Posted by: Dirk | November 14, 2009

(Book review) The Holy Grail of Macroeconomics – Lessons from Japan’s Great Recession

Originally published in 2008, the revised and updated 2009 edition features an additional chapter on the world balance sheet recession (ch. 8). Richard Koo, chief economist of the Nomura Research Institute, is the author of Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implication, which was a global success in 2003. Since I did not read that book, I will not be able to judge what exactly is new and what is old material in the Holy Grail.

The book’s main thesis is that the economy can be in two states, called yin (post-bubble) and yang (‘normal’). While in the yang state, the economy behaves just like predicted in the neo-classical models. Monetary policy works, fiscal policy is not so much effective, depending on whether it is crowding-out private investment or not. In the yin phase however, monetary policy does not work. Firms are trying to decrease debt, and the way they do that is by redirecting the cash flow from investment to repayment of debt. Therefore, investment slumps, pulling the economy downwards. Fiscal policy can and must come to the rescue and stabilize demand, never mind the fiscal costs.

The main idea is that cycles of indebtedness drive the yin and yang phases, explaining how the economy can change its behaviour as noticed by John Maynard Keynes in the General Theory and Irving Fisher in his 1933 paper on debt deflation. In Keynes phrase, the demand for liquidity depends on whether the company is doing just fine or must repay its debts. In the latter case, the preference for liquidity is quite high, leading to a fall in investment just like argued by Keynes. Richard Koo supports his theory by explaining that Japanese companies did have access to credit, so a ‘credit crunch’ was not a supply side problem but a demand side problem: nobody wanted to borrow.

When in such a situation, fiscal policy must be used to create money demand. Only then savings can be translated into investments and the economy be spared from a permanent fall. After balance sheets are repaired, which can take a decade or more as Japan’s example has shown, monetary policy will work once more. Fiscal policy as a tool for demand management can be blended out. In the real world, it will be very difficult to judge whether an economy is in a yin or yang phase. This means that the application of the theory will be very difficult and probably be dominated by the way you measure things. All serious economists have been aware of house price bubbles in the US, Ireland or Spain, but who is to decide whether this is a bubble? And if it is, should central banker try to burst it? These are old questions that can be dealt with in the clearer framework supplied by Koo.

Richard Koo claims he found the Holy Grail of Macroeconomics. It would explain why there are liquidity traps and prolonged recessions. He has achieved his goal, elegantly building on theories of giants, like Minsky, Keynes, Fisher and Leijonhufvud. The problem is two-fold. First, mainstream economists will ignore him, since he does not have a spelled-out economic model. The main issue is known since Hyman Minsky search for it: the Minsky moment. When exactly is existing debt too much? Without an answer to this question, modellers will be unable to predict the behaviour of an economy. This leads us to the second problem: without an alternative mathematical model, the financial community will ignore Koo as well. However, since he works at the investment firm Nomura, that is not so bad. Even if his Holy Grail cannot be translated into gold (and prove him right in this way), the intellectual achievement will stand for some time.


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