Balance sheet recessions and macro-micro linkages

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.


5 thoughts on “Balance sheet recessions and macro-micro linkages

  1. The reason that FDR was able to overcome conservative opposition to his New Deal policies was due to the rise of Communism in Rusia. And the Conservatives did not want to risk an uprising of the 99 % back then.

    Unfortunately Milton Friedman, Ann Rand and the Chicago School of Economics along with modern day conservatives have forgotten that lesson.

    Reagan planted the seeds of the 2008 meltdown by refusing to enforce the Glass-Stegal Act, Clinton repealed it leaving Bush 2 to reap the consequences.

    Leading to similar economic conditions here in the US that will eventually lead to more unrest and an eventual uprising of the 99%.

    • Thanks for you comment. It’s interesting how history repeats itself in some ways, although this time there isn’t the threat of communism to influence attitudes and policy.

  2. Thank you for the interesting post. Again lots of food for thought. Your ideas concerning the micro-macro link pique my interest, and I have a sense that they are very important, not least, in coming to grips with another subject that I would like to broach today:

    Bill Mitchell has a blog post (see link below) on Koo’s balance sheet recessions, in which he widens the perspective on Koo’s theory by claiming its weakness to lie in wrongly assuming that government is subject to a budget constraint akin to a household’s or a firm’s budget constraint.

    In Mitchell’s view, the wrong (macro-)economics behind this assumption leaves us with (one of) the greatest political challenges of our times: to convince the public that there is actually no such government budget constraint, other than a government being subject to the finitude of an economy’s real resources.

    The real-resources-constraint tends to leave far more room for fiscal manoeuvring (and successful crisis management) than the mechanistic focus on magical debt ratios fashionably endorsed nowadays both by “experts” and the public across the political board would make one believe.

    While I think Mitchell is making an important point, I think the devil is in the detail, i.e. in working out how much room there is for fiscal intervention before you eventually crash through the inflation-inducing ceiling by overtaxing real resources.

    I believe, government fiscal stimulus can do a lot (of good), as FDR seems to have shown or the golden age of capitalism (1945-75). But then, not only will there be plenty of disagreement on what kinds of projects should qualify as worthy of government sponsorship, there is also the real and sinister possibility of government policies that significantly harm the economy.

    I am more easily persuaded to believe that in principle we can run much higher government budget deficits with benign consequences than we do at present, than to think that we will find it easy to identify such programs, pursue the right ones, or arrive at a general consensus on what kinds of projects may be reasonably licensed for government fiscal support.

    What looks like an economic problem may be in large measure a political one. The post is entitled: Balance sheet recessions and democracy.

    • Thanks again for your comment. I sometimes read Bill Mitchell’s blog, which I find quite interesting. Koo is something like a Keynesian favouring fiscal policy in a balance sheet recession, and mainstream in ‘normal’ times and other types of recession, which he thinks require lower interest rates and relatively balanced budgets. He basically subscribes to the loanable funds theory outside of a balance sheet recession. I am not convinced by the Modern Monetary Theorists, as I think there is something that they all miss, and which I want to write about at some point: the rate of profit.

      Many Marxists place a great emphasis on the rate of profit and its key role in providing the funds and the incentive for investment. If the rate of profit is falling and the government runs an expansionary fiscal policy, growth could be maintained in the short term via the rise in aggregate demand, but a lower level of investment resulting from lower profits would limit the growth of capacity. Inflation might be the result at some point, giving rise to stagflation if growth subsequently slows as was experienced in the 1970s. Thus profits are important to the growth of both demand and supply. Outcomes could also depend on the use of the funds generated via the fiscal expansion. If they flow into necessary public infrastructure, this could help to expand capacity in the economy and crowd in private investment as profit opportunities expand.

      I think that post Keynesians and Modern Monetary Theorists neglect the role of supply, so their explanation is only partially right. Fiscal policy can be effective but, as ever, it all depends on various interacting factors, of which the rate of profit is central.

      I am still trying to work out how Koo’s ideas fit into the Marxist emphasis on the rate of profit. Firms in Japan are investing at a higher rate than in many rich countries but are saving much more than that, so there is a huge corporate savings glut there. They must therefore be making decent profits, but lack sufficient opportunities for efficiently-allocated investment, either from the demand (household consumption) or the supply side (investment opportunities). So Abenomics may be on the right track.

  3. The aspects that you are discussing are particularly interesting to me, for two reasons: firstly, I have not thought much about the supply side, at least not recently, and I am hardly acquainted with the role of the profit rate; secondly, I share your view that fiscal responses, while often very useful, must not be taken for granted concerning the power and benignity of their effects. We need to look more closely at the specific conditions under which they unfold.

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