Some add-on thoughts to yesterday´s article of Martin Wolf (Financial Times “Japan’s lessons for a world of balance-sheet deflation”) about balance sheet recessions.

In summer 2008 Richard Koo, Chief economist at the Nomura Research Institute, published “The Holy Grail of Macroeconomics”, the updated edition of an earlier publication about balance sheet recessions. His empirical analysis carries mostly unknown knowledge about the burst of asset-price-bubbles.

Bernanke once said the one with the most coherent analysis of the years before and during the Great Depression in the US, will have the “Holy Grail” of macroenconomics in his hands. Koo not only researched the US in the 1930s but also an equally traumatic episode in the history of business: the two decades lasting recession and deflation in Japan. In the comparison of both he highlights similarities & differences and tries to extract universally valid conclusions.

Koo´s core hypothesis: the “lost 15 years” in Japan were not lost at all. When the Japanese asset bubble burst in the early 90s, 1500 trillion Yen were lost – 3x Japan´s nominal GDP at that time. The US lost ´only´ 1x nom GDP during the Great Depression. The real GDP of the US dropped 46% during 4 years (1929-1932), the unemployment rate rose to 25%. Comparing to an avg GDP growth of 2% p.a. and an unemployment rate of below 5%, Japan played it well.

Wolf fingerpoints correctly that:

Yet what is happening inside the US is far from the worst news. That is the global reach of the crisis. Japan was able to rely on exports to a buoyant world economy. This crisis is global: the bubbles and associated spending booms spread across much of the western world, as did the financial mania and purchases of bad assets. Economies directly affected account for close to half of the world economy. Economies indirectly affected, via falling external demand and collapsing finance, account for the rest. The US, it is clear, remains the core of the world economy.

As a result, we confront a balance-sheet deflation that, albeit far shallower than that in Japan in the 1990s, has a far wider reach. It is, for this reason, fanciful to imagine a swift and strong return to global growth. Where is the demand to come from? From over-indebted western consumers? Hardly. From emerging country consumers? Unlikely. From fiscal expansion? Up to a point. But this still looks too weak and too unbalanced, with much coming from the US. China is helping, but the eurozone and Japan seem paralysed, while most emerging economies cannot now risk aggressive action.

Who are the players that can support the world economy with a large, solid balance sheets? Not many of the big players are solvent enough. Besides the USA  we have Germany waiting on the sideline. The largest economy of the EU is not paralyzed but shocked and concerned. It was taught by history that too much of monetary easing can lead to a catastrophy (WW II).

I think the concerns are emtionally understandable but economically baseless. Koo´s research has clearly shown, that Japan´s budget and state deficits did not lead to astronomically high inflation and sky-rocketing gov bond yields. Germany is a large and well respected lender in the world and therefore in a comparable situation. Germany has extensive financial scope. The 10y German gov bond yield just dropped to 3% despite the 2 announced stimuli packages.

Merkel, take it as a hint.