Economist Richard Koo has become well-known through his promotion of the idea of ‘balance sheet recessions’. These occur after the collapse of asset prices after a financial bubble, which leaves many firms technically insolvent and forces the private sector overall to use its earnings to pay down debt rather than borrow to invest. This will lead to a deep recession in the absence of a suitably ambitious fiscal policy from the government, which is the only actor in the economy which can borrow and spend the savings of the private sector in this situation.
Koo argues that in most economies with an independent monetary policy (ie not Eurozone members), in a balance sheet recession, interest rates typically fall to low levels despite the private sector surplus of savings over investment. The government will therefore not be competing with the private sector for borrowed funds.
In a ‘normal’ recession, or at other stages in the business cycle, a large government deficit will tend to drive up interest rates and crowd out private borrowing. Assuming that the private sector is more efficient than the government in allocating funds (which is not always the case), significant deficits are only really appropriate during a balance sheet recession. The latter needs to be tackled through government action until the private sector has repaired its balance sheets sufficiently and paid off its accumulated debt. This could take many years, but the situation will only be worsened if the government tries to balance the budget. The deepened recession and likely mass unemployment could well lead to political instability and the rise of extremist politics, as happened in Europe in the wake of the Great Depression of the 1930s. Thus a huge rise in public debt resulting from deficit spending during a balance sheet recession is a price worth paying. The time for reducing public debt is after the private sector has recovered from its trauma. This happened in the advanced world during the post-war period.
Koo’s argument is simple and powerful. He admits that the real barrier to preventing balance sheet problems leading to economic and social disaster is political rather than economic. In a democracy during peacetime, governments running large deficits tend to face pressure from voters to reduce them once some sort of recovery begins. Here in the UK, the right wing Conservatives, in opposition at the time of the Great Recession, rejected the need for deficit spending, and in the run-up to the following election and once in power, made the case for rapid deficit reduction. A sluggish recovery since then has meant that things haven’t turned out so well and a (smaller) deficit remains.
I have a few quibbles with Koo’s persuasive exposition. He ignores the fact that in many advanced economies, business investment is largely funded from retained earnings, rather than from borrowing from the household sector. This oversight is perhaps explained by his focus on Japan, where a huge asset price bubble collapsed in the early 1990s, and the economy has been stagnating ever since.
In post-war Japan, borrowing from the banking sector played a large role in funding rapid growth in business investment and output. This led many economists to question the role of the stock market in fuelling short-termism in other advanced countries and to praise Japan’s interventionist industrial policy. But Japan’s fall from its previously stellar performance shows that while the bank-based model worked for some time, the economy probably needed to move away from it as its income and wealth caught up with the rest of the advanced world. There have thus been structural problems as well as balance sheet problems facing Japan’s economy.
To be fair, Koo acknowledges the need for supply-side reform in Japan, which would involve in part an expansion in investment opportunities by opening up particular sectors in its economy. It is therefore important to link the financial balances of macroeconomics with microeconomic factors. Business profitability in Japan has been sustained by the government’s fiscal policy, but business investment, while it remains higher than in many rich countries, has been allocated relatively inefficiently, as it has not translated into a stronger growth performance. Business savings there have been persistently in excess of investment, which is a key deflationary force only countered by government deficits. Microeconomic reform which encourages excess business savings to be redistributed to households in the form of higher wages and dividend payments should produce a faster growth in consumption, which in turn will provide the growing demand needed to justify investment which would expand in a more efficient manner.
Problems in Japan since the 1990s found their echo across the world in the 2007 crisis, which fell into a balance sheet recession and has since struggled with a weak recovery. My emphasis would be on the linking of micro and macroeconomics in any explanation of economic performance. The separation between the two is artificial and can blind both orthodox and heterodox economists to linkages which run in both directions. While analysis using exclusively one or the other does simplify matters, it is vital to keep both in mind.