The Holy Grail of Macroeconomics, Revised Edition: Lessons from Japans Great Recession,   ISBN:9780470824948

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This book is a good account of the phenomenon of debt aversion. The thesis of the book is pretty straightforward and is that, after asset bubbles burst and businesses are technically insolvent through liquidation analysis, they are likely to pay down debt irrespective of monetary policy. The fact that the businesses are technically insolvent despite market prices is described as being a function of information asymmetry and bank incentives.

This realization is deemed to be the missing link to complete economist's understanding of how to bridge fiscal macroeconomic thought and monetary economic thought and the solutions required in the aftermath of a burst asset bubble. Discussing the shortfalls of Friedman's positions on the demand function for money to be a function of nominal interest rates, it is argued that when one is in the position of being insolvent yet operational, the focus shifts from using lending lines to maximise ROE to using free cashflow to minimize the debt that is causing this insolvency. When this market regime is upon us, it is the need of the government to use fiscal policy to fund the output gap.

I think this is pretty accurate as an analysis of the problems that arise in monetary policy when the world is in fear of the phenomenon that hurt them (being burdened with debt that is greater relative to the asset base one had assumed would back it) and this aversion has macroeconomic repurcussions. My only criticism is, I dont think this is as obscure a result as is described. Most ecnomists realize how output gaps can arise, how debt aversion can form. Richard Posner, who is a judge, talks about debt aversion off-hand as though its well known. So all in all i think its a god perscriptive piece on a very real phenomenon we deal with but its not revolutionary and this phenomenon is discussed by others (though few have gone in to as much detail about it).

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Richard Koo, chief economist of Tokyo's Nomura Research Institute, has written a fascinating and important book. He claims that capitalist economies have two phases: the ordinary phase, in which firms aim to maximise profits, and the post-bubble phase, when they aim to pay off their debts. He believes that he has found the missing link of economics: "corporate debt minimisation, therefore, is the long-overlooked micro-foundation of Keynesian macro-economics."

It's still boom and bust. Koo claims that in the boom phase, monetary policy works, but not fiscal; in the bust phase, only fiscal policy works, not monetary. He shows how monetary policy cannot fight a slump. He contends that only huge fiscal stimuli, government actions to boost domestic demand, can prevent slumps.

Koo claims that, in the 1930s depression, in Japan's recession since 1990, and in the present crisis, the problem was the private sector's lack of demand for loans, not a lack of funds from the central banks. Contrary to the consensus, these depressions were not caused by the wrong monetary policy.

How to fight a slump? Cutting spending to reduce government debt is the road to disaster. In the 1930s, both President Hoover and Chancellor Bruning insisted on balancing the budget, which crashed the US and German economies. In 1945 the British government's debt was 250% of GDP, but the country survived. Between 1933 and 1936, President Roosevelt raised government spending by 125%, so GDP rose by 48% and tax revenues rose by 100%. But in 1937 he changed tack and cut spending: industrial output fell by 33%.

Japan's recession (caused by falls in the value of its assets - land and loans) destroyed 1500 trillion yens' worth of wealth - three years of Japan's GDP. (The USA's depression lost it one year's GDP.) In Japan, monetary stimuli failed, so the Japanese government proposed irrelevant Thatcherite supply-side changes, like privatising the post office.

In 1997 the Hashimoto government, under IMF pressure, cut spending and raised taxes to balance the budget. As a result, output fell for five quarters, Japan's worst post-war meltdown, and the budget deficit rose from 22 trillion yen in 1996 to 38 trillion in 1999. In 2001, the Koizumi government did the same - with the same result. It also tried the monetary policy of quantitative easing. But this did not increase lending or the money supply. It was irrelevant.

Subsequently, the Japanese government adopted a policy of no fiscal consolidation without growth, i.e. no spending cuts or tax rises before private-sector demand recovered. This fiscal stimulus prevented a 1930s-style depression; by 2005, firms had started to borrow again.

Again, in Germany's balance sheet recession of 2000-05, "the Maastricht Treaty prevented it from applying the fiscal stimulus it needed. This deepened the recession", as Koo observes.

Finally, he notes the harmful effects of the free movement of capital: "in view of the explosion of cross-border capital flows during the past two decades contributing to adverse currency movements and the widening of global imbalances, some restrictions on those flows may be desirable." He also notes the damage done by free trade: "that market forces have not only failed to rectify trade imbalances but actually made them worse suggests that some kind of government action may be necessary."

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I am a neophyte in economics, I should have put my attention hear years ago -- being a "do gooder" at heart. The past three months I have delved into the dismal science. I never anticipated such divergence of opinions and theories. The Holy Grail of Macroeconomics is simply a gem of knowledge. Of the many books/texts I have aquired, this one is the best in gaining the meat. I mean by this, it is written in a dense style, reminisent of college texts years gone by -- yet each paragraph holds my attention and interest, unlike so many others. The author's analysis and view points are clearly stated with ample examples and "evidence." This fine writting is simply not of the "dismal science" but a wonder of clear analysis and clarity of writting.

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Excerpt page 109:

"It should now be clear that the key driver of the Great Depression was private-sector debt repayment, which torpedoed both the money supply and aggregate demand. The resultant deflationary spiral was impervious to monetary easing, because the highly leverage private sector was desperately minimizing debt. The present explanation of the Great Depression is also consistent with the behavior of monetary authorities, as well as what Bernanke called the "perverse behavior of money supply" of the period. .... In retrospect, this awareness was based on a completely faulty understanding of the situation - economists incorrectly assumed that the liquidity trap was a lender-side phenomenon, when it was actually a borrower-side phenomenon.

Excerpt page 222:

...The US was encountering the same "debt rejection syndrome" observed in Japan during the past couple of year, as described in Chapter 2. Indeed, the US economy is in stage 4 of the yin-yang cycle, in which companies that had to repair their balance sheets are in no mood to borrow money again even after the repairs are done.

My Summary: Koo's premise is to combat a balance sheet recession, strong monetary stimulus is needed to counter the "yin cycle". But at some point one begins "pushing on a string". The problem I foresee is that Treasury auctions will see a growing lack of external purchasing demand from China et al, and eventually even fail. Thus, the USA will have trouble raising the funds to support its aggressive monetary stimulus.

Then to counter the subsequent "yang-cycle", Koo suggests an aggressive fiscal policy to stimulate borrowing. I understand the key to this would be to decrease taxes on the populace and corporations, while creating government jobs in infrastructure for example. I see neither of these as part of the Obama "plan", or at least no tax cuts. And infrastructure projects haven't amounted to anything but "talk" for now.

I guess I'm not optimistic we are following Koo's suggestions, and even if we did there is no historical proof it would work. All that is for sure is that we live in interesting times.

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The book is worth reading if you're a macroeconomics enthusiast and fascinated by Japan's Lost Decade. Koo's thesis of "Balance Sheet Recession" is probably correct for Japan. It seems to fall short, however, of explaining the US Great Depression. Koo doesn't convincingly prove that falling credit demand (as opposed to falling credit supply or other factors) was the primary culprit. A glaring mistake is that he focuses on absolute interest rates instead of credit spreads; for an economist who works for a bank, that is doubly mystifying and unforgiveable.

You can also tell this was a (poorly) translated book. There are grammatical errors everywhere, some of the charts are unclear, and the narrative is exhaustingly repetitive. The latter may be the Japanese writing style shining through. I guess the Japanese like to repeat their point over and over and over again.....

Overall: A good book, but not a great one. Could have been.