JACK FARLEY: Today, our managing editor, Ed Harrison, speaks with Richard Koo. Mr. Koo is an economist renowned for his work on balance sheet recessions, a rare type of recession where drastic liquidity injections by central banks fail to increase the money supply because they remain trapped in a financial system that is all too willing to lend but simply can't find enough borrowers because companies are focusing on paying off debt, rather than on maximizing profits. In this interview, Koo cites numerous examples of where quantitative easing or lowering rates coincided with the contraction of credit, and he's got some excellent charts showing this phenomenon across multiple countries.
Koo and Harrison then map this framework on to the current economic crisis that the world faces where aggregate demand has fallen off a cliff, central banks are scrambling to support asset prices, and insolvency looms as a serious threat for many companies, especially small businesses. Using these frameworks, they look forward to the future and share what they see on the horizon. It's a fascinating conversation that's very in depth, and I hope that you find it valuable.
ED HARRISON: Richard Koo, it is a pleasure to talk to you. I actually am looking at your book right now, The Holy Grail of Macroeconomics, which I had read during the Great Financial Crisis so I'm really excited to talk to you about your ideas, about the balance sheet recession in particular. I want to talk about it right now, but actually, I want to frame the issue and go all the way back to Japan because that's where it all began for me. I noticed that Adam Posen, he had called Japan's lost decades, what he called the Great Recession and I've seen that you said that that was a really apt way of looking at it. Well, what can we actually learn about the Great Depression based upon what happened in the Great Recession in Japan, given all of the data that we have that we didn't have during the Great Depression?
RICHARD KOO: Well, I was in Japan at the time, in 1990 onwards. I was there from 1984, and I was a believer in the usual explanation of depression because that's what we were indoctrinated during our college, graduate school days in the Economics department. Then I observed Japan when interest rates came down to zero, Bank of Japan pumping tons of money into the system and nothing happened, and so we were all puzzled by it. One day, I looked at corporate borrowings of Japanese companies and realized that they were actually paying down debt at zero interest rates. That forced me to think that how would a company pay down debt at zero interest rates? There has to be some financial problem, or a balance sheet problem.
Then I look back and put all these ideas together with the data, Japanese companies during the bubble days borrowed concept money, the bubble burst, asset prices collapsed, liabilities remained, so they all have to repair their balance sheet by paying down debt. Paying down debt is the right thing to do for companies with plenty of cash flow but balance sheet's underwater. Japanese companies at the time have excellent products, exposed massive surplus because consumers all around the world wanted to buy Japanese products, so there's nothing wrong with the production side, the supply side, only the balance sheet was on the water. Everybody who was using cash flow from their products main line of work go repair their balance sheets. That's the right thing to do.
In the national economy, if someone is saving money, someone else has to be borrowing money to keep the economy going. In the usual economy, interest rates would adjust to make sure that savings and investments are more or less in balance, but when everybody's repairing balances after the bursting of the bubble, even if you bring rates down to zero, nothing happens because there are no borrowers. Once I understood that part that everybody is doing the right things, then nobody's doing the wrong things but then you end up with this recession because of the fallacy of composition problems.
Then you look at the Great Depression. You see exactly the same pattern, that after the stock market crashed October 1929, everybody started paying down debt all at the same time, but the government did not come in to borrow out, so the economy collapsed, GDP disappeared to the tune of 46%, nominal GDP fell by 46%, unemployment rate going sky high. Then you compare that with Japan, the Japanese bubble was even bigger than the Great Depression 1929 bubble, but Japanese GDP never fell below the peak of the bubble, even though private sectors are paying down debt like crazy, and that was because the government came in and borrowed the money.
That's how I came up with this whole concept of balance sheet recession, and then applied it to Great Depression and then I was able to explain how a great depression actually happen. The key difference between the balance sheet recession world that we were in two or three months ago and the world we are in now is that the financial market is much, much tighter, much more difficult to get money. The reason is that the world that we live in until three months ago, private sectors and all the major economies, the financial surplus meaning they were saving money, private sector as a whole meaning household sector, corporate sector, financial sector taken together.
They were all saving money in US, Europe and elsewhere, even with zero or negative interest rates. They were not back to the textbook world at all. In a textbook world, they would be borrowing money at zero interest rates, not saving money.
ED HARRISON: Do you see any analogues to the Great Depression there? Because the sense that I got is that Andrew Mellon, his view was actually, we're going to let these companies go under because they're poorly run and ultimately, that ended up having a vicious cycle because someone else's income is someone else's output. When this output goes away, someone else's income goes away and the whole thing starts to starts to fall apart.
RICHARD KOO: Right. There were of course, people who went overboard during the bubble days and it's unfortunate that that actually happened. When people are repairing balance sheets, they are all doing the right thing. If you're in that situation, I'm sure you'll be doing it. If I'm in that situation, I'll be doing it. If I have income, I'll use that income to pay down debt so that I reduce my liabilities to where the value of the asset is, and that's how you repair your balances. You compress your liabilities until it's balanced with your assets.
If everybody's doing the right thing, you could still get a wrong result, and that's the problem with a balance sheet recession. It's not someone that is doing something really bad, then we can go after those bad guys and shoot them down but in a balance sheet recession, everybody's doing the right thing. I'm doing the right thing repairing balance sheets trying to be responsible, you're doing the right thing trying to be responsible and fix your financial house in order, but when all of us do it all at the same time, then the economy collapses. In that situation, you don't ask who is doing what, the majority of the people at least are doing the right things, which is why we get the wrong result.
Individually, they cannot do anything different. I cannot say I'm not going to repair my balance sheet, this guy will go bankrupt, which is even a worse situation than you started out with. The government has to come in and take this extra money and put that back into the income stream. During the Great Depression, during the Great Recession in Japan, or in the United States and Europe after 2008, the money should be spent on something like public works, because that really goes into the economy and workers get the money and they spend it and the economy moves forward. However, in this recession, the pandemic recession, the government should really not spend the money but put the money into the hands of the people who need them because they really need that money right away.
If we tried to come up with a nice bridge and highways, someone has to produce the drawings, you have to go through the auction process or whatever, by then, everybody will be dead. In this recession, we don't want government to be spending money on public works. If they have extra money, of course, they can do that, but they should be spending money direct, bring them directly into the hands of people so that they can make the ends meet until someone comes up with a vaccine. It's a short term battle, a year, maybe a year and a half max but during that time, you don't want those companies to go under, and so even the use of money would be very different compared to the balance sheet recession situation.
ED HARRISON: Well, that makes me think about three different timeframes. There's the timeframe during the lockdown that we're in now in the US, that we're just coming out of, there's the timeframe after the lockdown, and then there's the timeframe after the vaccine is found. You were talking about the collective timeframe between when the virus hit and when the vaccine is found. One thought I had is about whether you can bifurcate those two in terms of timing, because right now, it sounds like we're filling a hole that was left because outputs just dropped through the floor because no one's working.
Once we start up, you're not necessarily going to be filling a hole, you are going to want to jumpstart the economy. If you don't jumpstart the economy, then you're going to get this so called L-shaped recovery. What do you think about the difference between how government directs their money before the lockdown and how they direct their money after the lockdown?
RICHARD KOO: During a lockdown of course, the money has to go to the people who need them desperately. Then I think we will have a period where suppose-- well, we don't know when the vaccines will be found but supposedly, the medical problem is behind us, then the economy should be recovering. That recovery probably will be very rapid because of the pent up demand, people already got locked in their houses for so long. Now, they want to come out and spend some money, so that recovery pretty fast and that probably won't require too much government intervention. The next step is where I worry and that is that once the income returns to a normal level, ordinary level, what would people do or what lesson did people learn from this pandemic? I think the key lesson that these people have learned from the pandemic, would have learned from the pandemic, would be that oh my gosh, we really have to have savings for the rainy days.
ED HARRISON: Definitely.
RICHARD KOO: They have exhausted their savings during the lockdown and the period before and after, so my guess is that once economic recovery reaches a certain point, people will be rebuilding their savings again, or re-saving as it were, because they lost so much savings during these couple months and furthermore, all these medical experts are saying we could have a second wave, we could have a third wave and they remember what it was like in the first wave. You were really scraping the bottom to make ends meet. Oh my gosh, we need to have good savings.
If they all start saving money, this will be just like balance sheet recession again. In that period, government may still have to pump in money to do public works and whatever if that urge to re-save turned out to be very large. We don't know that yet, because we haven't got there but if the people really decided to re-save after the initial recovery, then we might end up having the private sector, just like the private sector we had during the balance sheet recession, or they are the net savers. That also means, if that happens, that also means inflation is not going to be a problem for a long time.
People are worried that a central bank, the Federal Reserve, the Bank of England, the ECB, Bank of Japan, pumping this huge amount of money into the system right now and inflation could be just around the corner, but if the private sector then becomes net savers again after some period, then inflation cannot really go on and that will give plenty of time for the central bank to unwind their monetary policy that they expanded so rapidly during the pandemic, and so yes, we will have a recovery once the medical problem is behind us, but then we might enter something like the world we had three months ago again, but for a different set of reasons. That one was deleveraging, this time, it's rebuilding savings.
ED HARRISON: It's interesting that you would say last time it was deleveraging, this time, it's for building savings. I almost feel it's as if we're back to square one so that it's deleveraging and building savings at the same time. It reminds me of going back to what you were saying about Europe and the US where the Europeans and the US were after the Great Financial Crisis, even 10 years after the Great Financial Crisis, there was a sense in which we were still in a balance sheet recession, you said all of the private sector was in surplus, even though interest rates were at zero percent. That tells you that. Looking west at Europe and the US, and the most recent financial crisis, what did the bursting of the US subprime bubble and the attending Great Financial Crisis do regarding validating your balance sheet recession framework?
RICHARD KOO: The book that you mentioned, The Holy Grail of Macroeconomics, came out March of 2008 and I will say US is going through the same process that Japan just went through, and I think that prediction came true. Federal Reserve dropped rates down to zero very quickly, because remember, at that time, there was an argument that the BOJ was too slow, so if you bring the rates down quickly, things will be so much better. Well, the Federal Reserve moved it down very quickly. Still nothing happened. Then when they started the QE, increased the monetary base by massive amounts, but money supply growth, credit growth remained very low, credit growth actually went into negative rates, just like during the Great Depression.
During the Great Depression, credit growth was actually negative all the way until 1936 from 1929, seven years, even though monetary base was increasing very rapidly after 1933. If you just look at the amount of the base using that, US economy recovered because of the Federal Reserve changing monetary policy to a much more expansionary one, but when you look at the credit growth, how much money actually came up with the banking system and entered the real economy, it was still negative from 1933 to 1936, and it recovers very, very slowly from 1936 all the way until the World War II.
The only reason money supply grew after 1933 was government borrowing money, which was President Roosevelt's new policies. When you actually look at the chart that I have in the book, actually, just look at it, money supply is a liability of the banking system, because it's basically bank deposits. For liability to grow, the assets must grow. You look at what assets grew in the bank's balance sheets, it was lending to the government, and so it was the government borrowing starting in 1933 that increased both the money supply and the GDP because the private sector borrowing remained flat all the way until early 1940s.
Same thing happened in Japan after 1990, and same thing happened in the United States and Europe after 2008. Private Sector borrowing was collapsing even though monetary base was rising very rapidly because of quantitative easing, but because this money could not come out of the banking system because private sector was not borrowing money, inflation remained flat. I think the Great Depression was a balance sheet recession, and I will say Great Depression was a balance sheet recession in the purest form because the government did not enter during the first four years from 1929 to 1933.
ED HARRISON: The question that a lot of people seem to have in that situation is what I would call the fairness doctrine. That is, who's getting the money, and is that a good thing? The question is, are the big companies getting the money? Are the small companies getting the money? Are well-run companies getting the money, or are poorly run companies getting the money? A lot of people have the conclusion that when it's an exigent circumstance like this, and you're flooding the system with liquidity, a lot of companies that are poorly run that have low productivity, or that are just simply large are getting money that they don't deserve. What do you think of that whole criticism of how this is being done?
RICHARD KOO: Well, if we somehow have a perfect knowledge, and you'll know in advance that some companies are lousy and some companies are good, then of course, by all means, let the bad companies go and continue keeping the good companies. We don't have that perfect knowledge, but time is of the essence. If we don't do something now, and this virus really decimates the population, we're really in sad shape and so when we are in a situation like this, I would say that save everybody, don't ask too many questions because if you keep on asking questions, the other side will say, no, it's too much struggle to get this money from the government. Too many paperwork is necessary. I just go, I just give up, and that hurts everybody.
Furthermore, in all these criticisms about fairness, then they say, the rich shouldn't benefit but rich is always a minority. Rich people are always minority in any society. In order to make sure that rich doesn't benefit, and the poor people get hurt, that's completely against what you're trying to achieve. Even if some rich people get this extra money, we can tax them later, but to make sure that the money is needed should go to the poor people as quickly as possible, and because the speed is so important in this day, I think we should put this fairness issue aside, save everybody, and if rich had extra money, well, we can tax them later. I think that's the way we should approach this issue.
ED HARRISON: One thing that I was thinking, as you were saying that, I was thinking about the term that Ludwig von Mises has used called malinvestment. Because a lot of people, especially from the libertarian perspective, they say to themselves, wait a minute, if we allow the government to deficit spend at these levels to make up for the private sector savings, then the government might actually use the money to build bridges to nowhere and ultimately, it's going to be a negative because productivity wise, those are very positive. They're not net NPV type of projects. What's your thinking about dealing with that malinvestment question?
RICHARD KOO: The assumption that these authors are making, they said if the government won't spend the money, the private sector will, and if the private sector will spend them, borrow and spend the money, then of course, private sector on average are far better in spending money than the public sector, so your malinvestment argument holds in that case. Suppose the government, if the