Macroeconomic Theory and the Current Crisis

See Appendix A-1 for analyst

certification, important disclosures

and the status of non-US analysts.

Any authors named on this report

are research analysts unless

otherwise indicated.

Macroeconomic Theory and the Current Crisis:

The World Economy’s Escape from Balance Sheet Recession

November 2013

Richard C. Koo, Chief Economist

Nomura Research Institute, Tokyo +81-3-5533-2160

[email protected]

US House Prices Have Been Following the Japanese Experience

Exhibit 1. Cause of Breakdown in Monetary Transmission:

Bursting of Debt-Financed Bubbles

1

40

60

80

100

120

140

160

180

200

220

240

260

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

US: 10 Cities Composite Home Price Index

(US: Jan. 2000=100, Japan: Dec. 1985=100)

Note: per m2, 5-month moving averageSources: Bloomberg, Real Estate Economic Institute, Japan, S&P, S&P/Case-Shiller® Home Price Indices, as of Oct. 31, 2013

Composite Index

FuturesJapan: Tokyo Area Condo Price1

77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 9 7 98 99

Japan: Osaka Area Condo Price1

Japan falls of f its f iscal clif f(Apr. 1997)

US

Japan

Futures

Exhibit 2. Europe also Experienced House Price Bubbles,

except Germany

2

75

100

125

150

175

200

225

250

275

300

325

350

375

400

425

450

475

500

525

550

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Ireland

Greece

Spain

Germany

(end of 1995 = 100)

Notes: Ireland's f igures before 2005 are existing house prices only. Greece's f igures are f lats' prices in Athens and Thessaloniki. Sources: Nomura Research Institute, calculated f rom BIS and Europace AG data.

90

303

342

514

a symptom of Eurozone crisis

Ireland256

Greece229

Spain214

Germany106

Exhibit 3. Challenge of Abenomics: Get Businesses to Borrow Money

3

-18

-15

-12

-9

-6

-3

0

3

6

9

12

15

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

(Financial Deficit)

(Financial Surplus)

(as a ratio to nominal GDP, %)

Households

Rest of the World

Corporate Sector(Non-Financial Sector +

Financial Sector)

General Government

Financial Surplus or Deficit by Sector

Balance Sheet Recession Global Financial

Crisis

Private

Sector Savings:

8.17% of GDP

1991-2003 shift

= 22% of GDP

Note: All entries are four-quarter moving averages. For the latest f igures, four-quarter averages ending with 2Q/'13 are used.Sources: Bank of Japan, Flow of Funds Accounts, and Government of Japan, Cabinet Of f ice, National Accounts

Exhibit 4. US in Balance Sheet Recession: US Private Sector

Increased Savings significantly after the Bubble

4

-15

-10

-5

0

5

10

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Housing Bubble

IT Bubble

(Financial Surplus)

(Financial Deficit)

(as a ratio to nominal GDP, %, quarterly)

Rest of the World

Households

General Government

Corporate Sector(Non-Financial Sector +

Financial Sector)


Note: All entries are four-quarter moving averages. For the latest f igures, four-quarter averages ending with 2Q/'13 are used.Sources: FRB, US Department of Commerce

8.61% of GDP

Exhibit 5. Europe in Balance Sheet Recession: European Private

Sectors Increasing Savings despite record-low Interest Rates

5

-20

-15

-10

-5

0

5

10

15

20

25

30

03 04 05 06 07 08 09 10 11 12 13

UK

Spain

Ireland

Portugal

Italy

(as a ratio to nominal GDP, %)

(Financial Surplus)

(Financial Deficit)

* Private Sector = Household Sector + Non-Financial Corporate Sector + Financial SectorNote: All entries are four-quarter moving averages. For the latest f igures, four-quarter averages ending with 2Q/'13 (only Ireland and Italy,

1Q/'13) are used.

Sources: Flow of funds data f rom Off ice for National Statistics, UK, Banco de España, National Statistics Institute, Spain, The Central Bank of Ireland, Central Statistics Off ice Ireland, Banco de Portugal, Banca d'Italia and Italian National Institute of Statistics

Private Sector Savings as %

of GDP

Ireland: 6.88%

Spain: 12.41%

Portugal: 8.94%

UK: 3.49%

Italy: 1.73%

Exhibit 6. Drastic Liquidity Injections Resulted in minimal

Increases in Money Supply and Credit (I): US

6

70

100

130

160

190

220

250

280

310

340

370

400

430

Monetary Base

Money Supply (M2)

Loans and Leases in Bank Credit

(Aug. 2008 =100, Seasonally Adjusted)

0.5

1.0

1.5

2.0

2.5

3.0

07/1 07/7 08/1 08/7 09/1 09/7 10/1 10/7 11/1 11/7 12/1 12/7 13/1 13/7

(%, yoy) Consumer SpendingDeflator (core)

Sources: Board of Governors of the Federal Reserve System, US Department of CommerceNote: Commercial bank loans and leases, adjustments for discontinuities made by Nomura Research Institute.

422

141

100

+1.23%


Increases in Money Supply and Credit (II): Eurozone

7

80

90

100

110

120

130

140

150

160

170

180

190

200

Base Money

Money Supply (M3)

Credit to Euro Area Residents


0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

07/1 07/7 08/1 08/7 09/1 09/7 10/1 10/7 11/1 11/7 12/1 12/7 13/1 13/7

(%, yoy)

CPI core

Sources: ECB, EurostatNote: Base money's figures are seasonally adjusted by Nomura Research Institute.

139

108

100

+0.8%


Increases in Money Supply and Credit (III): UK

8

50

100

150

200

250

300

350

400

450

500

Reserve Balances + Notes & Coin

Money Supply (M4)

Bank Lending (M4)

Aug. 08'


1

0

1

2

3

4

5

6

07/1 07/7 08/1 08/7 09/1 09/7 10/1 10/7 11/1 11/7 12/1 12/7 13/1 13/7

CPI (ex. Indirect Taxes)(%, yoy)

Sources: Bank of England, Of f ice for National Statistics, UKNotes: 1. Reserve Balances data are seasonally unadjusted. 2. Money supply and bank lending data exclude intermmediate f inancial institutions.

458

112

85

+2.9%


Increases in Money Supply and Credit (IV): Japan

9

50

100

150

200

250

300

350

400

450

500

550

Monetary Base

Money Supply (M2)

Bank Lending

QuantitativeEasing

(1990/1Q = 100, Seasonally Adjusted)

Bubble Burst

Quantitative and Qualitative Easing

-3

-2

-1

0

1

2

3

4

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

(y/y, %)

CPI Core(ex. fresh food)

Note: Figures for bank lending and BOJ's targets are seasonally adjusted by Nomura Research Institute.Source: Bank of Japan

Earthquake

498

183

+0.7%

106

Exhibit 10. Japan’s GDP Grew despite major Loss of Wealth and

Private Sector De-leveraging

10

down87%

25

40

55

70

85

100

115

130

0

20

40

60

80

100

120

140

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

(Sep.1990=100, Seasonally Adjusted)

Real GDP(Right Scale)

Land Price Index in Six Major Cities(Commercial, Left Scale)

(Sep. 1990=100)

Sources: Cabinet Of f ice, Japan Real Estate Institute

Nominal GDP (Right Scale)

Likely GDP Path w/o Government Action

Last seen in 1973

Reported Fiscal Multiplier

Actual Fiscal

Multiplier

Cumulative 90-05 GDP

Supported by Government

Action: ~ ¥2000 trillion

Cumulative Loss of

Wealth on Shares and Real Estate

~ ¥1500 trillion

Exhibit 11. Japanese Government Borrowed and Spent

Unborrowed Savings of Private Sector to Sustain GDP

11

overall deficit ¥460

trillion

20

30

40

50

60

70

80

90

100

110

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Source: Ministry of Finance, JapanNote: FY2013 is initial budget and FY2012 is supplementary budget.

Government spending

Tax revenue

Bubble Collapse

(Tril. yen)

(FY)

cumulativecyclical

deficit

90-05 ¥315 trillion

Exhibit 12. Japan’s Money Supply Has Been Kept Up by

Government Borrowings

Credit

Extended to

the Private

Sector

¥601.6 tril.

Credit

Extended to the

Public Sector

¥247.2 tril.

(+106.8)

Foreign assets

(net)

¥74.1 tril.

(+41.4)

Foreign Assets

(net)

¥32.7 tril.

Credit Extended

to the Public

Sector

¥140.4 tril.

Money Supply

(M2+CD)

¥621.5 tril.

Credit

Extended to

the Private

Sector

¥501.8 tril.

(-99.8)

Other Liabilities

(net)

¥78.7 tril.

(-74.5)

Other Liabilities

(net)

¥153.2 tril.

Money Supply

(M2+CD)

¥744.4 tril.

(+122.9)

Balance Sheets of Banks in Japan

December 2007

Total Assets ¥823.1 tril. (+48.4)Total Assets ¥774.7 tril.

December 1998Assets

Assets

Liabilities

Liabilities

Source: Bank of Japan "Monetary Survey"

Money Supply Is Kept Up by Government Borrowings (II)

12

Balance Sheets of All Member Banks

Exhibit 13. Post-1933 US Money Supply Growth Made Possible by

NEW DEAL Borrowings

Credit

Extended to

the Private

Sector

$29.63 bil.

Deposits

$32.18 bil.

Credit

Extended to

the Public

Sector

$5.45 bil.

Other Assets

$8.02 bil.

Reserves

$2.36 bil.

Capital

$6.35 bil.

Other

Liabilities

$6.93 bil.

June 1929 Assets Liabilities

Total Assets $45.46 bil. Total Assets $33.04 bil. (-12.42) Total Assets $46.53 bil. (+13.49)

Credit

Extended

to the

Private

Sector

$15.71 bil.

(-0.09)Credit

Extended to

the Private

Sector

$15.80 bil.

(-13.83)



Deposits

$23.36 bil.

(-8.82)

Deposits

$34.10 bil.

(+10.74)

Credit

Extended

to the

Public

Sector

$8.63 bil.

(+3.18)

Credit

Extended

to the

Public

Sector

$16.30 bil.

(+7.67)

Other

Assets

$6.37 bil.

(-1.65)

Other

Assets

$8.91 bil.

(+2.54)

Reserves

$2.24 bil.

(-0.12)

Reserves

$5.61 bil.

(+3.37)

Other

Liabilities

$4.84 bil.

(-2.09)

Other

Liabilities

$7.19 bil.

(+2.35)

Capital

$4.84 bil.

(-1.51)

Capital

$5.24 bil.

(+0.40)

(= Money Supply)

Source: Board of Governors of the Federal Reserve System (1976) Banking and Monetary Statistics 1914-1941 pp.72-79

13

Bank Reserves as Multiples of Required Reserves

Exhibit 14. But in terms of Potential Growth of Money Supply, Kuroda

BOJ Is in the Process of Catching up with the Fed and BOE

14

0

5

10

15

20

25

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Japan

Japan: estimate

U.S.

Eurozone

U.K.

(x)

Bank reserves ÷statutory reserves

19.5x

9.7x

2.6x

Notes: 1. Estimates are based on the assumption that required reserves will increase by 3% a year and bank reserves constitute88.8% of f inancial institution's current deposit holdings with the BOJ.

2. The BOE has suspended reserve requirement in March 2009. The post-March 2009 f igures are based on the assumption

that the original reserve requirement is still applicable.Sources: Nomura Research Institute, based on BOJ, FRB, ECB and BOE data

11.8x

18.7x

21.6x

10.3x

1

2

Exhibit 15. US May be Facing a QE “Trap” (1)

15

Images of Long-term Interest Rates with and without QE

t0 t1 t2

BubbleCollapse

(Long-term interest rate)

without QE

with QE

Economic Recovery(slower growth rate due to higher interest rate)

QE "Trap"

Economic Recovery (normal growth rate)

(Time)

Exhibit 16. US May be Facing a QE “Trap” (2)

16

Images of GDP with and without QE

(GDP)

Benefit of QE

Cost of QE

t0 t1 t2

without QE

BubbleCollapse

with QE

(Time)

Exhibit 17. Peripheral Eurozone Bond Yields Diverged

significantly from the Global Trend

17

0

2

4

6

8

10

12

14

16

18

20

2007 2008 2009 2010 2011 2012 2013

Japan

UK

US

Spain

Portugal

Italy

(%)

Note: As of Oct. 31, 2013.Source: Bloomberg

3%

Eurozone crisis

2.0%

Exhibit 18. The Collapse of Neuer Markt in 2001 Pushed German

Economy into Balance Sheet Recession

18

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

(Dec. 31, 1997 = 1000)

Source: Bloomberg As of Oct. 31, 2013

TecDAX

9694.07

306.32

-97%

1129.85

Exhibit 19. German Private Sector Refused to Borrow Money

after the Dotcom Bubble

19

-15

-12

-9

-6

-3

0

3

6

9

12

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

(as a ratio to nominal GDP, %, seasonally adjusted)

(Financial Surplus)

(Financial Deficit)

Rest of the World

Corporate Sector(Non-Financial Sector + Financial Sector)

General Government

Households

German Private Sector Savings 13.0% of GDPDotcom Bubble

Balance Sheet Recession

Notes: The assumption of Treuhand agency's debt by the Redemption Fund for Inherited Liabilities in 1995 is adjusted.All entries are four-quarter moving averages. For the latest f igures, four-quarter averages ending with 2Q/'13 are used.

Source: Nomura Research Institute, based on the data of Bundesbank and Eurostat


Exhibit 20. ECB’s Drastic Rate Cuts to 2% in 2003 Failed to Revive

the German Economy

20

0

1

2

3

4

5

6

7

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

(%)

Sources: BOJ, FRB, ECB, and BOE. As of Oct. 31, 2013.

Eurozone

US

UK

Japan

Exhibit 21. German Households Stopped Borrowing altogether

after the Dotcom bubble

21

-12

-10

-8

-6

-4

-2

0

2

4

6

8-8

-6

-4

-2

0

2

4

6

8

10

12

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

right scale

left scale left scaleFinancial Assets Financial

Surplus/Deficit

Financial Liabilities

(as a ratio to nominal GDP, %, seasonally adjusted)

Note: Seasonal adjustments by Nomura Research Institute. Latest f igures are for 2013 Q2.Sources: Nomura Research Institute, based on f low of funds data f rom Bundesbank and Eurostat

(as a ratio to nominal GDP, %, inverted, seasonally adjusted)

Collapse of the Dotcom

Bubble

Exhibit 22. Spanish Households Increased Borrowings after the Dotcom

Bubble: Now They Are in Severe Financial Distress

22

-16

-12

-8

-4

0

4

8

12

16-16

-12

-8

-4

0

4

8

12

16

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Notes: Seasonal adjustments by Nomura Research Institute. Latest f igures are for 2013 Q2.Sources: Nomura Research Institute, based on f low of funds data f rom Banco de España and National Statistics Institute, Spain

right scale

left scale left scaleFinancial Assets Financial Surplus/Deficit


(as a ratio to nominal GDP, %, seasonally adjusted) (as a ratio to nominal GDP, %, inverted, seasonally adjusted)

Collapse of theDotcom Bubble

Exhibit 23. Irish Households Increased Borrowings after the Dotcom

Bubble: Now They Are Deleveraging

23

-20

-15

-10

-5

0

5

10

15

20

25-25

-20

-15

-10

-5

0

5

10

15

20

02 03 04 05 06 07 08 09 10 11 12 13

right scale

left scale left scaleFinancial Assets Financial

Surplus/Deficit


(as a ratio to nominal GDP, %, seasonally adjusted) (as a ratio to nominal GDP, %, inverted, seasonally adjusted)

Notes: Seasonal adjustments by Nomura Research Institute. Latest f igures are for 2013 Q1.Sources: Nomura Research Institute, based on f low of funds data f rom Central Bank of Ireland and Central Statistics Of f ice, Ireland

Collapse of theDotcom Bubble

Exhibit 24. German-Eurozone (ex. Germany) Competitiveness Gap

Has Macro (50.2%) and Micro (49.8%) Factors

90

100

110

120

130

140

150

160

170

180

190

200

210

220

230

00 01 02 03 04 05 06 07 08 09 10 11 12

Eurozone ULC (ex. Germany) based on German M3 Growth*

Eurozone ULC (ex. Germany)

129.9

German ULCGerman M3

115.2

156.0

100.6

(1Q 2000 = 100, Seasonally Adjusted)

50.2%: Macro-Monetary Effect

49.8%: German Labor Reform Effect

(ULC = Unit Labor Cost)

Eurozone M3 (ex. Germany)

217.0

MonetarySource of

Competitiveness Gap

Note: * Parameters obtained f rom the regression result on Eurozone ULC (ex. Germany) on Eurozone M3 (ex. Germany),log(Eurozone ULC (ex.Germany)) = 3.155506 + log(Eurozone M3 (ex.Germany)) x 0.318227, applied to German M3data indexed to 1Q 2000 = 100.

Sources: Nomura Research Institute, based on ECB, Eurostat and Deutsche Bundesbank data

24

Exhibit 25. Germany Recovered from Post-Dotcom Balance Sheet

Recession by Exporting to other Eurozone Countries

25

-6000

-4000

-2000

0

2000

4000

6000

8000

10000

12000

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Source: Deutsche Bundesbank

(€mn, seasonally adjusted)

Eurozone

Asia

US

German Balance of Trade

driven by Eurozone housing bubble

driven by weaker Euro

Exhibit 26. Two Structural Deficiencies of Eurozone

26

Maastricht Treaty restricted

fiscal stimulus needed to fight balance sheet recessions

Procyclical and destabilizing

capital flows between gov. bond markets of member

countries

Countries suffering from

balance sheet recessions fall into deflationary spirals, while

excessive easings by the ECB end up creating bubbles

elsewhere

Excessively low gov. bond

yields during bubbles

Excessively high gov. bond

yields during balance sheet

recessions

Require countries in balance

sheet recessions to implement sufficient fiscal stimulus with

blessings from the Troika in order to protect the ECB

Introduce different risk weights

for holdings of domestic vs foreign gov. bonds to keep

domestic savings at home

(1) (2)

Problem

Solution

Exhibit 27. Yin Yang Cycle of Bubbles and Balance Sheet Recessions

27

Notes 1. Recovering from 1990 Heisei bubble.

2. Recovering from 2000 IT bubble

3. Recovering from 2008 housing bubble

Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession , John Wiley & Sons, Singapore, April 2008 p.160.

(1) Monetary policy is tightened, leading the bubble to collapse.

(5) Private sector phobia towards borrowing gradually disappears, and it takes a more bullish stance towards fund raising.

(8) With the economy healthy, the private sector regains its vigour,

and confidence returns.

(9) Overconfident private sector triggers a bubble.

(7) Monetary policy becomes the main economic tool, while deficit reduction becomes the top

fiscal priority.

(6) Private sector fund demand recovers, and monetary policy starts working again.

Fiscal policy begins to crowd out private investment.

(4) Eventually private sector finishes its debt repayments, ending the balance sheet recession.

But it still has a phobia about borrowing which keeps interest rates low, and the economy less than fully vibrant.

Economy prone to mini-bubbles.

(3) With everybody paying down debt,monetary policy stops working.

Fiscal policy becomes the main economic tool to maintain demand.

(2) Collapse in asset prices leaves private sector with excess liabilities,

forcing it into debt minimization mode. The economy falls into a balance sheet recession.

BubbleYin (=Balance Sheet Recession) Yang (=Textbook Economy)

US3

Spain3

UK3

Japan1

Germany2

Exhibit 28. Contrast Between Yin and Yang Phases of Cycle

28

Yang Yin

Textbook economy Balance sheet recession

Adam Smith's "invisible hand" Fallacy of composition

Assets > Liabilities Assets < Liabilities

Profit maximization Debt minimization

Greatest good for greatest number Depression if left unattended

Effective Ineffective (liquidity trap)

Counterproductive (crowding-out) Effective

Inflationary Deflationary

Normal Very low

Virtue Vice (paradox of thrift)

a) LocalizedQuick NPL disposal

Pursue accountability

Normal NPL disposal

Pursue accountability

b) SystemicSlow NPL disposal

Fat spread

Slow NPL disposal

Gov. capital injection

Source: Richard Koo, The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession ,

John Wiley & Sons, Singapore, 2008

1) Phenomenon

2) Fundamental driver

3) Corporate financial condition

4) Behavioral principle

8) Prices

9) Interest rates

10) Savings

11) Remedy for

Banking Crisis

5) Outcome

6) Monetary policy

7) Fiscal policy

Documents

Macroeconomic Theory and the Current Crisis