Lessons from Japan on sovereign default and balance sheet recessions

Edward wrote a piece about Japan’s government net asset value falling below zero. He thought it would make sense if I gave you an alternative view using Richard Koo’s latest thinking about the Japanese experience, especially given the parallels to the U.S. regarding balance sheet recessions.

Before I get to Koo, I should add that, for all of the talk about Japan’s "national insolvency", I still don’t see their Social Security cheques – or the Japanese equivalent – being bounced. The fact that debt issuance exceeds tax revenues only tells me that the economy remains in dire straits, not that the country is bankrupt. The latter implies a shortage of yen, which can never been the case in a country which has retained its sovereign ability to create currency.

I know Edward understands this despite his Austrian-oriented sensibilities. but it needs to be reiterated. See Edward’s piece “Russia, sovereign debt defaults, and fiat currency.”

As for Koo, the only thing I’ve seen from Koo recently was an interview he conducted with Nomura Research Institute about 6 weeks ago.

Koo was asked how GDP can continue to grow if the private sector are taking “massive hits to their wealth”, which is also a common theme among the debt-deflationists – that we have to take our medicine now and excoriate the debt and allow industry to suffer widespread failure as a consequence. Some people even believe you need mass unemployment to assist in this debt elimination process.

Koo rejects this "Austrian" line of thinking. An October 2009 post from Bill Mitchell explains.

… Japan’s GDP grew even after the massive loss of wealth it suffered when its real estate bubble burst … That happened even though the private sector was rushing to pay down debt all during that time. And the reason is that the government’s fiscal spending kept incomes growing enough that GDP never fell below its bubble peak, in either nominal or real terms …

And this was over a period that commercial real estate prices fell by 87 per cent from their 1990 peak – and the total wealth effect amounted to “the largest loss of wealth in human history, in peace time.” GDP kept growing because the Japanese government was “highly liberal with public spending”. Moreover, he rejects the Austrian arguments in this regard (that is, a sharp recession to clear the decks and the debt) because it would be extremely costly in human and economic terms:

… that experiment was tried from 1929 to 1933 and almost half of U.S. GDP disappeared. Unemployment rate went to 25% and bringing the economy back to full employment literally too the Japanese attack on Pearl Harbour. I don’t think that’s the way we want the world to come back to life. People who argue that zombie companies should be allow to go to hell … don’t realise that, first of all, zombie companies with no cash flow cannot pay down debt, and if they cannot pay down debt, they are actually not the source of the problem … Balance sheet recessions are caused by good companies with good cash flow paying down debt.

How fiscal policy saved the world, Bill Mitchell, billy blog, October 2009

The problem Koo notes again is that while the first wave of Japanese fiscal injection instantly worked (building roads and bridges) they considered it a temporary measure only. Unfortunately, the Obama people view deficit spending in the same way. Larry Summers talks about deficit spending being "targeted, timely and temporary" (my emphasis on the last).

Koo concludes that:

… what my work shows is that the total additional, or cyclical, deficit that the government created to sustain GDP during Japan’s balance sheet recession … took the fiscal deficit to about 63% of GDP. But I would argue that this 63% of GDP deficit represents the most successful fiscal stimulus in history.

His computation is based on the fact that GDP would have dived (perhaps by more than 46 per cent) if the stimulus was not provided. To be conservative, however, he assumes that GDP returns to its pre-bubble level of 1985 with no stimulus.

How fiscal policy saved the world, Bill Mitchell, billy blog, October 2009

There’s also some good charts that have been reproduced from Koo’s work in the cited example from Bill Mitchell’s blog.

  1. gaius marius says

    marshall, ed — kudos on your continuing great work.

    it seems to me, having been so educated by john hempton last year, that the major difference between japan and the US is that japan was a massive fiscal surplus country whose banking system was loaded with excess savings well before their crash. the US however has run a massive current account deficit, leaving its banking system today very reliant on funding derived of borrowed foreign deposits. he likened the US now to 1997 korea rather than 1990 japan, and prone to a sudden stop rather than a long deflation.

    it seems to me that the idealized current state of affairs — offsetting the change in private sector/local & municipal debt repayment/saving by replacing cash flow leakage with equal but opposite public deficits — can be made to work if and only if there is not a run on that funding similar to what was underway in september 2008. with the backstops put in place then, that essentially has since meant a run on US sovereign debt.

    mechanistically, i perceive that even in a run on treasuries the fed could step in to monetize the revulsed debt, preventing/mitigating the rapid unwind of the banks with an accompanying interest rate spike and currency volatility. i’m more curious about your view first of the rationality of my perception — and then further the political likelihood that the fed would be able, aware and allowed to do so in a sovereign funding crisis.

    1. Marshall Auerback says

      Thanks for the kind words. I hear this distinction made between the US
      and Japan a lot, but I don’t think the distinction holds water.
      While the huge holding of foreign treasuries is usually presented as
      foreign “lending” to “finance” the US budget deficit, one could just as well
      see the US current account deficit as the source of foreign current account
      surpluses that can take the form of accumulations of US treasuries. In a
      sense, it is the willingness of the US to simultaneously run trade and
      government budget deficits that provides the wherewithal to “finance” foreign
      accumulation of treasuries. Obviously there must be a willingness on all
      sides for this to occur—you could say that it takes (at least) two to tango—
      and most public discussion ignores the fact that the Chinese desire to run a
      trade surplus with the US is linked to its desire to accumulate dollar
      assets. At the same time, the US budget deficit helps to generate domestic
      income that allows our private sector to consume—some of which fuels imports,
      providing the income foreigners use to accumulate dollar saving—even as it
      generates treasuries accumulated by foreigners.
      In other words, the decisions cannot be independent—it makes no sense to
      talk of Chinese “lending” to the US without also taking account of Chinese
      desires to net export. Indeed all of the following are linked (possibly in
      complex ways): the willingness of Chinese to produce for export, the
      willingness of Chinese to accumulate dollar-denominated assets, the shortfall of
      Chinese domestic demand that allows China to run a trade surplus, the
      willingness of Americans to buy foreign products, the high level of US aggregate
      demand that results in a trade deficit, and the factors that result in a
      US government budget deficit. And of course it is even more complicated than
      this because we must bring in other nations as well as global demand taken
      as a whole. While it is often claimed that the Chinese might suddenly
      decide they do not want US treasuries any longer, at least one but more likely
      many of these other relationships would also need to change. For example it
      is often said that China might decide it would rather accumulate Euros.
      However, there is no equivalent to the US treasury in Euroland. China could
      accumulate the euro-denominated debt of individual governments—say, Greece!
      —but these have different risk ratings and the sheer volume issued by any
      individual nation is likely too small to satisfy China’s needs. Further,
      Euroland taken as a whole (and this is especially true of its strongest
      member, Germany) attempts to constrain domestic demand in order to run trade
      surpluses. If the US is a primary market for China’s excess output but euro
      assets are preferred over dollar assets, then exchange rate adjustment
      between the dollar and euro could destroy China’s market. I’m not arguing that
      the current situation will go on forever, although I do believe it will
      persist much longer than most commentators presume. The fact is that these
      changes are complex and that there are strong incentives against the sort of
      simple, abrupt, and dramatic shifts that are posited as likely scenarios.

      In a message dated 2/22/2010 13:11:29 Mountain Standard Time,


      1. Edward Harrison says

        The Pettis article I just referenced in the next post gets to a lot of this it takes two to tango duality to the current account and reserves:


        Marshall is right that there are very strong incentives to maintain the status quo. Obama is playing with fire if he takes Krugman’s advice and raises the protectionist rhetoric to the next level.

  2. Aileen Chang says

    I just wrote about some doubts I have about Koo’s argument on my blog (www.uprofish.com), and I thought I’d share. To summarize:

    – I’m not sure if required incremental government borrowing is exactly the same as the deleveraging by private sector. (Govt is less efficient to begin with)
    – Even if the above is true, I’m not sure if that means there will be abundant local funding available for US govt at low rate, as was the case with Japan. Unlike Japanese, US private can invest overseas without exchange rate risk.
    – I think the fundamental problem for Japanese private sector’s refusal to lend is “deflation” rather than “debt trauma” as Koo argues.
    – Japanese private sector’s increased appetite for debt can actually cause JGB rate to bounce up causing Japan debt service problem.
    – And philosophically, I think there is nothing wrong with economy reducing its size the improve quality, but Koo seems say that the total debt level of an economy should not decline as it will hurt output level.

    You can find the longer version here (https://www.uprofish.com/2010/02/increased-private-debt-appetite-can-threaten-jgb-funding-and-some-doubts-on-richard-koos-argument/)

    Your opinion, criticism, agreements are all welcome.

    Thank you always for nice posts, Marshall and Ed.

    1. Marshall Auerback says

      Well, I’ve read your stuff, Aileen, and I respectfully disagree with your
      conclusions. I don’t think Japan has a debt service problem and I still
      think that you omit a key accounting variable in your analysis.Basically, it
      boils down to this simple observation: it is foolish, dangerous, and
      thoroughly counterproductive to treat fiscal balances in isolation. In particular,
      setting a fiscal deficit to GDP target equal to expected long run real GDP
      growth in order to hold public debt/GDP ratios at a completely arbitrary
      (indeed, literally pulled out of thin air) public debt to GDP ratio without
      for a moment considering what the means for the feasible range of current
      account and domestic private sector financial balance is utterly nonsense.

      It is crucial that investors and policy makers recognize and learn to
      think coherently about the connectedness of the financial balances before they
      demand what is being currently called fiscal sustainability, or discussing
      the need for the size of the government sector to shrink. You can do that
      without recognising the impact on some other sector. As it turns out,
      pursuing fiscal sustainability as it is currently defined will in all likelihood
      just lead many nations to further private sector debt destabilization. To
      put it bluntly, if the private sector continues to pursue a high net
      saving/financial surplus position while fiscal retrenchment is attempted, unless
      some other bloc of nations becomes large net importers (and the BRICs are
      surely not there yet), nominal GDP will fall in the fiscally “sound”
      nations, the designated fiscal deficit targets WILL NEVER BE ACHIEVED (there can
      also be a paradox of public thrift), and private debt distress will simply
      escalate. The corollary applies if it’s the government (witness the impact
      of Clinton’s budget surpluses in the late 1990s on domestic demand).

      And all you need to know to reach that conclusion is some 6th grade algebra
      and the principles of double entry bookkeeping which have been around for
      five centuries or so. This is not high Keynesian theory. It is simple,
      straight forward accounting,. But investors and policy makers insist on
      remaining blind to this in their determination to enforce some arbitrary
      definition of fiscal sustainability which will in all likelihood lead to more
      private sector financial destabilization. So in that regard, I think Koo is spot

      Where is disagree with Koo is in respect of his belief in a government
      budget constraint (GBC) – automatically associated deficit spending with
      borrowing (even when he is talking about economies with near zero interest rates
      and therefore no need to borrow to maintain interest rate targets).
      Koo clearly understands the relationship between nominal spending and real
      capacity in relation to an analysis of inflation. When the former exceeds
      the latter you start to get the threat of inflation and that’s when I think
      you can talk about reducing the size of the government sector, as you
      propose. But not in a situation where rising private saving creates a spending
      gap that will be deflationary – that is, cause output and employment to
      In that situation, I think (as does Koo) that the only show in left in
      town is for the government to spend and “finance the saving intentions”. Now,
      Koo does not express it this way because he is a deficit-dove in this
      regard and via the GBC he thinks the government is borrowing the funds from the
      savings and then spending them to keep money returning back into the
      income-generation stream.
      This is backwards reasoning. The money that the private sector uses to buy
      the bonds comes from the government net spending (deficits). The same
      deficits provide the funds to ensure that the private saving desires can be
      realised. If the deficit did not expand to meet these desires then, as above,
      the paradox of thrift, would drive income (and output) down and a crisis
      would emerge.
      As an aside, I am beginning to recognise that the essence of my
      disagreement with the Austrians is that they believe households can save without any
      repercussion on or requirement for other sectors.

      Since they don’t get that, they can argue that systems restricting credit
      to savings are viable, so things like 100% reserve banking that prohibit
      credit money creation can fly.

      Anyway, thanks for the thoughtful comments.

      In a message dated 2/22/2010 19:21:03 Mountain Standard Time,


      1. Edward Harrison says

        You are probably right about strict Debt to GDP targets like the ones we saw in saw in the Maastricht treaty. A 3% hurdle at all times is something even the Germans and French have violated on a repeated basis. However, in the case of Europe, there must be some way to put a check on public debt that threatens a country’s ability to repay.

        In Japan’s case, a Debt to GDP approaching 200% is simply astronomical and unwise regardless of the existence of a balance sheet recession. Would you explain how this is a good thing and how the Japanese will not suffer a debt crisis as a result? If and when excess capacity is whittled away and the private sector is ready to releverage for good, you would still have that massive public sector debt burden. How would the Japanese prevent debt service costs from rising rapidly in this environment?

        1. Marshall Auerback says

          It seems to me that this is precisely the time when the stabilisers will
          work in reverse, that the deficits will come down. The scenario you posit
          suggests that the government spending would finally be filling the output
          gap. Note that during WWII the government’s deficit (which reached 25% of
          GDP) raised the publicly held debt ratio above 100%– much higher than the
          ratio expected to be achieved by 2015 (just under 73%). Further, in spite of
          the warnings issued in the Reinhart and Rogoff book, US growth in the postwar
          period was robust—it was the golden age of US economic growth. Further,
          the debt ratio came down rather rapidly—mostly not due to budget surpluses
          and debt retirement (although as we discuss below, there were small surpluses
          in many years) but rather due to rapid growth that raised the denominator
          of the debt ratio. By contrast, slower economic growth post 1973,
          accompanied by budget deficits, led to slow growth of the debt ratio until the
          Clinton boom (that saw growth return nearly to golden age rates) and budget
          surpluses lowered the ratio. I don’t see why Japan should be any different.
          The size of the debt is simply an accounting device which reflects the stock
          of debt held by the owners of that debt. It doesn’t have the broader
          macro implications you suggest, in my opinion.

          In a message dated 2/23/2010 10:32:34 Mountain Standard Time,

          In Japan’s case, a Debt to GDP approaching 200% is simply astronomical and
          unwise regardless of the existence of a balance sheet recession. Would
          you explain how this is a good thing and how the Japanese will not suffer a
          debt crisis as a result? If and when excess capacity is whittled away and
          the private sector is ready to releverage for good, you would still have that
          massive public sector debt burden. How would the Japanese prevent debt
          service costs from rising rapidly in this environment?

      2. Aileen Chang says

        Marshall, Thank you for your comments.

        I think there is some misunderstanding. I didn’t say anywhere fiscal stability is defined as public debt/GDP nor I consider “fiscal balance in isolation”. I didn’t mention it in my comment above, and if you are reader of my blog you would know I am very opposed of such thoughts. (I tried to explain this point in post “how to think about a nation’s indebtness” using family analogy. https://bit.ly/cZAEiq)

        My worries about Japan are from the fact that
        1) not only public debt but the nation’s debt (public+private) is very high. (see 1st graph here https://bit.ly/9hmp9h)
        2) interest expense is already over 25% of its tax revenue which is equivalent to operating cash flow (see https://bit.ly/cxUJ2F)
        3) it would be best if Japan can grow GDP and thus reducing both interest burden and debt/GDP ratio as you recommend, but Japan is in deflation and growing GDP in deflation is not easy. In fact, in deflation, debt/GDP can only go up. (see https://bit.ly/cnRtik)
        4) according to Koo, Japanese private sector have stopped reducing debt in 2005. however, private sector is not borrowing. well, because in deflation even 0 interest rate does not mean the money is free.
        5) it is repeat now: so, the government has to spend more but its tax receipt is lower and private can finance public but it is quite unbelievable that this cycle can continue forever or that this is a healthy cycle.

        i do not have answer yet. my inclination is that there is too much complacency (or give up) for jgb in investment community, and jgb is likely to cause trouble than be non-issue. i am still working to see if my inclination is right or not.

        however, i wanted to let you know that you seemed to misunderstand me and your reply seems to be for a generalized investors rather than for my specific comments which is about some doubt on Koo’s opinion. I never said I disagree with Koo either. I think Koo’s argument has many sound part, but I have some doubt on some of his points.

        BTW, I thought your comment that in economic trouble, private sector wouldn’t have the money to save without government’s help and in fact government is fulfilling private’s desire to save through deficit spending was brilliant.

  3. rp says

    Yes yes, the GDP number is all very impressive. But what about opportunity? The younger generations in Japan have had temporary jobs their entire lives. Hardly any even get married now because the normal expectations of raising a family are completely out of reach. This is generational theft writ large. They propped up their grotesque economy by kicking away the ladder for their children. They deserve their fate.

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