Another example: Richard Koo’s ‘Yin and Yang’ and fiscal policy

Following on from the theme of my previous post, the economist Richard Koo offers another example of where a changing economic environment changes the appropriateness of a particular policy, in this case fiscal policy. This is particularly relevant to the UK and US, as well as economies in Europe, where the mantra of fiscal austerity, or aiming to balance the government budget, seized the consciousness of politicians quite soon after the Great Recession of 2008. As the recession took hold more than six years ago, UK Prime Minister Gordon Brown led the way in global economic policy by encouraging the governments of the largest and richest industrial economies to engage in a fiscal expansion: they did this by adopting some combination of increased public spending and tax cuts to purposefully increase the government deficit and thereby raise aggregate demand and fight the collapse in spending brought on by the recession. It is arguable that, at least in the short term, this prevented the Great Recession becoming a new Great Depression akin to the 1930s. While the trend fall in world industrial output tracked that at the beginning of the Great Depression for a few months, it turned up after some time instead of continuing downwards. This led many commentators to argue that ‘Keynes was back’: one of the great 20th century economist’s main ideas was that governments should counter the falling aggregate demand or overall spending characteristic of recessions by cutting interest rates (monetary policy) and, in the case of deeper recessions, increase the budget deficit (fiscal policy).

Richard Koo has argued that the Great Depression of the 1930s, the long depression in Japan from the 1990s onwards, and the Great Recession of 2008 were what he calls ‘balance sheet recessions’ and should be distinguished from milder economic downturns. In a balance sheet recession, companies and individuals tend to focus on paying down debt, and cutting spending or increasing saving to do so, due to the fact that in the previous boom they have borrowed excessively. In the case of companies they may have borrowed to invest, whereas individual and household consumers may have borrowed to consume or buy financial assets such as property. These groups of economic actors may continue to cut spending and pay off debt even when interest rates are cut close to zero, as happened in recent history across the developed world. This retrenchment produces a collapse in private spending (consumption and investment) and a rise in saving, precipitating a recession as aggregate demand falls sharply. Ignoring the spending flows on foreign trade of exports and imports for the moment, this causes the government deficit to rise automatically (the fiscal stabilizers). If the government then tries to balance the budget in the midst of the downturn by raising taxes and cutting spending the recession will only deepen. The rising private sector savings act as a withdrawal of spending from the economy. Where rock-bottom interest rates fail to stimulate renewed private borrowing, since the private sector is acting to minimise and pay off accumulated debt, the government must, Koo argues, run an offsetting budget deficit which will spend the private sector savings so that their depressive effect is reduced, if it wants to lesson the impact of the recession. This part of the economic cycle Koo calls the ‘Yin’ stage, where the majority of the private sector acts to minimise debt due to its high level.

Government policy should be different in a shallower and more typical recession or in an economic expansion, Koo argues. This is during the ‘Yang’ stage, where individual and household saving is generally positive, and these savings are borrowed by companies, via the financial system, for investment. In this instance, balancing the budget is necessary to prevent a ‘crowding-out‘ of the funds available for private investment. Monetary policy or interest rates should be sufficient to manage aggregate demand and the growth or slump in spending. I should mention here that this view is not universally accepted. The late economist Wynne Godley has argued in his magnum opus that the sum of private sector saving (from both companies and households) is usually positive over the economic cycle (Koo argues that it will be zero, if all household savings are borrowed by firms) so, ignoring foreign trade, the average government deficit must be positive to offset this and maintain aggregate demand and growth. This really is a matter for empirical analysis and cannot be resolved through purely theoretical discussion.

Returning to Koo’s ideas, and summing up, the above analysis shows that a policy of fiscal austerity may be appropriate during particular stages or kinds of economic cycle, whereas in the case of a balance sheet recession, running a potentially large deficit may be necessary to mitigate the downturn. It all depends, in Koo’s words, on whether the economy is in a ‘Yin’ or ‘Yang’ phase. More practically, the return to austerity in the UK in 2010 by the coalition government was arguably premature and, combined with the Eurozone crisis’ effect on exports, resulted in three years of stagnation. Although he likes to argue that he has been following a ‘long term economic plan’, the UK chancellor (finance minister) George Osborne, proved to be more flexible than he makes out by putting back by several years the goal of balancing the budget. Alongside a renewed rise in spending by consumers and some recovery in private investment, growth returned in 2013. But the initial austerity policy has proved damaging and Oxford economist Simon Wren-Lewis has echoed the figures of the independent Office for Budget Responsibility (set up by the current government) in a recent blog post, which suggest that austerity has cost every household in the UK £4000 through its effect in slowing income growth for several years.

I have argued elsewhere of the importance of the average rate of profit in an economy, which some Marxists such as Michael Roberts support. A policy of austerity, even though it slows the economy in the short run, may help to restore private sector profitability and encourage its restructuring as weaker, less profitable firms go bust and stronger and more profitable firms gain an advantage. This may well be the case. But it remains that austerity during a balance sheet recession weakens growth in the short run and may have effects on the longer run which are hard to reverse. So the overall picture is complex. Koo’s useful analysis of different kinds of recession and the appropriate policy responses highlights the flexibility needed by wise politicians aiming to improve the prosperity of a nation.


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