Nomura Securities Co Ltd, Tokyo 8 June 2010

Economic Research – Flash Report

Richard Koo: a personal view of the macroeconomy

Kan replaces Hatoyama as PM after Futenma imbroglio

It has been several weeks since my last report. During that time the eurozone turmoil sparked
Date
by problems in Greece grew and spread to Hungary. The euro weakened further and gold
resumed its rise amid a global equities correction. 8 June 2010
(issued in Japanese on 7 June 2010)
The US payrolls report for May, released last Friday, was also a disappointment: despite a
headline increase of 430,000 jobs, the private sector generated only slightly more than 40,000
jobs when temporary hirings of census workers are excluded. R. Koo
r-koo@nri.co.jp
In Japan, Yukio Hatoyama resigned as prime minister after being driven into a corner on the Chief economist
Futenma air base issue, and the DPJ chose Naoto Kan to succeed him. Nomura Research Institute, Tokyo

* Pragmatism informs Kan’s economic perspective Nomura research sites:

www.nomura.com/research
I would first like to touch on Mr. Kan’s policy skills and vision. As noted in previous reports, his Bloomberg: NMR
primary interest lies in social and not economic issues. He played a particularly important role in
obtaining relief for hemophiliacs who contracted AIDS via contaminated blood products.

A survey of his past statements and actions reveals a careful observance of the ideals of social
justice and democracy. It also leaves the impression that he is less interested in economic
matters, particularly macroeconomic matters. Please read the important
disclosures and disclaimers
But at the same time, the fact that he is not tied to a single economic theory or set of economic on pages 8–9. gl
principles allows him to adopt a pragmatic and flexible stance on economic matters. I suspect
this characteristic will receive more attention as the market digests the new administration’s
policies.

* Was Kan’s “tolerance” of weaker yen born out of economic pragmatism?

A prominent recent example of this pragmatism can be found in Mr. Kan’s indication soon after
becoming Minister of Finance that he would be willing to tolerate a weaker yen. In the statement
in question, made in January, he did not actually call for a weaker yen—he merely said that
many companies were in favor of a weaker yen. The markets, however, interpreted the
comment as an attempt to guide the currency lower.

The statement hardly came as a surprise, given that the yen has become perhaps the world’s
strongest currency, causing great suffering among Japan’s export-dependent manufacturers.
Too, many investors in Japanese equities argue that a weaker yen is the quickest shortcut to
higher share prices in Japan. Against this backdrop, it would hardly be surprising if Mr. Kan
envisioned a scenario in which a weaker yen pushed stock prices higher, thereby contributing to
a Japanese economic recovery.

* Aso and Fujii saved global economy from competitive currency devaluations

In contrast, Yasuhisa Fujii—Mr. Kan’s predecessor at the Ministry of Finance—and former

Prime Minister Taro Aso had a deep understanding of both the real economy and economic
history. They were well aware that when the global economy faced a similar crisis in the 1930s
and countries tried to export their way out of their problems, the result was a round of
competitive currency devaluations that led to protectionist measures and, ultimately, a global
economic collapse.

Mr. Aso and Mr. Fujii feared that if Japan—a trade surplus nation—were to guide its currency
lower, it would provoke a round of competitive devaluations by the US and other trade deficit
nations. Consequently, they never suggested that a weaker yen would be preferable or even
tolerated, which was understandably quite unpopular within Japan.

1 Nomura Research
8 June 2010

Inasmuch as Japanese currency intervention to soften the yen could have sent the global
economy back to the 1930s, the strong principles of Mr. Aso and Mr. Fujii and their refusal to
take the easy way out by devaluing the yen helped save the world economy.

In that sense, it was extremely fortunate—both for Japan and the global economy—that these
two men, with their extensive knowledge of economics and economic history, were at the
controls at this pivotal moment in economic history following the Lehman collapse.

* Kan’s decision saved Japanese economy in 1998

On the other hand, we should not overlook the fact that Mr. Kan’s pragmatic flexibility and his
desire to do the right thing for the people—and not just for his party—once saved the Japanese
economy and its financial system.

In 1998 the Japanese economy was in serious trouble and faced a growing number of problems
in the banking sector. Local banks were forced to pay a “Japan premium” to borrow on
international capital markets, and Long-Term Credit Bank of Japan and Nippon Credit Bank
went under.

Meanwhile, the Hashimoto administration’s fiscal consolidation policies sparked stock market
investors to “sell Japan,” which in turn pushed the yen sharply lower. This double weakness in
the yen and Japanese equities served to lower the capital adequacy ratios of Japanese banks
as their dollar-denominated assets grew and the unrealized gains on their cross-shareholdings
fell sharply. The result was an unprecedented credit crunch.

To address this situation it was essential that the government inject capital into the banking
system and get banks lending again. But the opposition parties were violently opposed to this
strategy—it was simply out of the question, they said, to spend the money of already suffering
taxpayers to save banks and their high-earning employees.

The situation grew steadily worse, and it was thought to be only a matter of time before Japan
experienced large-scale bank runs.

The situation was so serious that I was asked to appear on television programs every week to
explain why the banking system needed a capital infusion. The ruling LDP, on the other hand,
had just experienced a major defeat in the summer upper house election, draining its strength
and vitality.

* Kan’s idealism saved Japan’s economy

It was at this point that a miracle occurred. Mr. Kan was the leader of the main opposition party,
which had been violently opposed to a bailout. Yet he offered to end his opposition to the
Financial Reconstruction Law if the LDP agreed to certain conditions.

These conditions were not particularly onerous, and they were accepted as-is by the LDP. As a
result, the Financial Reconstruction Law finally became law, and Japan managed to pull through
its worst postwar financial crisis.

If Mr. Kan had not changed his stance, the LDP government might well have collapsed, giving
way to a DPJ administration. That, in turn, could have cast Japan’s financial sector into the
abyss.

But Mr. Kan gave precedence to saving the economy and financial sector and left the
opportunity for his party to take power for another day. His decision effectively delayed the birth
of a DPJ government by a decade.

In my view, this story reflects Mr. Kan’s idealism—specifically, his view that the party’s interests
should be sacrificed if necessary to save the nation and its people. His decision, on the other
hand, generated a great deal of debate within the DPJ at the time.

I remember speaking to a DPJ representative immediately after the Financial Reconstruction

Nomura Research 2
 8 June 2010

Law passed. When I remarked that Mr. Kan had performed a great service by choosing his
country over his party, she said the situation within the party had been very difficult.

In a subsequent magazine interview, Mr. Kan said Ichiro Ozawa had told him that he didn’t
understand politics and had made a major mistake by not taking advantage of the party’s
chance to topple the LDP.

* Kan’s political philosophy likely to lead to more politically driven policy decisions

In the same interview, Mr. Kan said that administrative reform is the goal of a change in
government. That belief stems from his deep-seated concern that the concept of “neutrality” and
“continuity” so highly valued by the bureaucrats who had traditionally governed Japan was
fundamentally inconsistent with the principles of democracy.

Mr. Kan believed that 70% of the policy decisions in Japan were made by bureaucrats and just
30% by the politicians. That implied that no matter which party the people elected—including the
Japan Communist Party—70% of policies would not change. The principle of popular
sovereignty cannot exist under such conditions, nor can we expect meaningful changes in policy
based on the people’s will.

The LDP had thrived in this system for half a century and was not in a position to implement
administrative reform. That is why it was necessary for the DPJ—which was not bound by the
past—to take power and develop an administrative system capable of reflecting popular
sovereignty.

If this reflects the core of Mr. Kan’s underlying political philosophy, I suspect we will see more
decisions made by politicians instead of bureaucrats. Mr. Kan’s appointment of ex-Itochu
president Uichiro Niwa to serve as ambassador to China (as opposed to someone from the
Ministry of Foreign Affairs) is part of this shift.

At the same time, Mr. Kan differs from Mr. Hatoyama in having experience as a cabinet minister
and, as he demonstrated in the AIDS-contaminated blood scandal, being skilled at managing
bureaucrats. In that sense, I think there is a real possibility that he will bring something new to
the table. That would be a welcome relief from the last eight months, which have been
characterized by steady conflict and turmoil between politicians and bureaucrats with few
decisions being made.

* Policy views of Kan’s economic “brain,” Osaka University’s Yoshiyasu Ono

Mr. Kan’s partner in the aforementioned magazine dialog was Yoshiyasu Ono, an Osaka
University professor who is said to be Mr. Kan’s key advisor on economics issues and who was
recently appointed cabinet consultant. The two apparently saw eye to eye from the time they
met for this interview in November 1999.

Strangely enough, I participated in a dialogue with Mr. Ono for the same magazine in February
2001. I remember quite well that, with one exception, our views were in perfect agreement. (All
of the dialogues in this series were subsequently gathered together in Mr. Ono’s book,
Reducing Spending Won’t End the Recession [Japanese]).

Mr. Ono argued that during a severe recession with high unemployment, structural reforms will
only create more unemployment and will not boost the economy. At such times, he argued, the
government needs to engage in public works spending in order to boost demand.

He was also well aware of macro- and micro-level differences. Companies, for example, can lay
off staff in order to enhance efficiency, but a country cannot “lay off” citizens working at
inefficient businesses. As such, he said, the kind of “efficiency” that should be pursued by
companies and governments is naturally different.

I concurred wholeheartedly. We also shared a taste for the term “fallacy of composition,” which
arises when what is good (i.e., the right behavior) for the individual, when taken together, is

3 Nomura Research
8 June 2010

actually counter productive for the group.

Both of us had strong reservations about the simplistic argument—which was extremely popular
at the time in Japan and elsewhere—that micro-level improvements via structural reforms and
self-help efforts would naturally lead to improvements in the macro situation.

Japan was suffering from all sorts of fallacies of composition at the time: the harder the private
sector tried to improve its position—whether it was companies deleveraging or banks disposing
of nonperforming loans—the sicker the economy grew and the further asset prices fell. This was
clearly not the simplistic situation described in economics textbooks.

* Quantity beats quality for public works spending during balance sheet recessions

There was one point on which I disagreed with Mr. Ono. I felt his view that public works projects
had to be useful undertakings in order to help the economy reflected a lack of understanding of
the causes of the recession.

My position was that the Japanese economy had fallen into a balance sheet recession, which
results when the private sector seeks to minimize debt rather than maximize profit.

GDP cannot be maintained in such situations unless the government steps in to borrow (and
spend) the surplus savings resulting from private-sector deleveraging. The question of how the
government spends the savings is of secondary importance.

In a world in which damaged balance sheets leave businesses and households paying down
debt and unwilling to borrow money despite zero interest rates, demand shrinks by the amount
of private savings. Assuming a private savings rate of 10%, what started out as income of
¥1,000 will progressively contract to ¥900, ¥810, ¥729, and so on.

If the government stands back and does nothing to stop this process, the jobs supported by the
borrowing and spending of this money will be lost, and the situation will continue to deteriorate
until the private-sector deleveraging process stops.

If we accept that unemployment represents the worst possible allocation of economic resources,
the government’s first priority under such circumstances should be to prevent the economy from
falling into a deflationary spiral by borrowing and spending surplus private savings. In the
example above, the government would need to borrow and spend the initial ¥100 in savings
(10% of ¥1,000). When added to the ¥900 spent by the private sector, this would ensure that
total spending remained at ¥1,000.

Under such circumstances, I argued, it was not an option for the government to stand by and do
nothing because it could not find any worthwhile projects to invest in.

* “Empty” public works projects not always meaningless

Although Mr. Ono agreed that Japan suffered from a severe demand shortage, he did not think
the shortage would grow worse without government action. Hence he could argue that for the
government to invest in empty public works projects would be tantamount to doing nothing at all.
But if the government does nothing at all during a balance sheet recession, the demand
contraction will spiral out of control.

As a taxpayer myself, I am no happier than anyone else when my taxes are used to pay for
empty projects. But at a time when private businesses are paying down debt (and thereby
creating a deflationary gap) worth ¥30trn a year, or 6% of GDP, it was clearly not the time to be
worrying about the quality of the projects. If the government had decided not to borrow this
¥30trn because there were no worthwhile projects available, Japan’s GDP could have shrunk by
¥30trn a year.

In effect, Mr. Ono and I were in agreement that Japan’s economic problems could not be
addressed by the kind of structural reforms being promoted by Prime Minister Koizumi and
Heizo Takenaka and that public works projects were necessary, but we disagreed on the

Nomura Research 4
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content of those projects.

* Content of public works projects will greatly influence future of Japan’s economy

Today the situation is very different. Japan is clearly in the final stages of its balance sheet
recession. Although there has been some increase in savings and debt paydowns since the
Lehman crisis, the private sector has finished repairing its balance sheet, and there is little risk
of the economy falling into a deflationary spiral, unlike the situation a decade ago.

On a less positive note, the US and European economies face a severe shortage of demand
resulting from the collapse of the housing bubble, and Japanese output remains at the levels of
2003.

And for the first time in history other economies, especially China, are giving chase to Japan.
China has home-grown technology to build nuclear submarines and rockets for outer space. Its
foreign reserves exceed $2trn, and it has 1bn industrious workers willing to work for a fraction of
what their Japanese counterparts earn.

If Japan is to stay ahead of this challenge and maintain a developed-world standard of living for
its citizens, it must continue to provide the most advanced goods and services, which will
require further scientific and technological advances along with training and education. The
government has an essential role to play in these efforts.

In summary, Japan (1) faces a shortage of demand (more accurately, a shortage of external
demand) and (2) is being pursued by strong economic competitors. Under such circumstances,
the government’s ability to spend money on areas with future potential is critical to the
economy’s future. The kind of public works projects undertaken in the coming years, therefore,
will have a major bearing on the nation’s future.

When a government decides to engage in public works spending to stimulate the economy, the
question of whether to focus primarily on quantity (the amount of money spent) or quality (the
kinds of projects pursued) depends on the prevailing conditions in the economy. In that sense,
the issue of the content of projects that Mr. Ono was talking about 10 years ago has become a
critical issue today.

* Japan can use debt to fund projects without raising taxes

Recently, however, Mr. Ono and Mr. Kan have suggested that the government should increase
public works spending even if that means raising taxes. I disagree with the second part of that
argument.

I suspect their view is based on the assumption that the government can no longer fund its
deficits in the financial markets. This stance not only ignores the market reality but is quite
dangerous.

Markets exist to discover the price that equates demand with supply. In the market for
government debt, that price is the price of government bonds or the inversely related yield on
those bonds.

Today, Japanese government bonds are priced near all-time highs, with the yield on the 10-year
JGB trading at less than 1.3%.

This is far less than the record low yield of 1.85% on 10-year US Treasurys during the Great
Depression 70 years ago. It highlights the absence of attractive private investment opportunities
at a time when corporate deleveraging and household savings have created a large surplus of
savings.

Contributing to this situation is an aversion to debt at Japanese companies, which spent 15

years paying back loans after the bubble collapsed. Now that they have finally emerged from
this debt “hell” and cleaned up their balance sheets, many are determined never to borrow
money again—even at zero interest rates.

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8 June 2010

At a time when the private sector continues to be characterized by a massive surplus of savings,
I find it hard to understand the argument that the government needs to raise money via taxes. It
does not.

* Tax hike would depress economy even if proceeds were spent on public works

Economics has a concept called a balanced budget multiplier, which says that public works
spending will still provide a stimulus to the economy even if it is funded with a tax hike.

According to this concept, some of the money collected through higher taxes represents money
that the private sector would otherwise have saved. By spending that money, the government
can stimulate the economy while maintaining a balanced budget.

But today’s world is a far cry from that described in the economics textbooks. Ten-year
government bond yields of less than 1.3% imply that private loan demand is virtually nonexistent.
If the government were to tax more and issue less debt, the private sector would not step in to
borrow the money that the government had stopped borrowing. That money would then drop out
of the economy’s income cycle, creating a new deflationary gap.

If the resulting hit to the economy exceeded the stimulus from (tax hike-funded) public works
spending, the economy would suffer on balance. I think the possibility of that happening is quite
large under current conditions.

* Taxes can be hiked after private loan demand normalizes

To be more precise, if the kinds of promising public works projects envisioned by Mr. Kan and
Mr. Ono are implemented in addition to existing projects, I think the overall economic impact will
be positive even if the additional spending is financed by a tax increase.

But if the new projects are simply substituted for existing projects and funding for them is shifted
from debt issuance to a tax increase, the private sector will have less money to spend for the
same the government outlays, weighing on the economy.

For the past decade Japanese government bonds have traded at record prices, and the
government has experienced absolutely no problems in financing its deficits. The greater
concern, in my view, is that businesses and households remain averse to debt, as happened in
the US following the Great Depression, and private loan demand refuses to recover, leaving
interest rates anchored at low levels.

The government’s first priority should be to tackle this issue and create an environment
conducive to higher private-sector investment. Once private loan demand has recovered, then
we can discuss the issue of whether to finance remaining projects with higher taxes.

* Instead of worrying about spike in interest rates, we should be asking why rates remain
low

On recent trips to the US and Sweden, I spoke with people in both financial and academic
circles. Many continued to argue that countries, including Japan, should engage in fiscal
consolidation now because, while bond yields may be low today, there is no telling when they
might spike higher. “Look at what happened in Greece,” they said.

But people have been saying the same thing about Japan for 15 years, and their concerns have
never been realized. When someone is wrong for 15 years running, his time would be better
spent asking why he has been so wrong for so long than predicting the same outcome for the
16th year.

From that perspective, the last 15 years in Japan—and more recent periods in the US and
Europe—have with few exceptions (one of which was Greece) been characterized by a sharp
increase in private savings and debt paydowns. The government has effectively become the
sole remaining borrower in these economies. In other words, there is plenty of excess private
sector savings to finance government debt.

Nomura Research 6
 8 June 2010

Germany has completely disregarded this surplus of private savings and is not only pursuing
fiscal consolidation on its own but is trying to force the entire eurozone to do so. This is not only
a major policy blunder but also an extremely dangerous one. If Europe follows Germany’s lead
despite its private savings surplus, its economic slump and market turmoil will only grow worse.

* Premature fiscal consolidation is a threat to democracy

Pushing ahead with these misguided policies risks a collapse of social and economic
foundations and could even threaten the survival of democratic structures. A good example is
prewar Germany’s Brüning cabinet, which insisted on fiscal retrenchment and allowed the
emergence of Hitler in the 1930s. The risk is especially high in Central and Southern European
countries, which have a relatively short history of democracy.

Ultimately, I think the reason so many academics and pundits do not trust current low yields on
government debt and expect them to rise suddenly is that they do not trust the market economy.
When a price level set by the market persists for many years, we need to realize that there is an
underlying economic structure supporting those prices.

What governments—including Japan’s new administration—should be thinking about is how to

find promising public works projects and implement them in order to offset the deflationary
pressures from private-sector deleveraging and provide the private sector with a sense of
direction.

When private loan demand is nonexistent, the government must do whatever is necessary to
find and carry out promising public works projects (including education and environment-related
projects) without worrying about tax hikes.

Richard Koo’s next article is scheduled for release on 15 June 2010.

7 Nomura Research
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policies, maintenance of a Stop List and a Watch List, personal account dealing rules, policies and procedures for managing conflicts of interest
arising from the allocation and pricing of securities and impartial investment research and disclosure to clients via client documentation.

Disclosure information is available at the Nomura Disclosure web page:

http://www.nomura.com/research/pages/disclosures/disclosures.aspx