On Balance Sheet Recessions: the economics of Richard Koo

RichardKooRichard Koo is best known for his concept of a Balance Sheet Recession (BSR), which was defined briefly in yesterday’s post. Two of his books are highly recommended: The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession and The Escape from Balance Sheet Recession and the QE Trap.

They are not difficult reading. The basic idea of a BSR is outlined many times throughout, and his arguments are clear. He also employs plenty of empirical evidence mainly in the form of charts.

This post summarizes some of Koo’s main ideas from the two books, although it is by no means exhaustive.

  • BSRs occur following the collapse of an asset-price bubble, when the value of liabilities (debt) exceeds the value of assets, leading to negative net worth. If cash flows are still healthy, the private sector (firms and/or households) will use these funds to save and pay down debt, rather than borrowing to invest. As a consequence, the demand for borrowed funds falls even in the presence of very low interest rates, so that the latter does not stimulate aggregate demand and investment. In the absence of an appropriate policy response, the likely consequence is a debt-deflation and severe recession with mass unemployment.
  • In a ‘normal’ recession, most companies maximise profits. In a BSR, they minimize debt.
  • There is a need for fiscal policy in the form of budget deficits in a BSR, since monetary policy (interest rates) is useless. This is Koo’s ‘Holy Grail of Macroeconomics’ (monetary policy to manage demand most of the time, fiscal policy in a BSR). It is also a rejection of traditional Keynesian economics as a general theory of the economy and a return to seeing it as a special case (used only during a BSR).
  • A BSR can create a private sector aversion to borrowing, which may take many years to overcome, even after sufficient debt has been paid down. This can be seen in Japan’s two decades of economic stagnation.
  • Sluggish economic growth despite fiscal deficits can be mistaken for ‘structural’ or supply-side problems. For example, an economy with a trade surplus, low inflation and interest rates, and positive cash flow in companies implies that the problems are demand-side rather than supply-side. Koo argues that growth performance would be even worse in the absence of fiscal deficits, due to the BSR.
  • In a BSR, increased fiscal stimulus may be the only force that keeps credit and the broader money supply growing. In its absence the latter would shrink or stagnate. If this is true, both Ben Bernanke, former chairman of the Federal Reserve, and monetarist and Nobel Prize-winner Milton Friedman were wrong in their assessment of the role of monetary policy mistakes during the Great Depression of the 1930s. This is because they ignored the role of the demand for borrowed funds, which falls in a BSR, and focused only on the supply of money. Koo argues that the Great Depression was a BSR.
  • Monetary policy is ‘normally’ effective in fighting a (non-BSR) recession, when fiscal policy will crowd out private investment and misallocate resources. In a BSR deficits will improve resource allocation by fighting deflation and unemployment.
  • The Austrian School approach to recessions, which rejects any role for state intervention and argues that the recovery should be left to the free market, may only be valid if a small proportion of the economy has BS problems or if the country is small and relatively open to international trade. Then a devaluation can work to restore growth. But a large economy with significant BS problems (firms with negative net worth) needs fiscal stimulus to avoid a massive collapse and the potential of a global depression if many economies are involved.
  • During the 2008 recession and the years that followed, private credit and broad measures of the money supply have stagnated despite a huge increase in the monetary base by central banks (known as Quantitative Easing or QE). This is because the demand for borrowed funds from the private sector has been too weak. Fiscal stimulus can sustain growth in the money supply during a BSR as it creates a demand for the private sector savings which are being used to pay down debt.
  • In a BSR the financial system has large liabilities but only the government can find a use for them with a fiscal stimulus.
  • During a BSR interest rates should not rise despite fiscal stimulus. If this is the case, it implies that there will be no ‘crowding out’ of private investment or any misallocation of resources.
  • A private sector financial surplus, or positive net saving, despite very low interest rates, is an indicator of a BSR.
  • Koo’s work was inspired by the experience of Japan since the collapse of its asset-price bubble and long stagnation from the 1990s. The Japanese economy is still struggling despite years of fiscal deficits, but there is great potential in ‘Abenomics’, the three policy ‘arrows’ of fiscal stimulus, monetary stimulus and structural or supply-side reform, to restore prosperity. In particular, and perhaps contrary to some of Koo’s earlier arguments, supply-side policies in the form of deregulation of certain sectors of the economy, could open up markets and increase investment opportunities, re-igniting the demand for borrowed funds. So there is an interaction between demand and supply in the economic response to certain policies.
  • The eurozone crisis was, according to Koo, caused by a combination of macroeconomic (BSRs) and microeconomic (international price competitiveness) differences between Germany (the core of the zone) and the periphery (Spain, Portugal, Italy, Greece, Ireland). Germany went through a BSR following the collapse of its IT bubble in 2000. In response, the European Central Bank (ECB) cut interest rates sharply, which failed to stimulate German domestic demand due to the BSR. Instead it created asset-price bubbles and boosted demand in the periphery. This helped Germany recover by boosting demand for its exports. The German government did not apply a fiscal stimulus to overcome its BSR, and instead undertook ‘structural’ labour market reforms which led to a stagnation in wage growth and domestic demand. This led to a divergence in competitiveness between the core and the periphery of the eurozone. Koo shows that roughly half of the competitiveness gap with Germany was reflected in the money supply growth differential (a BSR effect), and half from wage stagnation. Only Greece had a truly profligate government; the other peripheral economies went through private sector consumption booms and asset-price bubbles. The divergence in competitiveness and the trends in domestic demand growth led to much higher current account surpluses in the core and corresponding deficits in the periphery. This gave rise to capital flows between member states and a divergence in bond yields (market interest rates), which made independent fiscal stimulus by individual states impossible to finance in states in which yields rose sharply. Koo’s solution to this is to ban the trading of domestic sovereign debt (government bonds) in other member states. He also proposed a revised Maastricht treaty which would allow for sufficient fiscal stimulus in the case of a BSR.

Of course there may be an alternative to shifting debt from the private sector to the public sector via massive fiscal stimulus during a BSR: what Steve Keen and Michael Hudson have called a Debt Jubilee, or a large-scale writing off of private debt. This would transfer resources from the financial sector to non-financial firms and households, supporting recovery in the ‘real’ economy and shrinking the financial sector.

It may be radical stuff, but since much of the debt bubble we have been living through simply fueled asset prices rather than real investment in tangible capital, it has great potential and would be a form of redistribution that could promote both social justice and renewed prosperity.

Another way to help restore global prosperity is for policymakers to encourage a ‘great rebalancing’. This idea comes from Michael Pettis, who goes further than Koo in exploring the roots of the Great Recession, putting it down to the buildup of current account imbalances between surplus countries such as China, Germany and Japan, and deficit countries such as the US, UK and eurozone periphery.

The excess savings of the surplus nations needs to fall and consumption shares to rise in order to rebalance the major economies of the world. As I have written about a number of times, Germany could ignite a eurozone boom by expanding domestic demand more rapidly and moving its current account towards balance or even into deficit, which would help restore balance in the deficit countries and enable them to pay down their accumulated private and public debts.

Some combination of all these policy ideas may be more effective than one on its own. But the focus on balance sheets, the relationship between assets and debts, and global imbalances is surely vital to creating a renewed prosperity across the world. This is in contrast to the sluggish growth amid unsustainable debt burdens which still need to fall dramatically in many countries.


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