This is the second of a multi-part series of articles by Liam Auer on the causes of the ongoing economic crisis. In each edition of the George Street Review, Liam will examine the different theories of the crisis and what policy solutions flow on from these theories. The first, “Why the downturn?” looked at one demand-based explanation and one supply-based explanation. The second, “New ideas gaining momentum”, looked at nominal GDP targeting and zero-marginal product workers. In the final print edition of GSR for 2011, he looks at balance sheet recessions and the implications of long-term unemployed.
Throughout this series I have covered Krugman’s mainly Keynesian position, the concept of expansionary austerity, the use of NGDP targeting by central banks as an appropriate tool to return to economic health and zero marginal product workers. This final chapter will examine Richard Koo, Chief Economist of Nomura Research Institute (a division of the Japanese investment bank Nomura), and his theory of a balance sheet recession, as well as hysteresis in the labour market.
Again, referring back to the Venn diagrams provided by Mike Konczal is a helpful way of knowing what camp each theory fits into: demand-side or supply-side.
Figure 1. Demand-based explanations
Source: Mike Konczal, http://rortybomb.wordpress.com/
Koo’s balance sheet recession
Drawing upon his experiences with Japan’s “Lost Decade” (which is actually closer to two decades, now), Koo believes that the US’s current recession was caused by the popping of a debt-financed asset bubble (notably in housing, and associated debt securities). With the free fall in these asset prices, the balance sheets of firms and households have become extremely constrained as their liabilities far exceed the value of the assets. With this new constraint, firms and households moved away from their traditional profit-maximising behaviour consistent with economic theory to debt-minimisation to rebuild their balance sheets.
Along with a majority of economic theory, monetary policy is a big casualty in this scenario. As Koo explains, “Businesses and consumers suffering from a debt overhang are not interested in increasing their borrowings at any interest rate, and few banks want to lend money to borrowers with impaired balance sheets.” Liquidity injections, lower interest rates and increases in the money supply have little effect on the economy. The data supports this. Liquidity injections by Japan in the Lost Decade and by the US over the past few years have done little to spur on borrowing and credit growth, which would in turn encourage investment and economic growth.
The mechanics of a balance sheet recession is pretty simple. In normal times, when one economic agent increases their savings in a national economy, a nation’s production (i.e. GDP) will contract unless another agent steps into borrow those saved funds. The loanable funds market balances this, with the interest rate equating the changes in supply and demand for funds. Once a balance sheet recession hits, though, this all changes. Demand for funds can fail to match the supply of funds, even with interest rates at zero. Unborrowed funds are trapped in the financial system, leading to an output gap and a deflationary spiral.
So, with monetary policy rendered useless and a large aggregate shortfall, fiscal stimulus (i.e. government spending) is the only available option. There is an important point to be made here that fiscal stimulus must be sustained throughout the entire duration of the deleveraging process. Premature fiscal consolidation is extremely damaging, as the US in 1937 and Japan in 1997 found out. Unfortunately, it seems to be a lesson that has gone unheeded, with the UK, France, Italy and other countries engaging in fiscal tightening, despite some truly horrendous growth figures.
Fiscal stimulus is only one part of the equation with a balance sheet recession. Impaired financial institutions also need to undertake a gradual writing-off of their non-performing loans. This will allow banks to trade their wake back into financial health without having to worry about markets closing funding to them. Once financial institutions are back on track, they can get back to their normal function of borrowing and lending funds within the economy.
Koo is a little unfair on the impotence of monetary policy here; he seems to forget the role that monetary policy plays in shaping expectations about the economy and how that can spur growth. Indeed, this is largely the concept of central banks announcing a NGDP level target or price level target to move the economy back on track, a tool favoured by a growing chorus of top economists. Bernanke circa 2003 looked at the Japanese problem and concluded that they didn’t go far enough with monetary policy. The same problem applies to the US today – the Federal Reserve needs to adopt an economic version of the Powell Doctrine for growth, where they shock and awe the markets with overwhelming monetary firepower to kick-start the economy.
Hysteresis and the implication of long-term unemployment
Figure 2. Supply-side explanations
Source: Mike Konczal, http://rortybomb.wordpress.com/
Hysteresis is essentially the morphing of an aggregate demand problem into one of an aggregate supply problem. In essence, a long period of underinvestment combined with the long-term unemployed becoming unemployable reduces that productive capacity of an economy. Although this is presented as a supply-side question, I see it more of a justification that something – monetary or fiscal policy – needs to be done about the demand shortfall before it starts having a severe impact on the future capacity of developed countries around the world.
In the US, the problem is already starting to rear its ugly head. Courtesy of Krugman, here is the manufacturing capacity of the US:
Figure 3. US manufacturing capacity
Source: Paul Krugman (http://krugman.blogs.nytimes.com/2011/09/18/hysteresis-begins/) and Federal Reserve Economic Data)
Producers in the latest recession are not only failing to expand to at least keep pace with long-term growth trends, but also scrapping capacity in absence of adequate demand. This is also mirrored in the labour market and the housing market. The result of all this is that when a recovery finally does occur, these economies will run up against capacity constraints quicker than they otherwise should have if they responded with appropriately sized stimulus in the first place. This means that inflation will arrive earlier than we otherwise would have suspected (although there is no danger of inflation right now).
This just highlights the foolishness of policymakers in depressed economies, particularly Europe, slashing government spending. They are reducing their economy’s long-term growth potential, reducing expectations of future tax revenues and exacerbating their debt positions in the long run.