Question

4. Many economists argued that the deep depression in Japan in the 1990s, caused by the bursting of the “bubble economy,” failed to respond to aggressively expansionary monetary policies because the economy was in a liquidity trap. But Koo argues that the real problem was a balance sheet recession. What’s the difference? What evidence does Koo give for this. What is a balance sheet recession?

Answer 1

The balance sheet recession means that when the high levels of private sector debt the companies or individuals are trying to use the saving to repay it rather than saving or investing, leads to slow economic growth in the economy. The balance sheet recession can arise in three stages like, the borrowers can expect to repay the debt by using the expected cash from the investment. In the second stage, their hopes will be limited, and they are unable to pay the debt, and the principal amount will be on due. In the final step, they cannot cover the interest they need to pay and the asset they are compelled to sell at a profit. The rush of an asset of sale will lead to financial recession because borrowers seek the debt repayment. In Japan, the companies are sold all their asset like this and lead to a financial crisis called balance sheet crisis.

The famous economist Richard Koo wrote about Japan’s financial crisis of 1990 as a balance sheet crisis. It is because of the collapse in land and stock prices, and the firms end with substantial negative equity, which means that asset price is lower than liabilities. The continues zero interest rate and increasing the money supply the firms pay their debt by using their business earnings than borrow to interest. It reduced corporate investment a significant factor in Japan’s GDP. The firms in Japan will become savers than investors. Koo points out this as a massive fiscal stimulus in the country. And government unable to maintain their GDP.