Friday, May 21, 2010

Book Review: The Holy Grail of Macroeconomics

The Holy Grail of MacroEconomics: Lessons From Japan's Great Recession, by Richard Koo, talks aboun the macroeconomic lessons that can be learnt from Japan Recession and applied to the US Great Depression.

Interesting Points:
1) Japan's Recession is due to balance sheet recession. A balance sheet recession is one whereby the private firms seek to pay down debt and stops investment. These scenario arises out from the huge debt owned by the firms due to the huge decline in asset prices and the large leverage the firms have used to purchased the assets at a high price during the bubble stage.

2) In a balance sheet recession, monetary policy become ineffective as firms will not borrow regardless how low the interest rate becomes.

3) Only expansionary fiscal policy is effective in balance sheet recession. Given the fall in investment, it is up to the government to increase spending and prop up the GDP.

4) If the government choose to cut its government spending (due to the wish to reduce fiscal debt), it may result in a more than proportionate fall in tax revenues and thus futher enlarge the fiscal deficit. This was what happened to Japan in 1997 and in 2001.

5) Balance sheet recession is hard-to-detect, as no firms would wish to disclose that its net assets are negative and that given sufficient time, its positve cashflow will pay down the debt and turn its net assets to postive.

6) The Great Depression was similarly a balance sheet recession. And, it was probably due to the large fiscal expenditure in the late 1930s that end the Great Depression. The Great Depression was not due to the lack of money supply as the author presents evidence showing lack of demand for loanable funds.

7) The author splits the macroeconomic situations into yin and yang. Yang is the normal scenario whereby firms are willing to borrow and monetary policy is effective. Yin is the scenario whereby firms refuse to borrow and thus monetary policies are not very effective. In the Yin situation, savings are a vice, deflation is likely and there are weak demand for funds. And, economic growth is likely to be below its potential. The US Great Depression, Japan's long-drawn recession and Germany's underperforming economy in the early 2000s belong to the yin situations.

8) The author also notes that monetary policy has become more difficult as the global economy becomes more integrated. Monetary policy effects may have unintended consequences. For example, when countries like New Zealand raises interest rates to dampen prices or investment, it may experience a countervailing effect as international investors attracted to the higher interest rates may place more money in New Zealand and thus making more money available for loan.

9) Finally, the author suggests different ways to deal with 4 different banking crisis:
a) Yang and ordinary crisis: quick NPL disposal and pursue accountability
b) Yang and systemic crisis: slow NPL disposal and fat spread
c) Yin and ordinary crisis: Normal NPL disposal and pursue accountabililty
d) Yin and systematic crisis: Slow NPL disposal and inject capital.