Monday, February 01, 2010

To: Martin Wolf. From: Richard Werner

Here's a funny thing about economics. Martin Wolf is one of the top economic journalists on the Financial Times and has twice in the past year written about the findings of Nomura Research economist Richard Koo. The most recent article by MW (FT. 12 Jan 2010)  has prompted a response from Richard Werner (Prof. of International Banking at Southampton University).  Werner was at the centre of Japanese economics since the late 1980's and he wrote several books on it including the best selling Princes of the Yen (2003) explaining why Japan had been so economically successful since its defeat in WW2, AND why it struggled since the 1990's and has done ever since. 

You would have thought that the FT would be interested in comment from Werner in the interests of open discussion to find solutions to seemingly intractable problems. 

But no. Despite Werner's regular responses by letter to the FT , (with the notable recent exception of one in September 2009) the FT seems to block Werner's insights. The problem for Werner is that he gives ordinary people understanding into the the secrets of banking.
One can only deduce that the FT is more interested in trying to keep these smothered. I wonder why?     

Werner has given me his most recent January 2010 FT (not published) letter to post here,  and another below it from February 2009 (not published) . The most recent one is first.  

The Editor, The Financial Times
Dear Sir,

Martin Wolf rightly reminds us of the continued problems Japan is facing, and wonders whether we have learned the lessons (‘What we can learn from Japan’s decades of trouble’). Unfortunately, Mr Wolf seems to have forgotten to mention them. He cites Richard Koo, who argues that for the past twenty years companies and households did not wish to borrow. The ‘lack of demand for money’ argument has been repeated like a mantra by the Bank of Japan as excuse for policy inaction – despite strong evidence that small and medium-sized firms have been desperate to obtain funding, and ditto for the government (highlighted by Mr Wolf’s own public debt statistics). So clearly, there has been demand for money. The problem has been – as the current global financial crisis has established as universal issue – that banks, when burdened with bad debts from prior misguided speculative lending, will reduce their willingness and ability to extend credit. This restricts the money supply and hence domestic demand.

Mr Wolf also cites Mr Koo’s argument that fiscal policy has been helpful, despite the fact that fiscal policy disappointed each time it was used – with the economy consistently falling far short of the predictions made by forecasters prior to the announcement of the fiscal stimulation packages. Mr Wolf focuses on two further weaknesses in Mr Koo’s argument, namely the lack of explanation of the sizeable debt overhang, and why Japan has remained vulnerable, despite twenty years of ‘balance sheet adjustment’. His answer, that there is an ‘underlying structural problem’ echoes the other mantra of the Bank of Japan, and its other excuse for failing to implement suitable monetary policy, namely that Japan’s recession is due to structural problems. However, structural policy (aka ‘supply side policy’) aims at raising potential output. Since actual output and factor utilisation has consistently remained short of potential, it is the demand side that has held the economy back. Successful structural policy could at best raise potential output. Since deflation is a function of the size of the gap between potential and actual output, this would merely increase deflation and do nothing about boosting demand.

It may be pertinent to consult those ‘few’, as Martin Wolf mentioned them, who correctly predicted almost twenty years ago that Japan was likely to head into a banking crisis and economic depression: since 1991 I have warned of this possibility. My policy recommendations on how to end the recession and sustainably boost the economy should also be of interest; perhaps in his next column.


Richard Werner, D.Phil. (Oxon)
Professor of International Banking
School of Management
University of Southampton
Southampton SO17 1BJ

This one below dated 19 Feb 2009:
Dear Sir,

Martin Wolf praises Richard Koo’s recent book (18 February, Japanese lessons for a world of balance sheet deflation), which re-iterates Richard’s argument that the Japanese recession is a ‘balance sheet’ recession. Mr Wolf even calls it the best book on Japan’s experience. Indeed, Richard’s argument about the recession being a ‘balance sheet’ recession is accurate up to a point. That point arrives fairly early. For his analysis fails to reflect properly the role and mechanics of the most important balance sheet of all – that of the banking system. So what is missing in the argument is the true Holy Grail of understanding economics: the role of credit creation. In Richard’s argument credit demand drives credit supply. This flies in the face of ubiquitous evidence today that banks are restricting credit supply – as well as the facts of Japan since the early 1990s. Joe Stiglitz and others have made a convincing case that banks always ration credit – even in good times – as the demand for something as desirable as money is so high that it would drive equilibrium interest rates beyond healthy levels: the sensible projects would be discouraged and banks would be left with the crazy proposals whose default rates are high. A rationed credit market is thus determined by the supply of bank credit. Whether banks will still create an asset bubble that will turn into bad debts, inflation or instead non-inflationary growth depends simply on who they lend the money to and what use it is put to.

Without an understanding of the role of bank balance sheets, Richard – as well as the day’s FT’s editorial writer – had to overstate the role of fiscal policy. Its key aspect is that it does not create credit. Thus it can’t help, as the Japanese case has demonstrated: I have shown that for every yen in government expenditure, private demand shrank by one yen, delivering complete crowding out. This crowding out happens not via interest rates, but via balance sheets (something Richard should take a look at): total balance sheet growth of the economy is restricted by the balance sheet growth of the banking system. When it does not grow, or even shrinks (i.e. there is insufficient credit creation), the economy will not grow. Fiscal policy does not create credit and hence cannot grow balance sheets. Conventional monetary policy cannot help either, because the credit market is rationed and thus lowering rates does not necessarily increase credit creation. Fed chief Bernanke – another expert on the Japanese experience – explained quite well in his LSE lecture last month why he is therefore not following the Bank of Japan’s policies, but instead intends to boost total banking system credit creation. That’s the only policy that can blow up balance sheets again. As I argue, this can be linked successfully to fiscal policy by ensuring its monetisation. There are other policies that have proven effective in the past. But they all involve boosting credit creation. I recommend Mr Wolf, as well as Richard Koo, to read my 2005 book ‘New Paradigm in Macroeconomics’, which draws on the Japanese experience, but also predicted the UK banking collapse.

Professor Richard A. Werner
Director, Centre for Banking, Finance and Sustainable Development
School of Management
University of Southampton
Southampton SO17 1BJ

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