they have to change course because both of those things are coming true.

Smick: Describe the QE trap and how we can avoid it.

Koo: The QE trap refers to the difficulty of removing the massive amounts of liquidity that are already in the banking system. Actually, I don't know how we can avoid it. The question is how can we minimize the problem. QE is like the unwanted child of a balance sheet recession. During a balance sheet recession, the private sector is...

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