Richard Koo Explains Why The Recovery Will Be So Difficult

I'm happy about the fact that prior to this crisis, we had a lot of guests on the podcast whose expertise seems very relevant to the situation at hand. Now, yeah, i'd say that's right. I mean, I'm trying to think of some specific names, but the list is pretty long at this point. Now the list is pretty long. We

don't have to go through specific names. But I feel like, on some level, the fact that we have gone back on the last several weeks, we've done so many episodes with repeat guests, I think it says a sort of good thing about our our episode selection leading up to this, when we didn't know that there would be an imminent global economic and financial crisis. Oh, absolutely, we have the

right people on speed dial. I'd put it that way, alright, alright, that so that we can we can end end the bragging. Uh now. But obviously once again we will be speaking with someone who we talked to previously. Ah um, so I know who it is. This time it's Richard Coup from Nomura of balance sheet recession fame, and the last time he came on it was really really interesting discussion and I think it's going to be absolutely fascinating to see how much of that balance sheet recession idea, if

anything at all, actually applies to our current situation. Right. So, a lot of people, myself included, really discovered Richard Cou's work during the last crisis. He wrote a fantastic book, The Holy Grail of Macroeconomics, Lessons from Japan's Great Recession.

He's talked a lot about the need for fiscal policy as a tool to restore balance sheet health, and of course in this crisis, there's been this widespread consensus that monetary policy alone is clearly insufficient to address the scale and scope of the downturn, to replace all of the lost income from households and businesses. And although we have

seen a lot of fiscal action around the world. There continues to be a lot of debate about whether the tools are right, and whether they're sufficient, and what kind of recovery we have. So um looking forward to talking to Richard now, Richard Coua, thank you very much for joining us. Oh, thank you for having me here again. So let's start big picture, or let's actually start in the US, we saw a fairly substantial fiscal action performance

sort of passed at the end of March. Today is April twenty three, and we're expected to see another tranch of more grants being made available to businesses to keep workers on payeroll plus a few other things expected to pass this week. In your view, how sufficient or insufficient have the policy measures that you've seen put in place in the US so far been to address the size

and scope of this downturn. Well, if we take a snapshot of g d P in all these countries United States included, they have probably down quite substantially from what we consider normal levels. But this is brought about by this external shock, which is this coronavirus, and so ordinary measures like uh riscal and MONELTI policies won't be a match held because just because we had a loose monety policy doesn't mean I will supply Jain problems or lockdown

problems will go away. And so this time I think policies will have to be very specific to help those people who are affected by this coronavirus, which is airlines and traveling, the industry's restaurants, service sectors, and so forth. And I think US has done a very good job

in coming up with these big policies very quickly. I understand that large number of people already receiving payments from the government, and once you see your bank accounts uh filled with some some money from the government, I think people will feel that all the government is really uh

worrying about myself and the economy. And I think that has been very helpful in keeping people from becoming even more desperate or falling into despair, because if you compare that with what's happening in Japan, where I am, unusually I am, they talked about a lot, but very little payments have been made yet. And when you listen to the people there, they say, well, then pliticians are talking

all these honesties, but we haven't seen anything yet. So compared to that, I think the United States Germany are doing a much better job. But whether that's sufficient or not, I think we need to know how long this thing is going to go on, when the vaccines would be developed or some other ways we can we are able to contain this this coronavirus, and that's a medical question unfortunately, not an economic question, And so I think we have to be ready to putting more at as it becomes necessary.

Just to step back for the for a second. One of the things that I personally like about your balance sheet recession framework is that there's a big focus on the psychological impact of debt crises, and there's this notion that people are so sort of emotionally scarred by the experience that they're afraid to take on debt for years

to come. How much of the balance sheet recession framework applies to the current economic crisis, because I can see maybe not debt being an issue here, but I could see, for instance, people increasing their savings for years to come after this shock, right right, You know, there are a lot of people out there who were worried that with so much money into the system by the Federal Reserve and the government also borrowing money, definitely inflation will be

a huge problem once we come out of this recession. But when you think about it, those people who have savings, that it's companies and individuals, they probably quite well about me, sustained less damage than those people who didn't have much

savings so didn't have much retained earnings. In the companies, I mean, if you didn't have much retained earnings, or you bought back your shells and so forth, and then suddenly your your revenue drives up or you're in a huge mess, and I'm sure they have to scramble to get the cash in place so that they can make the payments. That kind of shock can affect people for

a very long time. And if you remember two US had a banking crisis also, and it was a credit crunch, and those businesses who suffered during that period almost never bought money for the the rest following ten years or so. If you remember that banking crisis, that was George Bush the father, and I think the same thing will happen this time again. With so many people talking about second wave, third wave of of this coronavirus. Even we come out of this one, the first wave, I'm sure people will

say to themselves. We really have to have some savings for the rainy days. And if they go back to this savings mode, corporates and individuals, then all the money that was pumped into the system will be used to save money instead of going into consumption or investments, and that will keep inflation rates from picking up. And that's

exactly what happened during the balancy recession. For balancy recession, people actually paying back debt because prior to the two or eight leaving crisis, people leveraging themselves up to invest in all sorts of assets. Then crisis happened as the prices collapse, liabilities remain, their balances under water, so people have to pay down debt, and that's what caused a balancy recession because in the national economy, if someone is saving money, including paying down debt, someone has to be

borrowing money to keep the economy going. Luckily, the US did that, Japan did that, euro Zone didn't do that, and that's how we saw all these differences in macro performances this time around. Once we come out of this recession, people will be saving money. They won't be paying down

debt perhaps, but they'll be saving money. But macro economically, saving money and paying down debt have almost exactly the same effect on the micro economy, and so I would think that inflation is not a big problem going forward, even after we come out of this this first way or it's a last way. But and if that's not the big worry, then the central bank, in the federal government shoe a few shook a few much more ease

in putting additional policy major assess they become necessary. So this is really interesting because at least so far, you view the US fiscal responses having been fairly decent, at least compared to Japan and perhaps some other places in terms of how fast money is getting into bank accounts and so forth. But sort of what it sounds like is, you know, everyone, and it's kind of a cliche, is trying to figure out the so called shape of the recovery and U shape and W shape and V shape.

I don't want to I don't think that's necessarily the most useful thing to talk about, but just this idea that this is going to leave a searing scar on corporate behavior, and so whether it's buy backed or actual capex or hiring, the experience that we're facing right now will alter corporate behavior and potentially household behavior for years to come. Yes, I believe so, just like this banking crisis, the credit crunch back in that period effect that corporate

behavior for our for the following ten years. I think we're going to see something similar that people said, oh gods, we really have to have some savings, we cannot really run two lean and that will affect macroeconomic performances if so many people are increasing savings all at the same time.

So what does that imply for the policy response? Because I guess when you have a balance sheet recession and the emphasis emphasis is on debt, then the ideal policy responses that governments sort of become the borrowers of last resort and do stimulusm in various ways along those lines. But if you have a crisis of sort of savings I guess, or or cash flow, what can governments or central banks actually do here? What what's the best thing

for them to do? Well? During balance recession, we have a very special situation in which financial market and financial market alone, or financial sector alone, it is flooded with cash. Everyone else have no money. Uh, households are paying down that companies are paying down debt, but financial market, if you put yourself in the o position of the fund manager, and all these savings, newly generated savings on the household sectors coming to you, those corporate debt payments are coming

back to you. In the central bank trying to meet the inflation targets also pumping money, which you have to manage at some point, so you're flooded with cash, and flooded in a sense that because everybody is paying down that no one's borrowing money, so you're kind of stuck with this cash. And if you're stuck with cash, there's only one borrow we left, which is the government. You

end up buying government box. And that's the reason why during the balancy recession, government bond iselds in spite of a huge deficit, keeps on coming down. And we saw that in Japan first, and then people thought that was a bond market bubble, but it wasn't because government was the only bara left, so all the money had to go to the government, and then it happened after two thousand eight. Also, that part, the fact that financial market is flooded with cash, is one of the key characteristics

of balancy recession. Now, in this recession or coronavirus recession, we have a different problem, and that is that everybody, at least for the moment until the economy recovers, they will be withdrawing money from the financial market, right because people have to rely on their savings to make pends meet.

So households will be withdrawing savings, corporates will be withdrawing savings, and corporates, some of them who don't have enough savings, would be desperately borrowing money the distress, borrowing to make

the ends meet. So instead of this problem of not having enough borrowers, which is the characteristics of balancing recession, at the moment, we have a situation where savers are disappearing because people are forced to dis save, whereas government would be coming in to borrow, and corporates who needs

cash also are coming to borrow. And so financial market gets much tighter, very sharply tighter in this type of recession, and we already see that in credit spars in the corporate bond market, where corporates used to be able to borrow a very low rates until around the beginning of March, and then suddenly all these corporates with slightly less than the pristine credit ratings suddenly faced much higher borrowing rates.

And that's the characteristics of this type of recession. I mean, this federal result brought rates down to zero, pump comes on money into the system, but corporate borrowing rates are significantly higher now than just two months ago. And a so called financial condition index, the one that Chicago Fed puts out, which shows how tight the financial market is, we see that it's much tighter now in spite of

all the work by the Fed. So in this situation financial market flooded with cash, that characteristics and balancing recession

doesn't apply. And if you have a very tight financial market as we do now, central bank will have to continuously pump money into the system to make sure that we really don't get into the kind of crisis we saw back into thousand and eight, and so this time around, I would say that central bank has a huge role to play, in addition to fiscal policy by the government, to make sure that financial market continues to operate in

in halfway decent manner. When you look at the actions of the Federal Reserve or other central banks, do you feel good that they recognize this. I think I believe that they are doing a good job. And only central bank that I worry about is the ECB, because ECB cannot openly try to help individual governments, right that that's

against the brandate. But everyone else Bank of Japan, Bank of England, Federal Reserve, they are I don't know what that I can say openly, but you know they are very really willingly adding money to the system to make sure that financial market doesn't become too tight. Mm hmm. Just in terms of the differences between how different countries are responding to the coronavirus outbreak and the economic damage that it's causing. You spoke a little bit about the US.

I know you focused a lot of your time on Japan as well, but how are you viewing the crisis response in Europe in particular, because it seems like there we might have a problem of cohesion within the Eurozone block. Japan was very slow incoming at the beginning, but now they have reasonably good policies moving forward. Very little payment has been made to the to the households or or the companies yet, but at least I think the debate

is moving in the right direction. In Europe. However, we discovered in two thousand and eight that national governments really don't have much room for fiscal policy. You know, in Europe. When they decided to join euro individual countries or the voters of individual countries were told that they're giving up their sovereignty amounty policy, but they still have sovereignty on fiscal policy. And that's how everybody agreed to join Europe.

But once they're started and when into town a fiscal policy became necessary because of the balancy recession, they discovered that they don't have a sovereignty on fiscal policy for two reasons. One is that the Mastery Treaty which created the euro says individual governments can bor only three percent of GDP and if you go beyond that, you get punished. But if private sector only saves three percent of GDP,

that'll be okay. But if the private sector, like in Spain, was saving seven percent of GDP after the umbursing of the bubble, but the government could only borrow three, then the remaining four percent becomes the deflationary gap, and Spain probably experienced you know, unemployment rate or or something at that point. If the Spanish government said, oh, we have, you know, plenty of savings seven GDP savings from the private sector. We just used a seven percent to fill

the deflationary gap. Well, that didn't work because in the Eurozone, all these people, now, all these countries, the investors are faced with choice of eighteen government bond markets, all denominated in currency. And so if Spain seems to be ramping up a fiscal stimulus, all these investors, including those in Spain, were quick move money to Germany or someone else where.

Deva said, it's not so large. And then even though Spain had seven percent private sector savings, government could not use the seven They could barely use maybe one or two because the money ran out. And that I think is one of the key problems of the Eurozone that all these government bonds are denominated in the same currency, whereas in the US it's u S traguries in dollars.

Japan is in the end, so all these investors who cannot take a large foreign exchange risk are forced to hold government bonds when privacy actor is not borrowing money. But in the Eurozone there's this possibility of capital flight between government bond markets, and that effectively removed the fiscal room for all all these eighteens, well I should say seventeen countries. The eighteen one, the one that is doing the best, of course, gets the opposite effect. All these

money will be coming into your company country. And that's where Germany is at the moment. So fiscal policy is not really available to very many countries in the Eurozone, and monetary policy, of course, they lost the sovereignty over it. So if you put yourself in the position of any Italian or and yet you have a devastated economy, so many people dying every day, and you cannot even use your monetary and fiscal policies to fight the economic depression.

And I find this very very disturbing, and I hope they can come up with some sort of a compromise where even though Mastery Treaty says you cannot or more than three percenter GDP, they will somehow come up with the ways to help Italy and Spain and other countries that are very badly affected by this coronavirus UH and need fiscal stimulus very badly, especially the kind of fiscal

spending that goes directly to the affected industries, households and companies. Yeah, I remember reading your this thesis, you set out about these sort of savings leakages from the periphery to German boon back during the last prices, and I thought it was fascinating only get back to sort of ideal government policies in the post crisis phase. So once the health aspect of the crisis begins to fade and people start in theory reopening up stores and coming back to work.

We talked before about the searing effect that this will have in terms of people's inclination to save. Perhaps corporrates will remain much less levered, or they're going to be very slow to hire and expand kpex after seeing revenues disappear in an instant. Obviously, as you say, okay, central banks need to do their part to make maintain liquidity. Governments need to do their part to mean spending. But how do you get off the cycle? And I guess

this goes back to your work looking in Japan. What did Japan fail to do in the post crisis period of its own crisis that it was never or that it was It had an extremely difficult time reviving the inclination to borrow and spend, so beyond just having the government run large deficits. What do they need to do policy wise to get the private sector back into a

sort of aggressive stand. There's a lot of feeling outside Japan that Japan did a very poor job of post post bubble period, but you know, Japan actually managed to keep its GDP above the bubble peak. For the entire thirty years, Japanese GDP never fell below the peak of the bubble. And with that GDP was kept. GDP kept means private sector had the income to pay down debt, and they kept on paying down debt. They were already finished with their payments. The balance seats are probably the

cleanest in the world. But because this experience lost it for so long, people became very averse to borrowing. And if you remember the Americans after the Great Depression, they went through the exactly the same experience, and many of these Americans never borrow money until they die, right because the experience was so bad. And we faced the same problem after when the Japanese bubble burst, and Japanese bubble

was absolutely massive. You know, when the Imperial Palace gardens in the middle of Tokyo about five kilometers, this was the entire state of California. You know how bad the bubble was. True, I've heard that fact many times. That really is true. Well, if you kind of extrapolate from the surrounding areas and they keep on the extrapolating, then you get that result. But I mean, I know they never really put the palace on market. But that's right,

that's so, this is all academic at all. So when the bubble burst, the amount of wealth Japanese loss just on stock market and real estate was like fifteen hundred trillion yen, which is three times Japan's GDP. The amount of wealth the American loss during the Great Depression was equivalent to one year's worth of nineteen twenty nine GDP. Japan was equivalent to three years of nineteen nine GDP. And because it took so long, people began very uh

averse to borrowing. We could have used more policies to encourage people to borrow, like accelerate the depreciation allowances and so forth, and some of those were actually put in place, but those policies have to be super attractive to get these people off the trauma trauma of borrowing money, and the one that we did put in in Japan wasn't all that attractive. Too much paperwork, too many conditions, and so unfortunately they didn't create positive response as much as

we expected. In the US case, after the two thousand eight firsting of the bubble, US actually did a fairly good job of keeping the economy from losing its bottom. And the US companies were never involved in the bubble to begin with. It was the household sector, and so US company could still borrow, and I think US was able to come out sooner than other countries, even the

US was the epicenter of of that crisis. Now this one, it's the household, it's the company's both both sectors are involved, and those effected sectors I'm sure will take a long time to recover, and especially the psychological part. My guess is that once we get to that stage, government will probably tried to come out with incentives to get these guys off the trauma. You know, this is a psychological thing.

So if you make the program super attractive, which is not what Japan did unfortunately, but if you come up with the various active policy and if people said, if it's that attracted, maybe I should try the bar at once, and if they borrow it and then they have a good result, then that trauma will be over and I hope that's how we will overcome this problem after this pandemic is behind us. Mhm. What do you think this

means for the relationship between central banks and governments? Because I'm thinking clearly governments are going to have to borrow a lot of money in order to finance whatever fiscal stimulus they undertake, and I suspect that means that central banks are going to have to step in and help them in some way, either by you know, doing QWI

type asset purchases. But a lot of people are also talking about sort of direct monetary financing by central banks of government debt at this point, do you see that kind of relationship happening, Well, I see probably noticed. I was the strongest opponent of the use of KILLY or use of helicopter money direct financing m m T during balancy recession, because my point was that the recession was caused by the exers savings in the private sector. Everybody's

paying down debt. That means the money needed to finance the government deficit is all in the private sector. So let the private sector financial government debt instead of the central bank. That was my argument all along. That's where I crashed with people like Paul Paul Krugman, who said, what center man should also come into to help. But I argue from the people in the finance as a member of the financial sector, that financial sector is absolutely

flooded with cash. If the private sector cannot even lead to the government, then the private sector will end up lending to in some funny places that could cause another bubble. So I was very much against quee helicopter money kind of arguments during that recession when financial market was flooded with cash. But this time I'm actually all for it. And that's because, for the reason I mentioned two earlier, people are this saving. Now financial market is not flooded

with cash. It's actually seeing cash being withdrawn to make by all these people who are making ends meet. And so if the center bank doesn't come in two finance the deficit, at least in the short run, interest rates can go sky high and that will start causing another set of problems. And so I very much like to see central bank come in and um solve some of these government bonds through quee until we are out of this mess, until some medical solutions are found to this

this crisis. Now, once that medical solution is found in we are out of this pandemic, then Central Bank should be withdrawing that liquidity that it put in during the crisis, because, as I mentioned earlier, by that time private sector should be increasing savings again. Instead of this saving, they will be rebuilding the savings that that they drew down during the pandemic. And when the private sector as a group

is increasing savings, then inflation cannot happen. You know, if the private sector as a group is actually saving money, money multiplier turns negative at the margin, and that's the reason why in the last ten twelve years central bank could never get to their inflation target because if the money multiplies negative at the margin, you know, we can put all the money into the system, you multiply with

the negative number, you go absolutely nowhere. And so once we return to that world, hopefully sooner than later, h at that point, central banks should be withdrawing money slowly at the beginning, so that at the end of the day, god knows how many years that is from now, access liquidity in the financial market is no longer a big issue, and so it has to It has to do tons of liquidity injections during the pandemic when the government needs

the money, when the private sectors withdrawing money financial sector. But once this pandemic is over, when the private sector is now trying to increase savings, then that means there will be no inflation because money multiplies negative of the margin. Then you use that time when the private sector is still rebuilding savings for the central bank to remove some of the liquidity that was put into the system. I think has to go in that sequence. So we've been

talking a lot obviously about corporate behavior post prices. What about in terms of household behavior? You mentioned incentives for corporates, like maybe some sort of tax incentives for capital investment, things like that. When will, of course, in the immediate wink of the crisis that you mentioned, households likely to start to rebuild the savings that they've drawn down to provide sustenance during times of no employment or no income.

What does the so what do the scars of the past tell us about how households will behave in the years, in the years to in the years to come. Well, I think it comes in different phases here. Also during pandemic. Of course, household there are two kinds. Right, If you're still getting paid during this crisis, but you won't be able to spend the money because yeah, in a lockdown world,

these people will be actually saving money. About for those people who are affected by the coronavirus and then their income has dried up, their savings have dried up. When the economy begins to do better, those people will be increasing savings. But for those people who still had income during this period, either by working from home and so forth, in the short run, they will be so happy to

spend money. Right, So when the lockdown is over, pandemics here is behind us, it's normal fear of second wave of third wave. They will be spending a lot of money. So we're gonna have a very sharp V shaped recovery from those kinds of consumption behavior. But at the same time,

this is a global pandemic. Global means that even though the country that came out of the crisis would be seeing some sharp pickup in consumption, that sharp increase I think will peter down as we go along because there are other countries that are still being affected, which means, for example, tourist industries will never really get back to where they will before as long as other countries are still being inaffected. Supply chains will still be affected, foreign

demand will still be affected. And so what I envisioned is that once this pandemic is behind us, there will be a V shaped recovery for perhaps a couple of months, and then it begins to kind of slow down until other economies recovered. And this is different from the UH

seventeen years ago when we had a source experience. Source actually only affected certain parts of Asia only, and so when that pandemic was behind or epidemic was contained, since other countries are all doing quite well, including Japan, those countries that are affected by Source could experience a real

V shaped recovery. But this time the V shaped recovery will be m short lift, and I think it'd be a it would be a very slow recovery until the fear of this coronavirus is completely behind us, and that that's gonna take a long time, because you know, we have so many countries in the world and some of them are just beginning to feel this pandemic. Richard coop Uh, it was great to have you joined us. Really appreciate you coming back to apply some of your wisdom and

theory to this current moment. And I hope you're well and looking forward to hopefully chatting with you again when we see more of what the ultimate recovery eventually looks like. Well, I'm looking forward to it. Thanks so much, Chure. That was great, Treacy. You know what I was thinking about during that um during that discussion is so his book about Richard's book about the aftermath of Japan's Great Recession

is called the Holy Grill of Macroeconomics. But I feel like, just since then, there's been like all these other potential holy grills that have just illuminated so much. Like you think Japan is, like, Okay, this tells us so much, but now we have so many other extraordinary examples of crises intention since then that he could probably write like

four or five sequels by that. Yeah, it's kind of like, maybe I'm carrying the analogy too far, But it's sort of like that scene from Indiana Jones where you have all the different cups right and to choose exactly the right one to fit a situation that you've never really been in before. Wow, Okay, I think I'm stretching that

way too far. I think that really works because that was actually one of the things that was striking to be listening to him is how all of these crises are similar but just like a little bit different, And it's really important to appreciate the subtle differences, whether it's the corporate set there there was participating in the bubble, whether it's real estate, households, et cetera, to understand like sort of like which policy or responses are going to

work back. Yeah, it's also really interesting to hear from someone who was against KIWI in the previous crisis really talk about the need for it here and even sort of hint at a layer of modern monetary theory or direct monetary financing or whatever you want to call it um sort of being necessary this time around. That's a big change, right, the idea of more explicit cooperation and coordination between the central Bank and the and the fiscal authorities.

Actually just think like, and you brought it up at the beginning, the psychological component of recovery is going to be so huge because so many households in businesses have experienced the laws of income. That was that was fathom ale. I mean basically a dent losses in many cases in the span of a few weeks. Nobody really anticipates that

kind of downturn. Plus the behavioral changes associated with the health emergency and the way all of our lives have just changed going on day to day living, it really feels like that's going to be such a big component obviously what any recovery looks like. Yeah, it sort of reminds me of those stories you hear about people who survived the Great Depression and then ended up, for instance,

hoarding food for the rest of their lives. Like, I'm sure there are going to be those sorts of lingering emotional effects and we're all going to be hoarding toilet paper or something like that forever, or at least keeping more in the house than we used to. But on a on a serious note, the other thing that I think is really important was his point about the pace of the recovery, because it's certainly something we've experienced here

in Hong Kong. Even if Hong Kong starts to recover and the number of new coronavirus cases starts to go down, when it picks up elsewhere in the world and we see economies elsewhere start to shut down. That's of has a ripple effect and comes back to hit Hong Kong. So even if one country recovers, if the rest of the world is in trouble, it's going to prolong the

economic pain. Yeah. I really liked his point about there will be some people around the world, people who managed to hold onto their incomes and jobs during the duration of the crisis, who will probably go on some sort of big spending spree the moment they can going out shopping and restaurants, etcetera. And you might get the appearance of a V. But the sort of the widespread nous of the crisis and the unevenness of the page at which different parts of the economy opens up almost guarantees

that that can't last very long. It will be very uneven. So even if we get a little V probably won't turn into a true V, lowercase V versus a big V. God another another letter to add to the to the to the right. That's good, all right, Um, should we leave with there? Let's leave with there? Okay. This has been another episode of the All Thoughts podcast. I'm Tracy Halloway. You can follow me on Twitter at Tracy Halloway and I'm Joe, Why Isn't All? You can follow me on

Twitter at The Stalwart. Be sure to follow our producer Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesco Levie at Francesca Today, as well as all of the Bloomberg podcasts under the handle at podcasts. Thanks for listening.