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Low long-term rates in so many parts of the world–in spite of higher oil prices, larger budget deficits, higher short-term interest rates in the United States, and pick-up in economic activity in Japan–have baffled both policymakers and market participants. Although some monetary officials are claiming that low long-term rates represent the triumph of their monetary policy in taming inflationary expectations, the real reasons for low rates may not be so pretty.
The champion of low long-term rates has, of course, been Japan, which has seen long bond rates lower then the lowest rate observed in the United States during the Great Depression for very many years. Furthermore, low rates are persisting despite a significant pickup in economic activity since the spring of 2003, and despite an ever-larger government budget deficit.
Even though their balance sheets may be under water, in most cases, their main line of business is still sound with healthy cash flow. The fact that Japan has maintained the largest trade surplus in the world throughout this period suggests that Japanese companies are still highly competitive, with good products that consumers around the world are willing to buy. The companies, therefore, are using their healthy cash flow from their main lines of business to pay down debt in order to repair their balance sheets.
Even though that is the right thing to do at the level of individual companies, when everybody does it all at the same time, the usual flow of funds in the economy is reversed, i.e., instead of going from household savings to corporate investment through the banks and capital markets, the companies are returning the money back to them. The households, on the other hand, have been saving money as before. With no borrowers left in the system, the entire banking system and capital market is flooded with cash. With so few borrowers left, the competition among the lenders is absolutely fierce, resulting in very low interest rates.
From the macroeconomic perspective, the sum of household savings and net corporate debt repayment, which is the money that is entering the banking system but is not coming out to re-enter the income stream due to the lack of borrowers, constitutes the deflationary gap of the economy. If this deflationary gap is left unattended, the economy will continue to contract by the amount of the gap until the private sector has become too poor to save any money or pay down debt. Such an outcome is usually called depression.
The extraordinary shift in corporate behavior in Japan is shown in the chart, put together from the flow of funds data indicating which sectors of the economy have been saving money (financial surplus), and which sectors have been borrowing and investing money (financial deficit). It is put together in such a way that when all sectors (household, corporate, government, overseas, and financial sectors) are added, they are supposed to add up to zero. In the interest of clarity, however, the financial sector, which should be neutral in the medium term, has been omitted.
In the ideal world, this chart would have the household sector at the very top, corporate sector at the very bottom, and all others in the middle at around zero, indicating that both the government budget and current account are in balance. The figure indicates, however that the corporate sector in Japan, which had borrowed and invested as much as 9 percent of GDP back in the early 1990s, has been in financial surplus since 1998. Today, it is in a surplus position to the tune of 6 percent of GDP or [yen] 30 trillion. This means the shift in corporate behavior subtracted nearly 15 (negative 9 to plus 6) percent from Japan’s GDP compared with the early 1990s. It is no wonder that the Japanese economy has been doing so poorly.
Indeed, the only reason Japan did not collapse into a depression in spite of the above shift in corporate behavior is that the government has been borrowing and spending the excess savings in the private sector. And it has been doing that literally from the first day the deflationary gap surfaced back in the early 1990s. As the chart shows, the line for the government sector has the exact opposite slope to that of the corporate sector. It shows that the government, acting as the borrower of last resort, kept both the level of economic activity and money supply from shrinking in the face of massive nationwide effort by the companies to pay down debt.
Starting in 2003, a number of major companies finally came out of their debt repayment mode and started moving forward. Their turnaround not only provided jolts to all the other companies to finish paying down debt as fast as possible, but also the bulk of good corporate news that has been coming out of Japan recently.
In spite of this encouraging development, interest rates remain very low for two reasons. First, the majority of companies are still in the debt repayment mode, and two, those companies that finished repairing their balance sheets are not borrowing money. Indeed those companies that had to pay down debt under duress typically become highly averse to borrowing even alter their balance sheets were repaired. These companies in what may be called “debt rejection syndrome” finance their investment activities almost entirely from their internal cash flow. The fact that Japanese companies are enjoying abundant cash flow after all that cost cutting and restructuring during the last decade means that they can go a long way before they will feel the need to borrow money. This is the reason why interest rates are remaining low in spite of a pick-up in economic activities.
The Japanese story is repeated to a remarkable degree in both Germany and the United States following the collapse of the global information technology bubble in 2000. Corporate sectors in both countries are in financial surplus as well, a highly unusual phenomenon.
In Germany, the bursting of the telecommunication bubble hit businesses and households badly. German companies, which are usually known for their caution, apparently dropped their guards during the bubble days as they increased their fund procurement sharply from 1997 to 2000. When the prices of telecommunication shares collapsed in 2000, they suddenly realized they were overextended and began running in the opposite direction, i.e., strengthening their balance sheets. By 2002, the German corporate sector was in financial surplus, a shift of nearly 6 percent of GDP in only two years.
As though this were not bad enough, German households sharply increased their saving rate during the same period. In other words, the German economy was hit from both the corporate and household sectors. It is no wonder the German economy has been doing so poorly in recent years. They are in a balance sheet recession just like Japan.
Furthermore, a serious credit crunch developed in Germany centering on major banks, bringing nightmares to so many companies that relied on those banks for financing. Even though many of these companies were subsequently saved by government and regional financial institutions, the bitter experience they went through made them highly susceptible to debt rejection syndrome.
In the United States, the story has a slightly longer historical twist. The U.S. corporate sector was actually in financial surplus in the 1991-93 period. This was the infamous credit crunch brought about by both the bursting of the commercial real estate bubble of the late 1980s and the backlash from the bank supervisors following the savings and loan fiasco that surfaced in 1989. In other words, as far as the corporate sector was concerned, this was largely an involuntary debt repayment forced upon them by the troubled banking sector.
This experience of forced debt repayment, however, apparently had tremendous impact on the psyche of U.S. corporate executives as they refused to increase borrowing for years afterwards. Even though the U.S. economy was doing extremely well during the 1994-2000 period, corporate debt rejection syndrome persisted as companies stayed away from procuring funds throughout the period. Even during the height of the information technology bubble, funds procured by the U.S. corporate sector amounted to less than 1 percent of GDP, in sharp contrast to their behavior before the 1991-93 credit crunch.
