SeekerBlog

This is a followup to my last on Koo’s thesis: Richard Koo: CSIS Economic Outlook Discussion.

The CSIS video linked isn’t especially useful – because the camera just sits on Koo and doesn’t show the slides he is talking from. I recommend you download the slide presentation, and the audio MP3. Then you can listen to his talk and reference the slides yourself – he is usually quite clear on which slide he is using.

Personally, I find his thesis compelling — see below for apparent agreement from such as Paul Krugman, Martin Wolf and Paul McCulley. The elevator pitch brief is this:

1. Very infrequently a country encounters what he terms a “balance sheet recession” which has completely different properties and treatments from normal business cycle recessions. Examples, today’s crisis, Japan’s 15 year slump, the Great Depression. Today’s crisis is especially serious because it is not just the US but involves simultaneous and similar responses in other credit bubble economies such as the UK – plus the global impact of the collapse in demand has brought down even the surplus countries like China.

2. The fall in asset values means the private sector must repair their balance sheets, which produces weak demand for funds and credit. Over years the deleveraging will be completed, but in the process the private sector shifts from profit maximization to debt minimization. Business profits and consumer surpluses instead of being spent or invested are deposited into the banking system (in the US this has averaged about $100 billion per month over the past six months). Normally this would support roughly ten times as much bank lending. Now the funds are trapped in the banking system due to the lack of demand for funds.

3. The sum of savings and debt repayments end up becoming the leakage from the income stream – which produces a deflationary feedback loop. More savings/deleveraging ==> lower incomes ==> lower demand for credit.

4. Repeat the adverse feedback until incomes (GDP) have fallen to a new equilibrium where the private sector is too impoverished to save.

5. In this type of recession, the economy will not enter self-sustaining growth until private sector balance sheets are repaired.

6. Monetary expansion is ineffective due to the lack of demand for funds/credit — the additional liquidity injected by the Fed just ends up in excess banking system reserves.

7. What policies can reduce the damage done to incomes by the deleveraging? Two policies according to Koo: (1) fiscal stimulus, where the government borrows at very low costs to spend the excess savings of the private sector. Japan’s experience demonstrated that GDP could be supported by sufficient government borrowing/spending — thus avoiding a catastrophic collapse in incomes. And (2) capital injections into the financial system to heal their balance sheets.

Richard Koo’s explanation of these concepts is much more clear than my summary — do listen to his talk together with his slides.

BTW, I disagree with his conclusion that tax cuts will not work, it must be government spending.

In his April 6, 2009 post Paul Krugman indicates that he is giving very serious thought to Koo’s analysis, concluding as follows:

[...] 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.

Writing for Financial Times February 19th, Martin Wolf agrees with Richard Koo’s concept of the “balance sheet recession” and the relevance of Japan’s experience to US, UK and other over-leverage economies (e.g., Spain). An excerpt:

[...] Most of the decline in Japanese private spending and borrowing in the 1990s was, argues Mr Koo, due not to the state of the banks, but to that of their borrowers. This was a situation in which, in the words of John Maynard Keynes, low interest rates – and Japan’s were, for years, as low as could be – were “pushing on a string”. Debtors kept paying down their loans.

How far, then, does this viewpoint inform us of the plight we are now in? A great deal, is the answer.

<snip>

Despite a loss in wealth of three times GDP and a shift of 20 per cent of GDP in the financial balance of the corporate sector, from deficits into surpluses, Japan did not suffer a depression. This was a triumph. The explanation was the big fiscal deficits. When, in 1997, the Hashimoto government tried to reduce the fiscal deficits, the economy collapsed and actual fiscal deficits rose.

Included with Martin Wolf’s essay is a 5 minute video where Marin explains how the crash happened in “The long road to ruin”. Pretty good short summary — missing are any particulars on the deleveraging death spiral.

PIMCO’s Paul McCulley examined the deleveraging adverse feedback loop in a column last July, 2008 — in his essay on The Paradox of Deleveraging An excerpt, beginning with the Paradox of Thrift (an example of the general class of paradox of aggregation):

[...] This principle is part of a whole range of macroeconomic concepts under the label of the paradox of aggregation: what holds for the individual doesn’t necessarily hold for the community of individuals. Understanding this paradox is absolutely vital to understanding macroeconomics and even more so to understanding what is presently unfolding in global financial markets.

Double Bubbles Bust

Once the double bubbles in housing valuation and housing debt burst a little over a year ago, everybody, and in particular, every levered financial institution – banks and shadow banks alike – decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense. At the collective level, however, it has given us the paradox of deleveraging: when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed. Put differently, not all levered lenders can shed assets and the associated debt at the same time without driving down asset prices, which has the paradoxical impact of increasing leverage by driving down lenders’ net worth. This process is sometimes called, especially by Fed officials, a negative feedback loop. And it is, though I prefer calling it the paradox of deleveraging, because the very term cries out for both a monetary and fiscal policy response, not just a monetary one. Lower short-term interest rates via Fed easing are, to be sure, useful in mitigating deflating asset prices, particularly if they serve to pull down long-term rates, which are the discount rates for valuing assets with long-dated cash flows. But monetary easing is of limited value in breaking the paradox of deleveraging if levered lenders are collectively destroying their collective net worth. What is needed instead is for somebody to lever up and take on the assets being shed by those deleveraging. It really is that simple.

Like Richard Koo, McCulley recognized the need for more than monetary policy. Though in this piece McCulley is focused on stopping the deleveraging negative feedback by buying up banks’ assets to arrest the price declines:

Time to Lever Up Uncle Sam’s Balance Sheet
As Keynes taught us long ago, that somebody is the same somebody that needs to step up spending to break the paradox of thrift: the federal government, which needs to lever up its balance sheet to absorb assets being shed through private sector delevering, so as to avoid pernicious asset deflation. That’s a fiscal policy operation and, fortunately or unfortunately, fiscal policy is not made by a few learned technocrats above the political fray of the democratic process, but is squarely in the hands of the legislative branch, consisting of 535 politicians, with far more lawyers than economists among them.