Balance Sheet Recessions [Theory Discussion]

Flamed Diving

This popped up on Paul Krugman's blog and I thought I would share it. We haven't had a discussion about theory (or a discussion about anything not-related to Ireland) for so long, I thought I would try drag things back to he good old 'Biz' days.

I know, I know...

APRIL 6, 2009, 12:23 PM
Balance sheets and the trade cycle (somewhat wonkish)

Paul Kedrosky has the slides from a presentation by Nomura’s Richard Koo on “balance sheet recessions”, a meme that’s been gaining ground lately. I’m in the process of trying to think this stuff through more formally; here’s a quick note about where my thoughts are tending.

As I see it, the balance sheet recession approach to the business cycle is a close cousin to a once-influential but largely forgotten literature: the “non-linear” theory of the business cycle. The original version, by John Hicks (”A contribution to the theory of the trade cycle”), set up the basics. The idea was that in the short run the economy is unstable: an economic boom causes rising investment spending, which further feeds the boom, and so on, while a slump depresses investment spending, deepening the slump, etc.. Hicks’s big contribution was to add limits to the boom and slump: a “ceiling” set by the economy’s capacity, a “floor” set by the fact that investment can’t go negative.

The cycle then went like this: the economy races to the ceiling during a boom, and stays there for a while. Eventually, however, overcapacity builds up, investment starts to fade, and a self-reinforcing slump takes hold. This pushes the economy to the floor. The depressed economy eventually revives when a combination of depreciation and growth in sources of demand not tied to the business cycle starts to create a shortage of capacity, which leads to an upward trajectory, and the whole thing starts all over again. (Yes, we can do this with equations …)

What Koo is arguing for is something similar, but with debt playing the role played by capacity in the old trade cycle. When the economy is growing, taking on more debt seems OK, and rising debt feeds rising spending, which feeds the boom. Eventually growth has to slow, however, and the debt starts to drag down spending, which reduces income, forcing more deleveraging, and so on to the floor. Then debt slowly gets paid down, until the cycle is ready to start again.

This suggests a prolonged slump. In particular, it tells us not to get too euphoric over “green shoots” and all that. Yes, we may — may — be approaching the “floor”, where the free fall ends. But it can take a long time, many years, before balance sheets are sufficiently repaired for the economy starts to climb off that floor.

It also suggests a positive role for fiscal expansion — and an answer to the line that debt got us into this, so how can it get us out? What this style of modeling suggests is that over the course of the whole cycle, the problem isn’t so much excessive debt as the fact that everyone tries to increase or reduce debt at the same time. What deficit spending can do is stabilize things: you have one big player in the economy that is increasing debt when the economy is stuck in a paradox-of-thrift world, then pays that debt down when the private sector is happy to borrow.

Much more when I have time to do a proper writeup.

http://krugman.blogs.nytimes.com/2009/04/06/balance-sheets-and-the-trade-cycle-somewhat-wonkish/

This looks like an interesting little hypothesis, I don't really have the time to watch the lecture yet, but I am going to investigate it some more in the coming days. I thought I would post it up and see if it generates any discussion.

Lecture slides with accompanying audio/video is here:

http://paul.kedrosky.com/archives/2009/04/richard_koo_on.html

Économiste Monétaire

Nice. I'll watch the video and post any thoughts. Just be careful of Krugman and any excuse for fiscal expansion

Excellent link.

I am actually working on a similar concept but through a very different medium for my MSc thesis at the moment. This might fit in.

silverharp

Just for fun , here is an article that would cover some of the points from a free market pespective

http://mises.org/story/3151

Austrian Economist Frank Shostak discusses the pool of real savings and a "do nothing" policy proposal in Good and Bad Credit.
<snip>
Neither the Fed nor the Treasury is a wealth generator: they cannot generate real savings. This in turn means that all the pumping that the Fed has been doing recently cannot increase lending unless the pool of real savings is expanding. On the contrary, the more money the Fed and other central banks are pushing, the more they are diluting the pool of real savings.

We suggest that decades of reckless monetary policies by the Fed have severely depleted the pool of real savings. More of these same loose policies cannot make the current situation better. On the contrary, such policies only further delay the economic recovery.

By impoverishing wealth generators, the current policies of the government and the Fed run the risk of converting a short recession into a prolonged and severe slump.

nesf

silverharp wrote: »

Just for fun , here is an article that would cover some of the points from a free market pespective

http://mises.org/story/3151

Austrian Economist Frank Shostak discusses the pool of real savings and a "do nothing" policy proposal in Good and Bad Credit.
<snip>
Neither the Fed nor the Treasury is a wealth generator: they cannot generate real savings. This in turn means that all the pumping that the Fed has been doing recently cannot increase lending unless the pool of real savings is expanding. On the contrary, the more money the Fed and other central banks are pushing, the more they are diluting the pool of real savings.

We suggest that decades of reckless monetary policies by the Fed have severely depleted the pool of real savings. More of these same loose policies cannot make the current situation better. On the contrary, such policies only further delay the economic recovery.

By impoverishing wealth generators, the current policies of the government and the Fed run the risk of converting a short recession into a prolonged and severe slump.

Honestly, meh.

Time Magazine

Let's try keep this a discussion on economic theory and leave the Austrian v. Interventionist debate for another thread.

johnnyskeleton

http://www.csis.org/media/csis/events/090326_koo_presentation.pdf

PDF format of the slides if you want to download them.

A good argument to the effect that simply printing money and putting it into the banks doesn't work; governments need to borrow and spend in a way that ensures it goes directly to businesses.

The problem I have with it is that you can't simply keep borrowing and spending forever, eventually the cycle has to be broken.[EDIT:nothing to do with Austrian school]

nesf

johnnyskeleton wrote: »

The problem I have with it is that you can't simply keep borrowing and spending forever, eventually the cycle has to be broken.

Indeed, his solution seems to be that the Government runs surpluses/grows out of the debt as tax revenues rise once the deleveraging is complete. It's an interesting argument.

There is a case I think, for a fiscal expansion to mop up unused credit in the domestic financial sector.

Flamed Diving

I won't get a chance to contribute until Wednesday evening, I'm really looking forward to viewing the lecture though. Is it well presented?

Économiste Monétaire

It's an interesting presentation and a different treatise on Japanese macro history. Transposing his ideas over to the Irish case, we can't borrow that amount of money. An overwhelming proportion of the purchasers of our debt are foreign agents, I don't know where that increased domestic demand to lend will come from (mutual funds, commercial banks, general shadow banking?). Koo shrugged off the importance of ratings agencies, a series of downgrades on our debt would mean that our banks could no longer use those assets as collateral in ECB MROs, which is keeping them liquid. This is an issue under consideration for Greek national debt, i.e. would the ECB lower its collateral standards.

Japanese debt stands at 173% of GDP, according to the OECD. Koo raises a good point on yield, though, which is slightly counter-intuitive. The interest payments on that debt, as a proportion of GDP, was 0.8% for 2008. Just for comparison on this issue (Source: OECD Economic Outlook):
Country|Gross Debt (% of GDP, 2008)|Debt payments (% of GDP, 2008)
Austria|62.6|2.1
Belgium|92.2|3.6
United Kingdom|58.7|1.8
United States|73.2|2.1

I guess his recommendation to Obama, to build roads and bridges to nowhere, is based upon a large supply side increase in lending. When the Federal Reserve starts to vacuum up the excess reserves, I don't really know where the funding will come from, especially when the standing facilities are removed for all but depository institutions.

I'm also highly sceptical of his fiscal multiplier figure for Japan. It's obvious that it could not be that high in our case, we're a small open economy, a lot of it would leak out. Has anyone studied empirical work on fiscal multipliers for a case like Ireland? I'm fairly certain that the savings figure in Exhibit 10 should be higher, the recent BEA figures show 4.2%.

He also discussed the "fat spread" idea, whereby banks have a relatively high differential between deposit rates and loan rates. I can't really see that idea working here, politically, but it is an interesting (cheap) concept to get banks back on good capital footing. The problem for Irish policy makers implementing this is basic arbitrage. Borrow in another Euro member country and lend that money here. You can't impose capital controls to stop that. I don't really think he presented anything new or counter-factual to common interpretations of ineffective monetary policy when banks won't lend. The view on a collapsing demand side is quite interesting, and pretty relevant going forward.