Economics is a discipline for quiet times. The profession, it turns out, may be quite good at understanding the day-to-day routines of normally functioning market economies, but it did not see the credit crunch and Great Recession coming, and even now has little idea of where we are heading. It has no grip on understanding how the abnormal grows out of the normal and what happens next, its practitioners like weather forecasters who don't understand storms.
The great leaps in economic understanding have come with individual political economists struggling with the abnormal. Adam Smith wrestled with the strange new phenomenon of industrialisation in the 1770s. John Maynard Keynes in the 1930s fought to understand depressions. Milton Friedman tried to explain stagflation in the 1970s. Today, some of the world's best economists - Paul Krugman, Robert Shiller, Larry Summers - are pointing to another figure who is opening up economic understanding in the same dramatic way.
He is Richard Koo, chief economist of Japan's Nomura Research Institute. He too has been wrestling with the abnormal - the fallout of a credit crunch in the £3tn Japanese economy. His prognosis is alarming. The Americans, British and especially the mainland Europeans are far too complacent. We simply don't understand what happens to firms and economies after a credit crunch.
We are anticipating green shoots and sustained recovery far too early. Indeed, unless western governments spend and borrow beyond anybody's current imagining, the risk is that the west - and Britain with it - could still topple into a 1930s-style depression. David Cameron's Tories insist Britain has to reduce its budget deficit fast - just like German fiscal conservatives - but they are basing their judgments on fair-weather times and fair-weather economics. What we are living through is so abnormal it requires abnormal responses.
Koo's thinking is informed by witnessing at first hand Japan's credit crunch and post- credit-crunch recession. A diminutive and neat figure, he talks with the quiet conviction of an economist who has developed a model of the world that works. He began his career with the Federal Reserve Bank of New York, before moving to Tokyo and becoming a close adviser of successive governments as they battled with Japan's never-ending recession of the 1990s and early 2000s. The market fundamentalist Americans lectured the Japanese on the necessity of tackling their structural problems - overstretched banks, commitment to lifelong employment, too much government influence over the economy, etc, etc. All were wrong - and completely missed the drama that was going on before everyone's eyes if they had the wit to see it.
Koo observed that Japanese firms in the 1990s and early 2000s had changed from profit maximisers to debt minimisers. Between 1970 and the early 1990s during the long yang ("sun" or "light") upswing, they had steadily built up their debts to finance investment and growth; from the early 1990s on they used every spare yen to pay these off. Even as interest rates fell to zero and firms seemed to have profitable opportunities for growth, they would still pay off their debts rather than invest. Japan's $15tn collapse in asset and share prices - equivalent to three years' GDP - traumatised them, because it meant that their grossly devalued assets no longer matched their liabilities. To restore their balance sheets to health they had to reduce their debts. Demand from Japan's corporate sector dropped by 20%.
Economies move in long upward and downward cycles, and in the yin ("moon", "dark") downswing, firms' behaviour changes so completely that the impact of interest rates and fiscal policy changes completely as well. Monetary policy loses its traction. There is no demand for money at any interest rate, because firms in the yin phase are debt minimisers.
Japan is criticised widely for allowing its national debt to rise to 180% of GDP after year after year of high budget deficits. Koo's reply is that, given the scale of the shock, without government deficits Japan would have experienced a 1930s-style US depression. Indeed, in The Holy Grail of Macro Economics (2008), he explains the Great Depression as a result of US companies becoming debt minimisers in the wake of a property crash and banking collapse that was not compensated by sufficiently large increases in federal spending and borrowing. Koo's "super Keynesianism" applies in the downward yin phases of the cycle; he is much more orthodox on yang phases. Don't worry about debt-rating agencies marking down high-spending governments' debts, he says; investors will buy public debt in yin phases - just as they will Britain's or the US's.
In Britain it is plain that a large number of companies are moving from being profit maximisers to debt minimisers. We have suffered a value collapse approaching £2tn - equivalent to 18 months' GDP. Less than Japan, but still traumatising. Companies may be less indebted than Japan's in the 1990s, but by British standards debt is high. Lending to companies fell in both April and May. Part of the problem is that loans are astonishingly expensive because of Britain's monopolistic, risk-averse banks charging the highest margins and fees in the G7. The result is that companies are repaying debt and not investing. As in Japan, low interest rates are having little traction.
The pound's huge devaluation and starting with low levels of public debt means that we are better placed than others. Yet, looking around the North Atlantic economy, it is clear that debt minimisation strategies are becoming commonplace. This is the story in the US and in Germany. Indeed, as Paul Krugman argued in my interview with him last month, Germany could become "Nipponised", relying on exporting its problems to the rest of Europe.
Even if Koo is only partly right, the economic debate in Britain and beyond is out to lunch. The consensus is to assail Gordon Brown for dishonesty and political disingenuity for still arguing that the state can maintain spending and borrowing despite a budget deficit this year of £175bn; leader-writers across the political spectrum congratulate themselves for their economic literacy in damning him for not saying where and what he is going to cut. A more telling criticism is that he is not spelling out how serious the situation is - and has lost his nerve over the radicalism that will still be needed to get through.
Obviously Britain cannot run deficits of 12% of GDP indefinitely - but cutting them aggressively in a world of debt minimisers will prompt a depression. The correct policy is three-pronged. The government must spend and borrow radically until the downward phase stabilises - but in such a way that spending commitments can then be radically reduced in stabler times. New banks need to be created and old banks broken up to deliver more competition, more credit flows to business and less systemic risk.
This is the yin leg of the cycle. It needs yin responses. Tough talk about deficit reduction must wait until calmer times.
Copyright Speakers Corner 2017