book

The Escape from Balance Sheet Recession and the QE Trap: A Hazardous Road for the World Economy

by Richard C. Koo

October 2014

Intermediate to advanced

320 pages

10h 41m

English

Wiley

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Notes on the Data Used in This Book
GDP and Inflation Fueled by Growth in Money Supply, Not Monetary Base Japan Fell into Balance Sheet Recession in 1990sPlunging Asset Prices Create Balance Sheet Problems for Businesses Japanese Firms Rushed to Repair Balance Sheets by Paying Down Debt “Correct” Private Sector Behavior Tipped Japan into Contractionary Equilibrium Collapse of Japan's Bubble Destroyed ¥1,500 Trillion in Wealth Why Japanese GDP Did Not Fall after Bubble Burst Fiscal Stimulus Saved Japan's Economy“Good” Fiscal Deficits Were Not Perceived as Such Balance Sheet Recessions and the Limitations of Econometric ModelsFiscal Stimulus Works in Two Stages FDR Made Same Mistake in 1937 Reactive Fiscal Stimulus Is Far Less Efficient Fiscal Deficits Are Easily Financed during Balance Sheet Recessions Self-Corrective Mechanism for Economies in Balance Sheet Recessions Two Types of Fiscal Deficits Require Different Responses Fiscal Deficits Must Be Viewed Relative to Private Savings Consequences of Leaving Things Up to the Market in a Balance Sheet Recession GFC Triggered by Insistence on Market Principles Volcker Understood Systemic Crises Little to Be Gained from Bashing Those Who Have Already Come to Their Senses Recovery from Balance Sheet Recession Takes Time Forward Guidance Important for Fiscal as Well as Monetary Policy Fiscal Consolidation: Better Too Late Than Too Early Three Points to Consider Regarding Costs for Future Generations Japan Had a Shot at Full Recovery in 1996… Conflation of Balance Sheet and Structural Problems Extends Recession Distinguishing Balance Sheet Recessions from Structural Problems and Financial Crises Democracies Are Ill-Equipped for Dealing with Balance Sheet Recessions Keynes Also Overlooked Private-Sector Debt Minimization Those Who Prevent Crises Never Become Heroes Democracy Plus Balance Sheet Recession Equals “Secular Stagnation” Appendix to Chapter 1: Summary of Yin and Yang Phases of EconomyNotes
Monetary Policy Impotent without Demand for FundsMechanisms for Money Supply GrowthGovernment Borrowing Drove Money Supply Growth in JapanEconomics Dogged by Incorrect Analysis of Great DepressionJapanese Monetary Policy Has Relied on Fiscal Policy for Past 20 YearsBalance Sheet Recessions Triggered by Borrower-Side Problems, Financial Crises Triggered by Lender-Side ProblemsBernanke Himself Says QE2 Unlikely to Have Major Macroeconomic BenefitsReal Aim of QE2: Portfolio Rebalancing EffectCan Higher Share Prices under QE2 Be Justified on DCF Basis?QE2 a Big Gamble for BernankeQE Undermined U.S. Leadership in G20QE with No Income Effect Harms Other CountriesDollar-Buying Intervention by U.S. Authorities Would Have Produced Different OutcomeInward Capital Controls Help Keep Bubbles Fueled by Hot Money in CheckQE Represents Government Intervention in Asset MarketsOperation Twist Lowered Long-Term Rates, but to No EffectOperation Twist Provided Only Limited Economic BoostBernanke Admits the United States Faces Same Problems as JapanFed Overestimates Impact of Quantitative Easing“Lower Long-Term Rates = Higher GDP” Formula Does Not Hold during Balance Sheet RecessionFed Has Also Underestimated Costs of QEUnorthodox Monetary Policy Distorts Signals from Bond MarketNeedless QE Acts as Drag on Financial InstitutionsWhy Fed Embarked on QE3 Two Months before Presidential ElectionPost-Bubble Wage Growth Nearly Identical in the United States and JapanThe “Inconvenient Truth” of the Real Cost of Quantitative EasingBOJ's First Round of QE Was Easy to Wind Down Because It Was Conducted in Money MarketRedemption of Central Bank Bond Holdings Will Not Reduce Commercial Banks' Current AccountsGovernment Issue of Refunding Bonds to Private Sector Would Absorb Excess ReservesRedeeming Fed Bond Holdings Has Same Effect as Issuing Deficit BondsStrength of Private Loan Demand Different at Start and End of QEPaying Interest on Excess Reserves Would Enable Rate Hikes . . .But Cost Could Be ProhibitiveCost of Winding Down QE Has Yet to Be Properly AnalyzedDebate over Winding Down QE Sparks “Bad” Rise in Rates“QE Trap” Appears Increasingly LikelyContinued QE Trap More Likely Than HyperinflationBOJ Found Itself in Same Position in 2006Fed Admits That Supply and Demand Matters, TooFed Changes Course Despite a 1.1 Percent Inflation RateTraditional Phillips Curve Relationship No Longer HoldsUpcoming Chapters in QE SagaCapital Injection Could Also Be Threatened If Blame Shifts to FedSales Should Start with Bonds Maturing SoonFinal Cost of QE Can Be Calculated Only at End of Fourth ChapterTheoretical Debate on QE Has Focused Entirely on Benefits and Ignored CostsCentral Banks Should Establish a New Reaction Function to Drain ReservesEmerging Markets Need Inward Capital Controls to Protect against QEJapan Should Learn from Pioneers in QE Using Long-Term BondsFinancial and Capital Markets during Balance Sheet RecessionsBalance Sheet Recession Brings Special Kind of Liquidity-Driven MarketIs Inflation of 1–2 Percent Too Low?Does Inflation Improve People's Standard of Living?Absence of Inflation Concerns May Have Lifted Utility of Consumption in JapanQE Should Not Be Pursued Any Further Given Difficulty of Winding It DownQE a Problematic Byproduct of Balance Sheet RecessionsNotes
Rating Agencies Need to Be More Tightly RegulatedWhy Was Lehman Allowed to Fail?TARP Prevented Bank Failures but Also Created TurmoilU.S. Authorities Changed Course with “Pretend and Extend”Fiscal Stimulus Shifts from “Three Ts” to “Three Ss”Obama Has Yet to Disclose the Name of the DiseaseBernanke's “Fiscal Cliff” Warning Saved the U.S. EconomyBernanke Declared Monetary Easing Could Not Offset Impact of Fiscal CliffFall from Fiscal Cliff Triggered Japan's DeflationU.S. Households Still Repairing Balance SheetsNonfinancial Corporate Sector Faced Difficult Years in the Wake of GFCU.S. Companies Hit Far Harder by GFC Than by Collapse of Internet BubbleCan U.S. Corporate Sector Become Economic Engine?Long-Term Rate “Conundrum” Kept Housing Bubble AlivePost-2007 Fed in Similar Position to BOJ in 1990sFlow-of-Funds Data Suffer from Poor AccuracyBad Data Were Good for Policy DebateEstimated Correctly, Private Sector Financial Surplus Continues to ShrinkRecovery in U.S. Private Sector Demand for Funds May Outpace JapanHousing Market Strength during the First Half of 2013 May Have Contained Temporary FactorsFed's Reputation Falls to EarthNotes
BOJ Already Had a Massive QE Program in PlaceWhy Didn't Japan's Institutional Investors Follow Their Overseas Counterparts?Yen Fell and Stocks Rose Because Japan's Institutional Investors Stayed in Bond MarketHoneymoon Altered Japan's Economic LandscapeBond Market Reaction Ended Abenomics's HoneymoonPrivate Sector Continues to Save after One Year of AbenomicsJapan's Growth over Last Year Attributable to Fiscal PolicyCan the Abe Administration Overcome the Trauma of Balance Sheet Recession?The Trauma of the Balance Sheet Recession Will Be the Last Effect to GoFocus of Structural Reforms Must Shift from Lenders to BorrowersIs Japan's Slump Due to Shrinking Population or Balance Sheet Problems?Slump in Domestic Demand Was Due to Balance Sheet Recession, Not Decline in Working-Age PopulationPersonal Financial Assets Have Already Been Invested SomewhereCorporate Debt Pay-Downs Weighed on Consumption and InvestmentReal Bottleneck in Japan's Economy: Lack of Loan Demand at Private CompaniesBalance Sheet Recession Has Taught Japanese How to Be FrugalIs Japan Really Closed to Immigration?Japanese Economy Would Cease to Function without ForeignersAgricultural Reforms a Major Step for LDP GovernmentStructural Reforms Are Microeconomic Policies That Take Years to WorkScale of Structural Reform Is Also ImportantWe Should Not Expect More Good FortuneKuroda May Be Trying to Close Gap between Expectations and Reality …BOJ and Government Must Stress That Inflation Overshoot Will Not Be ToleratedBOJ Had Weapon to Prevent JGB Crash during Balance Sheet RecessionNo One Has Criticized Japan for Currency ManipulationJapan Supported Global Economy for Four Years after Lehman CollapseReal Effective Exchange Rate Does Not Fully Express Japanese Firms' PainRising Fiscal Deficits Caused by Change in Corporate BehaviorHow Should Japan's Tax System Be Reformed?Fiscal Stimulus Introduced to Offset Consumption TaxCurrent Corporate Earnings Based on Massive Fiscal DeficitsWorking Down Public Debt Will Require Bold Policies to Lift Japan's Growth RateIncentives Needed to Restore Japan's Economic VitalityMore Effective Land Utilization Could Propel GrowthJapan Needs Bold Tax Reforms Modeled on U.S. and Hong Kong SystemsPolicies Need to Change Perceptions of Japan at Home and AbroadNotes
Euro's Adoption Lowered Interest Rates SharplyMaastricht Treaty Acted as Constraint on Credit RiskGreece Was Spoiled by Euro, and Germany Reacted ViolentlyGermans Believed Structural Reforms Required a CrisisGerman Balance Sheet Recession Eight Years before GFC Started the CrisisGerman IT Bubble Brought about Euro CrisisECB's Rate Cuts Create Bubbles outside GermanyMisunderstandings Regarding Lack of Competitiveness in Southern EuropeMoney Supply Growth Much Lower in GermanyGerman Reforms Responsible for Only Half of Competitive GapGermany Benefited Most from EuroOne More Mutual Dependency between Germany and Eurozone PeripherySpain's Vicious Balance Sheet RecessionIreland's Household Sector Forced to Pick Up Pieces after Massive Housing BubbleIrish Businesses Remain Net SaversPortugal's Balance Sheet Recession Began Quite RecentlyItaly Is in Same Position as PortugalWhy the Polarization of Eurozone Government Bond Yields?Eurozone Allows Investors to Buy Government Bonds of Member Countries with No Currency RiskEurozone-Specific Fund Flows Amplify Economic SwingsMeaning of “Fiscal Space” Differs Inside and Outside EurozoneMaastricht Treaty Is Defective and Should Be Revised ImmediatelyIn Practice, Fiscal Stimulus Requires EU and ECB ApprovalBan on Buying Other Nations' Debt Ideal Way to Stabilize EurozoneEfficiency Gains from Single Currency Remain IntactDifferent Risk Weights Should Be Applied to Domestic and Foreign Government DebtNext-Best Alternative to Risk Weights Already in Place?Separation of Sovereign Risk and Banking Risk a Rejection of Self-Corrective MechanismJoint Issue of Eurobonds Would Only Solve Half of Eurozone's Structural DefectsDraghi Unaware That There Are Two Kinds of Recessions and Fiscal DeficitsOutside of Greece, Capital Flight Is the ProblemExplaining Balance Sheet Recessions to the German PublicEven Germans Understand Need for Fiscal Stimulus If Properly ExplainedExcessive Focus on Fiscal Deficits While Ignoring Growth in Private SavingsLack of Private Loan Demand Biggest Problem for GermanyGermany Unlikely to Announce Stimulus PackageDisadvantages of Euro Exit for GreeceArgentina's Experience Also Suggests Euro Exit Would Have Few Merits for GreeceGermany's Competitive Gap with Other Countries Will Also Disappear in a Few YearsDraghi's LTROs Prevented Collapse of Eurozone Financial System“Grand Bargain” with ECB Is an Empty PromiseDouble-Dip Recessions and the Eurozone's Bad Loan ProblemEBA's Lack of Understanding of Systemic Crises Leads to Rash ActionsCypriot Bank Resolution Could Worsen Financial System JittersVicious Cycle of Creating New Bubbles to Paper over Old OnesEU Election Results the Result of Economic Policy ErrorsEuropean Policymakers Mistake Balance Sheet Problems for Structural ProblemsPolicymakers Need to Ask Why Euroskeptics Made Such GainsDisappointment with Established Parties Led to Rise of Nazis and World War IIContinued Disregard for People's Voice Puts Democracy in JeopardyU.S. Voters Had Policy Choices, Unlike Their European CounterpartsThe Euro Can Be Saved with Two RepairsNotes
China's Local Governments Began Borrowing en Masse Decoupling Would Not Have Been Possible in Ordinary Democracy China's Remaining Problems Include Overcapacity and Income Inequality China Understands Political Ramifications of Inflation China's Shadow Banking Sector: Misunderstandings and RealitiesProblem: Sharp Growth in Lending to Local Governments Post-Lehman Decoupling of China and Developed Economies to Continue Problems Facing China's Economy China Has Already Passed the Lewis Turning Point Rapid Economic Growth Continues until Lewis Turning Point U.S.-Led Free Trade Regime Enabled the Emergence of Asia Economy Starts to Mature Only after Passing the Lewis Turning Point Local and Global Lewis Turning Points and Inequality China Increasingly Tolerant of RMB Appreciation as Transition to Consumption-Led Economy Proceeds The West Is Conflating Problems of Trade Imbalance and Financial Crisis Liberalized Financial Sector and Capital Flows Could Weaken RMB China Could Fall into the “Middle-Income Trap” If It Neglects to Advance Its Industrial Base Japan, Korea, and Taiwan Escaped from Middle-Income TrapLabor Disputes Increase Sharply after the Lewis Turning Point Is Reached The Dilemma of Patriotism with an External EnemyWorking-Age Population Peaked Just as the Lewis Turning Point Was ReachedWill China Grow Old before It Grows Rich? The Next 15 to 20 Years Are Critical Uncertainty Due to Corruption and Lack of Legal Infrastructure Must Be Removed … Appealing to Patriotism without Creating External Enemies China Could Become a World-Class Nation for the First Time in Two Centuries Chinese Ambition and Industry Must Be Steered in Right DirectionNotes

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