14 February 2009

Balance Sheet Recessions and Japan Redux

Here are a few excerpts from an essay by Axel Leijonhufvud at VoxEU which was brought to my attention by xyphius from Japan.

The essay in particular was quite good, but the introductory comments in the email from xyphius were also quite to the point that we've been making here for some time.

"I've been wondering about the consequences of what Japan did in the lost decade and whether there are any lessons to be learnt from it. I remember asking a (Japanese) friend in the early part of this decade (before Chinese Viagra revived the moribund economy) why after so many years with so little to show from policy there was little pressure for change - his reply: "We aren't hurting enough to want to change."

I take my cue from that answer: Deficit spending was a palliative that bought off demands for political reform, and propping up the banks and by extension their insolvent clients prevented a liquidation in which a meaningful transfer of assets could have occurred. In short, the political, bureaucratic and business oligopoly maintained the status quo ante.

What might become of the cocoon years? A horrible festering mess?!"

It could be something beautiful if Japan embraces reform and becomes a more vibrant, open democracy and breaks up the keiretsu economy and the tyranny by bureaucracy. It is as likely if not moreso that Japan would choose a return to national fascism. But having expended the flower of its youth in the last great War, and with zero population growth, Japan would likely need a more youthful ally. War is an old man's game, but younger men provide the fuel.

The object lesson here for us of course is that the US is going down the same path, with a military-financial complex that resists change, and may subject the country to enough of a economic scourging to set the stage for rescue by a 'great man' as national saviour. Fascism was a rather popular choice the last time the world went through a deflationary depression.

To make it pointedly clear, the US must reform its financial system which requires breaking up the big Wall Street money center banks. Once broken up they may more easily be reintegrated into an organic economy, and stimulus may take root in a real economy.

The point is not to save the banks. The point is to save the depositors, the pension funds, and the good regional banks that are banks, and not vehicles of financial engineering.

The dollar must relinquish its role as the reserve currency of the world, because our hobbits, dwarves, and men have shown themselves incapable of wielding that power gracefully. It is too great a temptation and its misuse will result in our own destruction. But we must also reform the international trade system and prevent the blatant market manipulation of the Asian tigers, China and Japan.

There are those who say, "Why can't things just go on as they have done?" The awareness that things have changed will penetrate the public consciousness slowly. It's over. It's done. Things must go forward, and we can never go back. You cannot keep trying to rebuild the unsustainable, because eventually the great forces of probability will crush you.

Our fate should we fail to reform our system is to change into something more horrible than we can possibly imagine.

And here are the excerpts from the VoxEU essay by Axel Leijonhufvud.

Richard Koo (2003) coined the term “balance sheet recession” to characterise the endless travail of Japan following the collapse of its real estate and stock market bubbles in 1990. The Japanese government did not act to repair the balance sheets of the private sector following the crash. Instead, it chose a policy of keeping bank rate near zero so as to reduce deposit rates and let the banks earn their way back into solvency. At the same time it supported the real sector by repeated large doses of Keynesian deficit spending. It took a decade and a half for these policies to bring the Japanese economy back to reasonable health.

The Swedish policy following the 1992 crisis has been often referred to in recent months. Sweden acted quickly and decisively to close insolvent banks, and to quarantine their bad assets into a special fund. Eventually, all the assets, good and bad, ended up in the private banking sector again. The stockholders in the failed banks lost all their equity while the loss to taxpayers of the bad assets was minimal in the end. The operation was necessary to the recovery but what actually got the economy out of a very sharp and deep recession was the 25-30% devaluation of the krona which produced a long period of strong export-led growth. Needless to say, the US is in no position to emulate this aspect of the Swedish success story.
Why not?
The lesson to be drawn from these two cases is that deficit spending will be absorbed into the financial sinkholes in private sector balance sheets and will not become effective until those holes have been filled. During the years that national income fails to respond, tax receipts will be lower so that the national debt is likely to end up larger than if the banking sector’s losses had been “nationalised” at the outset.

No Ordinary Recession by Axel Leijonhufvud