Richard Koo About QE, Money Supply And Inflation

Some excerpts from the note by Richard Koo, the chief economist at Nomura, as of yesterday:

Money supply will not grow as long as private sector is paying down debt

The explanation for this phenomenon is quite simple: in a balance sheet recession, where the private sector is striving to minimize debt, the money multiplier is negative at the margin. No matter how much liquidity the central bank supplies, the private-sector money supply will continue to decrease.

Money supply growth is an essential component of inflation. The majority of the money supply consists of deposits, which are financial institution liabilities. For these liabilities to increase, the loans that represent financial institution assets must also increase. But when the private sector is trying to minimize debt, loans actually decrease.

Individuals and businesses repay debt by drawing down deposits, but if the entire private sector behaves in this way the money supply will decline. During the Great Depression, which began in 1929 and was the classic example of a balance sheet recession, the US money supply shrank by 30% as businesses and households moved collectively to pay down debt.

However, there are some doubts about paying off the debts, but rather defaulting on them. Before we start celebrating, one would consider whether deleveraging could never start, or whether the defaulting is actually not worse?

Well, then Richard Koo moves on with fiscal consolidation:

For the government to pursue fiscal consolidation and reduce borrowing at a time when the private sector is paying down debt means the money supply will decrease regardless of how much liquidity the central bank provides.


This move by businesses and households to minimize debt is the reason why Japan’s money supply did not grow and why inflation did not accelerate despite the ¥30trn in additional funds supplied by the Bank of Japan. It is also why the US money supply and inflation have remained stagnant despite the Fed’s $1trn boost to liquidity.

So, the end game should be nasty, and probably Japan will lead in this roulette, but the bet on final chapter of the game already now may be costly ...