The Holy Grail of Macroeconomics

Koo, chief economist at Nomura Research Institute, developed the concept of a balance sheet recession from Japan's experience after 1990 and argues it explains why conventional monetary policy failed there and would fail elsewhere in similar conditions.

His mechanism is specific. When an asset price bubble collapses, the assets purchased with debt lose value while the debt remains, leaving firms and households technically insolvent on a mark-to-market basis but still generating cash flow. Their rational response is to direct all available cash to debt repayment rather than to investment, and to continue doing so until balance sheets are repaired. Because this happens simultaneously across the entire private sector, aggregate demand collapses. Monetary policy cannot help, because the problem is not the price of credit but that nobody wants to borrow at any price. Koo documents that Japanese corporate borrowing was negative for years despite zero interest rates.

His policy conclusion is that only sustained government deficit spending can offset the private sector's simultaneous deleveraging, and that Japan's repeated attempts to reduce the deficit prematurely, particularly in 1997, caused the relapses that made the period appear to be a failure of stimulus rather than a failure to sustain it.

The framework was substantially applied by others after 2008. Critics argue Koo underweights structural problems in Japan, understates the costs of accumulated public debt, and treats his own diagnosis as more complete than it is.