Richard Koo

20 July 2021

“We are all Japanese now”

Richard Koo is chief economist at
Nomura Research Institute. This is his
Two weeks ago the European Central Bank (ECB) revised its policies following an 18- personal view.
month review of monetary policy. Key changes included a pledge to ease monetary
policy forcefully when inflation or interest rates approach zero, the replacement of the Richard Koo
existing inflation target of “below, but close to, 2%” with a symmetric target that pays r-koo@nri.co.jp
equal attention to readings falling above and below 2%, and a pledge to refrain from
preemptive inflation-fighting policies.
These are not only quite similar to the new monetary policy approach adopted by the
Fed in 2020 H2 but are also reminiscent of the policy “bazooka” unveiled by BOJ
Governor Haruhiko Kuroda in 2013.
In that sense, the Fed and the ECB have finally joined the BOJ to create a world in
which “We are all Japanese now.” To receive this publication, please
contact your local Nomura
ECB’s conclusions are highly problematic representative.
The ECB’s new guidelines are based on an assessment of monetary policy from 2003
to the present that President Christine Lagarde ordered immediately after taking office
at the end of 2019. The review was completed two months sooner than initially
planned, and the Bank’s policy-setting officials found themselves in agreement on its
conclusions.
In this report I will comment on both the results of the review and the changes to
monetary policy that were made based thereon. I see many problems with both and do
not think we should expect much from the new policies. The Bank of Japan has
forcefully implemented similar policies for the last eight years but has yet to reach the
inflation target it set for itself.
Was monetary policy as effective as ECB claims?
The 18-month review process was carried out by the same ECB staff who proposed
and implemented the policies being examined, so it is hardly surprising that they would
end up patting themselves on the back.
For instance, the review concludes that the various policies implemented starting in
2014—including negative interest rates, forward guidance, quantitative easing, and
longer-term refinancing operations (LTROs)—were all effective in lifting output,
employment, and the inflation rate.
But even after those policies were implemented, the ECB frequently had to lower its
own inflation forecasts, suggesting the measures did not have the expected impact. In
fact, the ECB has failed to achieve its own inflation target even once in the years since
2014.
Economic growth in the eurozone also remains modest at best. When the UK held a
national referendum in 2016 to decide whether to leave the EU, it was humorously
noted that Antarctica was the only continent with lower growth than Europe.
Although the argument can be made that economic growth and inflation would have
been even lower had these policies not been implemented, I do not think this position is
defensible once we take a closer look at the mechanisms responsible for the
eurozone’s low growth and inflation.

Japanese version published on

July 19, 2021.
Production Complete: 2021-07-20 18:07 UTC

See Appendix A-1 for disclaimers.

Nomura | Richard Koo 20 July 2021

Monetary easing cannot boost growth without borrowers

For monetary accommodation to raise economic growth, there must be more people who
respond to the easier financial conditions by borrowing and spending. Otherwise,
reductions in the policy rate will simply result in a transfer of income from lenders to
borrowers and will not have a positive impact on the broader economy.
The reason why an increase in borrowings positively affects economic growth is that
someone must spend money above and beyond their own income in order for the
economy to grow. If everyone spent only as much as they earned, the economy would
be stable but it would not grow.
And it is debt that makes it possible for people to spend more than they earn. So unless
borrowing increases meaningfully, we cannot expect the economy to expand.
A look at eurozone bank lending from this perspective (Figure 1) shows that loans have
increased only 12% in the almost 13 years since Lehman Brothers went bankrupt in
September 2008.

Fig. 1: Eurozone money indicators

650 (Aug. 2008 =100, seasonally adjusted)

635
600 Base money
550 Money supply (M3)
500 Credit to Euro area residents Feb. 2020
450

400 353
350

300

250 97
200
144 162
150 100
100 112
108 (0.9% a year)
50

2.4 (%, y-y) Core CPI (ex food, energy, alcohol, and
2.0 tobacco)

1.6
1.2 +0.9%
0.8
0.4
0.0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Note: Base money's figures are seasonally adjusted by Nomura Research Institute.
Source: Nomura, based on European Central Bank, Eurostat data

Monetary easing will not produce inflation unless lending increases

It is somewhat shocking that, while the ECB introduced negative interest rates, engaged
in astronomical amounts of quantitative easing, carried out numerous LTROs and
TLTROs (targeted longer-term refinancing operations), and adopted forward guidance,
lending grew at an annualized rate of just 0.9% between August 2008 and May 2021.
Traditional economics insists that such bold monetary accommodation by the central
bank should lead to dramatic growth in bank lending.

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Nomura | Richard Koo 20 July 2021

The reason it did not is simple. A central bank can always purchase assets to flood the
banks with liquidity (i.e., funds that commercial banks can lend out). During the period in
question, the ECB expanded the monetary base by 535%. Yet in order for those funds to
leave the banks and enter the real economy and lift growth and inflation, someone must
borrow the money from the banks and spend it. After all, the funds ultimately belong to
depositors and cannot be given away for free.
In this case, not only did the number of borrowers shrink dramatically after Lehman failed
in 2008, but many of them actually began paying down debt at a time of zero interest
rates.
Consequently, only 12% of the base money created by the ECB during this period made
its way out of the financial sector, while the rest remained trapped in the sector. An
increase in the supply of funds of just 12% over almost 13 years is clearly not sufficient
to produce inflation.
Depressed bank lending due to balance sheet adjustments following housing
bubble collapse
This happened because after the housing bubble burst in 2008, many of the borrowers
who had taken on a great deal of debt during the boom years now found themselves
technically insolvent—i.e., the assets they had purchased were now worth less than the
loans used to buy them. And the eurozone’s housing bubble was similar in size to the US
bubble (Figure 2).
Figures 3 and 4 show the financial surplus or deficit of the household sectors in Spain
and Ireland, where the bubbles were particularly large. In these graphs, white bars
stretching above the horizontal zero line in the graph signify an increase in private-sector
financial assets, while red bars below the zero line imply an increase in private financial
liabilities.
The lines with small circles in the graphs indicate financial assets less financial liabilities.
When this is above the center line, the private sector is running a financial surplus and is
therefore a net saver. When it is below the center line, the private sector is running a
financial deficit and is a net borrower.
The two graphs make it clear that the household sectors in these two countries took on
huge amounts of debt during the bubble and then began paying down debt (=red bars
above zero) and rebuilding their savings once the bubble burst. In other words, eurozone
borrowers disappeared after 2008 because many of them became technically insolvent
once the bubble collapsed and were forced to do whatever they could to restore their
financial health as quickly as possible.

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Nomura | Richard Koo 20 July 2021

Fig. 2: Eurozone and US house prices

(1995 Q4 = 100; quarterly data)

550
525 513
500
Ireland
475
Greece
450
Spain Ireland
425
435
400 Germany
375 Netherlands
Netherlands 340
342
350
US US
325 317 339
300 293
276 Spain
275 268
250 Greece
225 236
200
175 Germany
161
150
125
92
100
75
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21

Note: (1) Pre-2005 figures for Ireland are for existing house prices only. (2) Figures for Greece are for flats in Athens and Thessaloniki.
Source: Nomura Research Institute, based on BIS and S&P Dow Jones Indices data.

4
Nomura | Richard Koo 20 July 2021

Fig. 3: Financial surplus/deficit of Spanish household sector

(% of nominal GDP, seasonally adjusted) (% of nominal GDP, inverted, seasonally adjusted)

20 -20

lhs Financial assets

15 Financial -15
lhs
surplus/deficit

10 -10

5 -5

0 0

-5 5

-10 10
Financial
rhs
liabilities

-15 15

IT bubble burst
-20 20
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21

Note: Seasonal adjustments by Nomura Research Institute. Latest figures are for 2021 Q1.
Notes: Seasonal adjustments by Nomura Research Institute. Latest figures are for 2021 Q1.
Source: Nomura
Sources: Research
Nomura Institute, based
Research on flow
Institute, of funds
based ondata
flowfrom Banco de
of funds España
data fromand National
Banco de Statistics
EspañaInstitute, Spain
and National Statistics Institute, Spain.

5
Nomura | Richard Koo 20 July 2021

Fig. 4: Financial surplus/deficit of Irish household sector

(% of nominal GDP, seasonally adjusted) (% of nominal GDP, inverted seasonally adjusted)

20 -20

lhs Financial assets Financial

lhs
15 surplus/deficit -15

10 -10

5 -5

0 0

-5 5

-10 10

-15 15

Financial
rhs
-20 liabilities 20
IT bubble
bursts
-25 25
02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20

(CY)

Note: Seasonal adjustments by Nomura Research Institute. Latest figures are for 2020 Q4.
Source: Nomura Research Institute, based on flow of funds data from ECB and Central Statistics Office, Ireland

The eurozone’s private sector (households, nonfinancial corporations, and financial

sectors combined) was largely in balance before the GFC, running a financial surplus
averaging just 1.28% of GDP in the five years before Lehman failed. But in the 12 years
since then, it has run a financial surplus averaging 4.82% of GDP. Effectively, the private
sector has increased its savings by 3.54ppt of GDP over the pre-GFC era despite
interest rates that have dropped into negative territory.
This demonstrates that the private sector, desperate to escape from insolvency, has had
to focus on repairing its balance sheet regardless of the level of interest rates set by the
ECB.
It is unlikely that the private sector would have behaved differently no matter what the
ECB did, and to that extent I find unconvincing the argument that things would have
been even worse if the central bank had not adopted the policies it did.
ECB explanations for economic slump are inconsistent
The ECB’s recent policy review does not even mention that these private-sector balance
sheet problems are the main reason why the eurozone economy has been depressed
since 2008.
Instead, it argues that the slump is attributable to a lower real equilibrium interest rate
resulting from “a decline in productivity growth, demographic factors and persistently
higher demand for safe and liquid assets in the wake of the global financial crisis.” Here,

6
Nomura | Richard Koo 20 July 2021

“real equilibrium interest rate” refers to the rate of interest that will allow policymakers to
consistently achieve their inflation target.
Looking at the cited factors one by one, productivity growth has declined because a
private sector facing balance sheet problems was forced to change course and shift from
forward-looking capital investment to backward-looking balance sheet repairs. A similar
phenomenon was observed in Japan in the years after its bubble collapsed in 1990.
Next, demographic factors simply cannot explain the dramatic change in behavior that
occurred around 2008 (see Figures 3 and 4).
As for the third factor cited—an apparent preference for safe assets—this merely reflects
the fact that the private sector was no longer able to take on risk after balance sheet
repairs began. In other words, the ECB is only looking at the superficial phenomena of
economic slowdown without understanding the key driver behind the phenomena.
Equilibrium interest rate disappears during balance sheet recessions
Why is it necessary to pin down the main cause of the eurozone’s economic slump? If
balance sheet problems are the underlying reason for the changes in behavior shown in
Figures 3 and 4, it suggests that the equilibrium interest rate has not declined but instead
has disappeared altogether.
When technically insolvent people are struggling to return to solvency, they will not alter
their behavior no matter how low the central bank takes the policy rate. And the data
show that their behavior did not change when the ECB introduced its negative-interest-
rate policy in June 2014.
This indicates that while economists’ much-loved concept of an equilibrium interest rate
is meaningful when private-sector balance sheets are healthy and people are looking to
the future, it is meaningless when those assumptions do not hold, as in Japan since
1990 and Europe and the US since 2008.
Germany fell into balance sheet recession after IT bubble burst
Another big problem with the ECB’s recent policy review is that it completely ignores the
causal relationship between ECB monetary policy and the eurozone’s pre-2008 housing
bubble.
Inasmuch as the period studied begins in 2003, it should have been impossible for the
compilers of this report to overlook the relationship between ECB monetary
accommodation and the growth of the bubble during the five-year period from then until
2008, when the boom turned to bust. And this bubble was hugely supported by the
ECB’s decision to lower the policy rate to what was then an all-time postwar low of 2.0%.
The reason why the ECB took rates so low was that Germany’s economy had fallen into
a severe balance sheet recession after the dot-com bubble of 2000 collapsed, triggering
a crippling slump in that country.
During the dot-com bubble, the Neuer Markt—now the TecDAX—Germany’s version of
the NASDAQ, rose by tenfold before plunging 97% (Figure 5) and exacting a heavy toll
on private-sector balance sheets.

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Nomura | Richard Koo 20 July 2021

Fig. 5: Germany’s Neuer Markt/TecDAX

(Dec. 31, 1997 = 1000)

10000

9694.07
9000

8000

7000

6000 -97%

5000
3612.29

4000

3000
TecDAX

2000

1000

306.32
0
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21
(CY)

Source: Nomura, based on Bloomberg and MarketWatch, data, as of 16 July 2021

Germany’s private sector was immediately forced to pursue balance sheet repairs to
restore its financial health in spite of ultra-low interest rates. The household sector not
only stopped borrowing but actually began paying down debt (Figure 6) even though the
ECB had cut rates sharply after the dot-com bubble collapsed.
Although the ECB tried to revive the German economy by taking its policy rate to what
was then a historic postwar low, the private sector did not respond, the economy
remained mired in recession, and the nation became known as the “sick man of Europe.”

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Nomura | Richard Koo 20 July 2021

Fig. 6: Financial surplus/deficit of Germany’s household sector

(% of nominal GDP, seasonally adjusted) (% of nominal GDP, inverted, seasonally adjusted)

15 -15

lhs Financial assets lhs Financial

surplus/deficit
12 -12
IT
bubble
bursts
9 -9

6 -6

3 -3

0 0

-3 3

Financial
liabilities
-6 6
rhs

-9 9
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21

(CY)

Note: Seasonal adjustments by Nomura Research Institute. Latest figures are for 2021 Q1.
Source: Nomura Research Institute, based on flow of funds data from Bundesbank and Eurostat

ECB’s low policy rate did nothing for Germany but was too low for other EU
countries
Spain and other European countries that had not been caught up in the dot-com bubble
had pristine balance sheets. When they faced the lowest interest rates in postwar
history, they proceeded to plunge into real estate investment, partly as a hedge against
potential future inflation.
Germany’s economy, which was in a balance sheet recession and no longer had an
equilibrium rate of interest, failed to respond no matter how low the ECB took rates, while
in other countries the ECB’s policy rate was far below the equilibrium rate and served to
accelerate a housing bubble.
We can see this from the fact that German house prices steadily declined from 2000,
when Germany’s private sector stopped borrowing money, to 2006, while house prices in
other countries in the eurozone rose dramatically (Figure 2).
What can ECB do when only some countries are in balance sheet recession?
The ECB argues in its policy review that asset bubbles and other financial imbalances
should be addressed with both macro- and micro-prudential policy, but it completely
overlooks the question of what should be done when its own monetary policy is a key
driver of the asset bubble.

9
Nomura | Richard Koo 20 July 2021

Particularly important in the ECB’s case is the question of what sort of monetary policy is
needed when some members of the EU are experiencing balance sheet recessions but
the rest are in good shape.
Unfortunately, the review completely ignores this question, even though it is hard to deny
that it was the central bank’s own accommodative policies that exacerbated the housing
bubble in the years leading up to 2008. And it is this bubble whose collapse triggered the
balance sheet recession that has weighed on the eurozone economy for more than a
decade since.
Localized balance sheet recessions should be addressed with fiscal policy
Since there cannot be multiple interest rates in a single currency zone, the correct
response when a balance sheet recession has rendered monetary policy ineffective in a
given country (i.e., when the equilibrium rate of interest has disappeared) is to use the
fiscal policy of the same country.
If Germany had responded to the collapse of its dot-com bubble with its government
borrowing and spending the rapidly growing private-sector savings surplus, the economy
would have stabilized, the ECB would not have had to take interest rates so low, and the
housing bubbles in the rest of the eurozone would not have grown as large as they did.
Unfortunately, the Maastricht Treaty that created the single-currency framework does not
allow member nations to run fiscal deficits in excess of 3% of GDP. But between 2000
and 2005, when Germany was experiencing a balance sheet recession, its private sector
was saving more than 10% of GDP at the peak.
If the private sector is saving in excess of 10% of GDP, but the government can borrow
and spend only 3%, that leaves a deflationary gap amounting to 7% of GDP. This is the
primary reason why Germany became the sick man of Europe.
Inasmuch as the economic slump that continues to this day can be traced to the
mishandling of the German balance sheet recession that began in 2000, I suspect I am
not the only one who would have liked to see the ECB pay a little more attention to the
appropriateness of fiscal and monetary policy developments around that time in the
recent review.
Do higher inflation rates enable central banks to respond better to shocks?
Turning back to the present, the most important element of the ECB’s new policy
strategy is the statement that “especially forceful or persistent monetary action” is
required “when the economy is close to the effective lower-bound.”
The Bank argues that such action is necessary because using forceful policy tools to
keep the inflation rate—and with it the nominal equilibrium interest rate—at elevated
levels will give it room to lower interest rates in response to the next negative shock.
It also says that its failure to do so in the past is why nominal interest rates and the
inflation rate have been depressed for the last ten years.
In alignment with this conclusion, the ECB has replaced its previous 2% cap on inflation
with a symmetric target under which it will allow inflation to rise above 2% for short
periods of time.
Looser inflation target unlikely to lead to ECB success
This has many points in common with the “new approach” adopted by the Fed in 2020
and the BOJ’s “bazooka” under Governor Kuroda. However, it is deeply problematic in
many respects.
First is the question of whether central banks can raise the inflation rate with “forceful”
monetary policy. Given the utter failure of Kuroda’s extremely forceful bazooka, which
was introduced for exactly the same reasons eight years ago, I see little chance for the
ECB to succeed.
This is because Japan and the eurozone face similar balance sheet problems and are
both pursued economies, with emerging economies offering higher returns on capital
than domestic investments, resulting in a crucial shortage of borrowers in spite of ultra-
low interest rates.

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Nomura | Richard Koo 20 July 2021

Reckless easing possible only because central banks ignored shortfall of

borrowers
The approach taken by Governor Kuroda and now the ECB is based on the
assumption—which also underpins traditional economics—that lower real interest rates
will always be sufficient to elicit private-sector borrowing. But that assumption no longer
holds in today’s developed economies, which are facing balance sheet problems and
offer lower returns on capital than emerging markets.
Nevertheless, policymakers have refused to face the reality of this shortage of
borrowers—the ECB’s policy review makes almost no mention of the causes of this
shortfall—and continue to believe that borrowers will eventually appear if they only
continue their reckless easing policies.
Moreover, this line of thinking has already prompted these same central banks to
implement unimaginably large amounts of quantitative easing starting in 2008. As a
result of their actions, bank reserves, which are used to fund loans, have surged to 84.6
times the pre-Lehman (2008) level in the US, 16.7 times in the eurozone, 28.9 times in
the UK, and 58.7 times in Japan.
Little of businesses’ recent borrowing has been used for capital investment
Despite these aggressive injections of liquidity and negative interest rates in Japan and
Europe, none of these economies has been able to achieve its inflation target (until
supply mismatches pushed prices higher recently). That is because there are no
borrowers in the real economy.
While there are entities who want to borrow money to purchase existing assets, such
lending only results in a change of ownership and does not add to GDP growth or
inflation.
According to data compiled by the Institute of International Finance in 2017, the
percentage of the money that corporations procured via bank loans or bond issues that
was actually used to fund capital investment, thereby directly boosting economic growth
and inflation, was 25% in Japan and just 3% in the US and the eurozone.
The rest was being used to buy back shares, to refinance existing debt, or to provide
working capital, all of which make only a tiny contribution to growth or inflation. This
means the growth in real borrowing is even smaller than the 0.9 percent annual rate
shown in Figure 1.
Money that cannot reach real economy flows to existing assets, creating bubbles
Central bank efforts to generate inflation, therefore, are likely to end in failure given
current conditions in the developed economies, and that is precisely what has happened.
Meanwhile, most of the liquidity that has been injected is likely to be used to purchase
existing assets, pouring more gasoline onto the fire of rising asset prices.
The financial institutions receiving these funds from the central bank must invest them
somewhere, and if there is no capital investment-related demand for loans in the real
economy, their only option is to buy existing assets whose price is expected to rise.
Asset prices alone have continued to climb despite sluggish growth in GDP and inflation.
This trend became even more pronounced during the pandemic, as the stock and bond
prices of companies with depressed earnings and falling credit ratings rocketed higher.
The creation of such asset bubbles risks a repeat of the ECB’s tragic attempt to rescue
Germany’s economy by pursuing forceful monetary accommodation from 2000 to 2008,
thereby accelerating housing bubbles in the rest of the eurozone. The ECB and EU need
to take another look at their monetary and fiscal policy at the time if they want to avoid
repeating the mistakes of the past.
Surge in house prices symbolizes widening social wealth gap
As part of the review process, the ECB is said to have solicited opinions from people
across society. President Lagarde said people were most concerned about climate
change and the sharp rise in house prices.
I believe climate change is a critical economic issue in the sense that it will have a direct
and often adverse impact on many businesses and may therefore increase banks’ bad

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Nomura | Richard Koo 20 July 2021

loans. House prices, as shown in Figure 2, are well on their way to another bubble,
largely because of the ECB’s forceful supply of liquidity. If this bubble bursts, the
eurozone could again find itself in the balance sheet recession world of 2008.
The fact that many people were worried about rising house prices appears to have come
as a surprise to senior ECB officials, and the Bank has responded by pledging to
incorporate house prices in the price indices it monitors. However, this is a medium-term
pledge and will only cover increases in the cost of owner-occupied housing, which is a
very different matter from the rising house prices that most people are concerned about.
The appreciation of house prices, which is also becoming a problem in the eurozone, is
emblematic of the dissatisfaction with which many young people in the developed world
view the wealth gap and income inequality. Central banks that continue to engage in
forceful monetary accommodation that increases house prices risk becoming part of the
problem rather than part of the solution.
Authorities should respond with fiscal policy when needed instead of recklessly
easing monetary policy
What, then, should the policy authorities do? For now the ECB has chosen the
extraordinarily roundabout approach of pursuing aggressive monetary easing to
generate higher inflation and higher nominal interest rates, thereby creating room for it to
cut rates in the future when faced at some point with an external shock. What it should
do instead, is leave the economy alone and respond to exogenous shocks or deflation
with fiscal policy.
The ECB policy review did acknowledge that fiscal policy was more effective than normal
when interest rates were approaching zero and admitted that the fiscal multiplier could
vary depending on the circumstances. This represents a big step forward, even if the
Bank did not attempt to explain why this was the case.
Unfortunately, the fiscal deficits of eurozone governments are capped at 3% of GDP as
mentioned earlier, even at a time when private sectors have on average been saving
4.82% of GDP in the years since Lehman went bankrupt. This has created a structural
deflationary gap in the eurozone economy.
It is a tragedy for the eurozone and the ECB that the latter is forced to aggressively
implement monetary accommodation in an attempt to create inflation when deflation is
baked into the institutional framework. I believe this fundamental contradiction will
continue to weigh on the eurozone economy as long as these unreasonable Treaty
constraints on fiscal stimulus remain.
Excess liquidity will create big problems when borrowers return
The ECB adopted the same sort of symmetric inflation target used by the Fed to
demonstrate that it no longer intended to nip inflation in the bud. But as I noted in my last
report, this approach has the potential to create huge problems once private borrowers
return to the market.
The massive reserves supplied by central banks under quantitative easing have not
generated any inflation because they have been trapped in the financial sector due to an
absence of borrowers. But if businesses resume borrowing for capital investment—for
example, to combat climate change—banks will be able to increase lending almost
without limit given their massive reserves.
This growth in lending to the real economy will cause inflation to accelerate, and if
central banks want to use rate hikes to stop it, they will need to pay a higher rate of
interest on the entire amount of bank reserves—which as noted above have increased
84.6-fold in the US, 16.7-fold in Europe, and 58.7-fold in Japan since 2008. This is
necessary to prevent those funds from being lent out to the private sector.
Taxpayers must bear cost of rate hikes by central banks that engaged in QE
Figure 7 shows our estimates of the cost of this approach. The estimates assume a
policy rate of 3% for the US, 2% for the eurozone and the UK, and 1% for Japan, and
they are not at all insignificant. The ¥4.7trn figure for the BOJ, for example, is roughly
equal to the increase in tax revenues generated by the last consumption tax hike.

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Nomura | Richard Koo 20 July 2021

Fig. 7: Curbing inflation with rate hikes without unwinding QE is expensive

Bank reserves Required policy rate to Cost to taxpayer per year

as of June 2021
calm inflation1 (IOER)*
(multiples of Aug. 2008 level)

US $3.87 trillion2 3% $116.2 billion

(84.6x)
£828.4 billion
UK 2% £16.57 billion
(28.9x)

€3.59 trillion
Eurozone 2% €71.83 billion
(16.7x)

¥470.9 trillion
Japan 1% ¥4.7094 trillion
(58.7x)

Note: * Interest on excess reserves (1) Could be higher or lower depending on inflationary pressure (2) ECB’s figure is for May 2021.
Source: Nomura Research Institute, based on the data from FRB, BoE, ECB and BoJ

Moreover, the fiscal deficits of governments in these countries will increase by an equal
amount, which means taxpayers will have to foot the bill. And that bill will have to be paid
every year until quantitative easing is finally wound down.
In a democratic society, it would be difficult for the central bank to argue that taxpayers
should bear the cost of this undertaking. Yet the longer it hesitates to raise rates due to a
fear of political blowback, the more inflation will accelerate.
This mechanism, whereby the cost of rate hikes must be borne directly by taxpayers, has
never been observed because QE was never tried to this extent before 2008, and I
suspect most people are completely unaware of it. But central banks will encounter it as
soon as borrowers return to the market if QE-supplied reserves are left in place.
Rejection of preemptive response to inflation may destabilize financial system
In October 2017, the Fed moved to tackle this problem in advance by pursuing
quantitative tightening (QT). By mopping up the excess reserves it had supplied to the
market, it sought to regain monetary policy flexibility and eliminate the need for taxpayers
to bear the cost of future rate hikes.
However, the Fed was forced to temporarily discontinue QT in September 2019 when
other factors threw the money market into turmoil, and after the pandemic struck it had to
move policy in the opposite direction. Its adoption of a symmetric inflation target in the
second half of 2020 further reduced the likelihood of it trying to nip inflationary pressures
in the bud.
While I am in favor of central banks using quantitative easing when faced with a
completely exogenous shock like the pandemic, it worries me that at a time when the
economic impact of pandemic is winding down, central banks in Japan, the US, and
Europe are introducing symmetric inflation targets and emphasizing their opposition to
preemptive inflation-fighting policies.
Although their policies cannot be expected to boost inflation or GDP growth in the
absence of borrowers, they will serve to lift the price of already overvalued assets. I view
this as a high-risk, low-return approach that over an intermediate horizon has the
potential to exacerbate widening inequalities in society by creating bubbles and
otherwise destabilizing the financial system.
In the US in particular, where the government has emerged as a borrower and fiscal
policy is finally functioning properly—I find it concerning that the Fed is opposed to
preemptive efforts to stem inflation.

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Nomura | Richard Koo 20 July 2021

Appendix A-1
Disclaimers
This publication contains material that has been prepared by the Nomura Group entity identified on page 1 and, if applicable, with the contributions
of one or more Nomura Group entities whose employees and their respective affiliations are specified on page 1 or identified elsewhere in this
publication. The term "Nomura Group" used herein refers to Nomura Holdings, Inc. and its affiliates and subsidiaries including: (a) Nomura
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undertakes with the use of the Index.

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Nomura | Richard Koo 20 July 2021

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Nomura | Richard Koo 20 July 2021

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When Japanese government bonds (JGBs) for individual investors are purchased via public offerings, only the purchase price shall be paid, with no
sales commission charged. As a rule, JGBs for individual investors may not be sold in the first 12 months after issuance. When JGBs for individual
investors are sold before maturity, an amount calculated via the following formula will be subtracted from the par value of the bond plus accrued
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When inflation-indexed JGBs are purchased via public offerings, secondary distributions (uridashi deals), or other OTC transactions with Nomura
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indexed JGBs changes in line with the rate of change in nationwide CPI inflation from the time of its issuance. The amount of the coupon payment
is calculated by multiplying the coupon rate by the notional principal at the time of payment. The maturity value is the amount of the notional
principal when the issue becomes due. For JI17 and subsequent issues, the maturity value shall not undercut the face amount.
Purchases of investment trusts (and sales of some investment trusts) are subject to a purchase or sales fee of up to 5.5% (tax included) of the
transaction amount. Also, a direct cost that may be incurred when selling investment trusts is a fee of up to 2.0% of the unit price at the time of
redemption. Indirect costs that may be incurred during the course of holding investment trusts include, for domestic investment trusts, an asset
management fee (trust fee) of up to 5.5% (tax included/annualized basis) of the net assets in trust, as well as fees based on investment
performance. Other indirect costs may also be incurred. For foreign investment trusts, indirect fees may be incurred during the course of holding
such as investment company compensation.
Investment trusts invest mainly in securities such as Japanese and foreign equities and bonds, whose prices fluctuate. Investment trust unit prices
fluctuate owing to price fluctuations in the underlying assets and to foreign exchange rate fluctuations. As such, investment trusts carry the risk of
losses. Fees and risks vary by investment trust. Maximum applicable fees are subject to change; please thoroughly read the written materials
provided, such as prospectuses or documents delivered before making a contract.
In interest rate swap transactions and USD/JPY basis swap transactions (“interest rate swap transactions, etc.”), only the agreed transaction
payments shall be made on the settlement dates. Some interest rate swap transactions, etc. may require pledging of margin collateral. In some of
these cases, transaction payments may exceed the amount of collateral. There shall be no advance notification of required collateral value or
collateral ratios as they vary depending on the transaction. Interest rate swap transactions, etc. carry the risk of losses owing to fluctuations in
market prices in the interest rate, currency and other markets, as well as reference indices. Losses incurred as such may exceed the value of
margin collateral, in which case margin calls may be triggered. In the event that both parties agree to enter a replacement (or termination)
transaction, the interest rates received (paid) under the new arrangement may differ from those in the original arrangement, even if terms other than
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such as documents delivered before making a contract and disclosure statements.
In OTC transactions of credit default swaps (CDS), no sales commission will be charged. When entering into CDS transactions, the protection buyer
will be required to pledge or entrust an agreed amount of margin collateral. In some of these cases, the transaction payments may exceed the
amount of margin collateral. There shall be no advance notification of required collateral value or collateral ratios as they vary depending on the
financial position of the protection buyer. CDS transactions carry the risk of losses owing to changes in the credit position of some or all of the
referenced entities, and/or fluctuations of the interest rate market. The amount the protection buyer receives in the event that the CDS is triggered
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Nomura | Richard Koo 20 July 2021

by a credit event may undercut the total amount of premiums that he/she has paid in the course of the transaction. Similarly, the amount the
protection seller pays in the event of a credit event may exceed the total amount of premiums that he/she has received in the transaction. All other
conditions being equal, the amount of premiums that the protection buyer pays and that received by the protection seller shall differ. In principle,
CDS transactions will be limited to financial instruments business operators and qualified institutional investors.
Transfers of equities to another securities company via the Japan Securities Depository Center are subject to a transfer fee of up to ¥11,000 (tax
included) per issue transferred depending on volume. No account fee will be charged for marketable securities or monies deposited.

Nomura Securities Co., Ltd.

Financial instruments firm registered with the Kanto Local Finance Bureau (registration No. 142)
Member associations: Japan Securities Dealers Association; Japan Investment Advisers Association; The Financial Futures Association of Japan;
and Type II Financial Instruments Firms Association.

Copyright © 2021 Nomura Securities Co., Ltd. All rights reserved.

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