There are many questions about this current recession. Why did the economy decline so much? Why are most economies stagnating? Why has low interest rates and quantitative easing not lead to recovery? I recently read Richard Koo’s The Holy Grail Of Macroeconomics which answers these questions. I found it deeply insightful, not only for its explanation of the current recession and the Great Depression but also because it was written before the crisis even happened. Koo accurately describes out current mess, what’s wrong and what we have to do to fix it.
Unlike traditional neo-classical economics, Koo does not assume firms are profit maximising. Instead, he argues there are occasions when their focus switches and they become debt minimising firms. This change of priorities is crucial to his description of what he calls a balance sheet recession. It is for this reason economies have failed to recover from the 2008 financial collapse and why neo-classical economics has been at a loss to explain it. Although Koo draws his conclusions from the Japans’ recession in the 1990s, it can be applied to our current troubles. This is even more impressive considering the book was written in 2008 before the crash even occurred.
Koo begins his analysis at the end, after the crash, due to an asset price bubble. Due to the rapid decline in the value of their assets many companies find themselves in a state of insolvency. In response they try to pay down their debt as quickly as possible before anyone notices. However, as one person’s spending is another’s income, when these companies stop spending, they decrease demand and the economy declines further. It is only after several years of debt repayment that businesses are willing to start borrowing and spending. Until then the economy is mired in recession. In Japan this took the best part of 15 years. Even then managers will still be overly cautious about borrowing so there will still be under-investment in the economy. As businesses don’t want the world to know they are insolvent, they will naturally keep quiet which is why the fact they are not borrowing but rather paying down their debts gets so little attention.
Monetary policy is next to useless in solving the problem. Interest rates have been reduced to historically low levels yet this has not given a boost to the economy. This is because even at extremely low levels firms do not want to take out new loans. They are too busy reducing their level of debt and trying to avoid insolvency that they do not consider increases their level of debt no matter how attractive the offer is. Quantitative easing (printing money) is also ineffective because there is no one willing to borrow and spend all this extra cash.
Another feature of a balance sheet recession is that it is that there is a lack of borrowers not a lack of lenders. Surveys taken in Japan in the 90s and America in the 30s found that very few businesses had difficulty getting loans. Instead the problem was that few businesses applied for loans. Their priority was debt minimising so they were not taking out loans. While this makes sense from an individual point of view, if everyone does it the economy stagnates. Therefore while it is necessary in some cases (like Ireland) to get banks to lend more, this will not in itself solve the problem. This is why attempts to recapitalise the banks have not led to recovery. Even with extra funds, banks have no one to lend to.
With monetary policy ineffective, Koo recommends fiscal action. Governments must replace the drop in demand with spending. If businesses won’t spend then government must. Government must increase spending by a large amount for several years in until businesses have cleaned up their balance sheets and are willing to invest again. It interesting to compare how Japan reacted to the bursting of its bubble, to how we reacted to ours. Japan launched a major fiscal stimulus which managed to keep GDP from dropping despite asset prices having dropped by one-third. Many analysts drew the false conclusion that the fiscal stimulus was ineffective, failing to realise that without it, GDP would have suffered an enormous drop. In 2008/9 most countries did not launch a stimulus and as a result their economies were allowed to decline. Austerity Ireland now has unemployment of 14%, while mild stimulus America is at 8%. Importantly, austerity makes the situation worse. Cutbacks in 1997 and 1937 made the deficit larger and pushed the economy back into recession.
Koo describes what he calls the Yin and Yang phases of the economy. Yang is the typical textbook economy where the free market of profit maximising firms works well in harmony and it is best to avoid government intervention. Monetary policy is effective and prosperity will result. Yin is the other stage of the economy, the stage we are in at the moment. In it, the economy is stuck in a balance sheet recession where monetary policy is ineffective as firms are paying down their debt. Left to its own devices, a depression will result. It is necessary for large and sustained government intervention to restore the economy to prosperity.
Economics today is based on a Yang economy and is unable to deal with a Yin economy like the current crisis. The standard orthodox monetary policies are useless now; unorthodox fiscal policies are the solution. Koo highlights the important lesson that economics isn’t simply a question of which policies should be used in every situation as a one-size-fits-all. Rather it depends on the situation. “Right wing” policies like small government and monetary policies are (according to Koo) appropriate during boom times when things are going well, whereas “left wing” policies like large government spending are appropriate during recessions when times are bad. It is less a question of “what are the right policies?” as “what are the right policies for our current situation?” Koo criticises neo-classical economists for advocating the wrong policies in the 30s and now, but also the Keynesians for advocating the wrong policies during the 50s and 60s.
Koo develops an economic cycle that is similar to that described by Fisher, Minsky and Keen, except unlike most economists he begins with the crash. An asset bubble bursts, usually by tightening monetary policy. The resulting decline in asset prices leaves firms insolvent who then focus on repaying debt. This leads to further decline and renders monetary policy ineffective. At this point massive government intervention is necessary. Eventually firms finish paying down the debt, but are still averse to new debt. This continues until a new generation takes over without such reservations. The economy booms with new investment and big government is no longer needed. Prosperity leads to euphoria leads to hubris leads to crash. And the cycle repeats itself . . .