Book Review on The Holy Grail of Macroeconomics

Book Review on The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession by Richard C. Koo (Chief Economist of Nomura Research Institute, the research arm of Nomura Securities. Previously an economist with the Federal Reserve Bank of New York, and a Doctoral Fellow of the Board of Governors of the Federal Reserve System). Published in 2008.

This is an excellent excellent book. The arguments are logical, sound, concise, and backed up by data — what every book should do! The title of the book came from Bernanke’s remark in 1995 that “to understand the Great Depression is the Holy Grail of macroeconomics”. Richard Koo argues that both the Great Depression and Japan’s two decades of recession are balance sheet recessions.

Key Points:

Japan’s Recession

  1. Reasons ascribed by others
    1. Cultural or structural deficiency (journalists and general public)
    2. Failure of monetary policy (academics). Krugman pushed for QE and inflation targets. Bernanke argued for monetization of government debt (i.e. Central bank prints money to buy Government debt). Svensson and Eggertsson recommended price-level targeting and currency depreciation.
    3. Banking sector problem (Finance sector)
  2. Structural problems and banking-sector issues cannot explain Japan’s long recession

Characteristics of Balance Sheet Recessions


The Great Depression was a Balance Sheet Recession


Economic Problems in the U.S. and UK in the late 1970s (structural supply-side issues)

  1. What Happened
    1. Workers were frequently on strike, and factories produced defective goods, so consumers started buying foreign goods.
    2. Reagan and Thatcher realised that managing aggregate demand would not work.
    3. Fed tried aggressive QE which led to double-digit inflation.
    4. Consumers buying foreign goods and shunning domestic goods worsened the U.S. trade deficit. This depreciated the dollar and aggravated inflation [My note: foreign imports became more expensive. This is interesting because typically you would expect imports to decrease and exports to increase when the currency depreciates which would cause the currency to appreciate hence correcting the problem,  but with a structural supply-side problem, exports will not increase and imports will have a higher staying power because locally produced goods still can’t make it].
    5. Higher inflation caused a further devaluation of the dollar (high inflation means prices of domestic goods increased, so people would buy more foreign goods, buying foreign currency with dollars, causing the dollar to depreciate).
    6. Fed raises interest rates to curb inflation.
    7. Businesses put off capital investment which continued to hurt supply.
  2. The Problem
    1. Structural supply-side issue -> imports increase and exports decrease -> depreciation
    2. QE -> inflation -> depreciation
    3. Depreciation -> inflation
    4. The market mechanism to reverse the depreciation (which would curb the inflation) failed to work because of structural supply-side issue.
  3. The Solution
    1. Raise interest rates to kill businesses
    2. Killing businesses kills the structural supply-side issue which allows the market mechanism to work again
    3. Killing businesses kills consumer demand which reverses inflation

Another book  by the author is “Balance Sheet Recession: Japan’s Struggle with Unchartered Economics and Its Global Implications” published in 2003.



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