Balance Sheet Recession

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 . . .

5 thoughts on “Balance Sheet Recession”

  1. This sort of analysis is valuable in many ways. It makes sense in the context of its assumptions and the data it examines is interesting and illuminating. I enjoy looking at the graphs presented by Koo; it’s really great work.

    Unfortunately (and you knew this was coming), the analysis has severe blind spots with respect to basic features of how an economy works and grows. This isn’t merely a technical matter but something much more fundamental. Of course I could be wrong about these fundamentals too.

    The basic problem is the Keynesian and mainstream obsession with higher GDP and spending figures. The unchallenged assumption is that higher GDP is the same thing as higher economic growth and that falls in GDP are always necessarily a bad thing.

    Using a vision of the economy as a kind of spinning machine which sends money in circles from producers to consumers and back again, the mainstream economist thinks that if this machine starts to slow down, with velocity falling away and money getting clogged up, then the economy gradually grinds to a halt. One person’s spending is another person’s income, of course: if some people refuse to spend then others don’t get any income and therefore can’t spend. So less and less money gets to circulate, GDP collapses, jobs disappear as more businesses close and we have an economic catastrophe.

    What’s missing from this vista? In two words: capital theory. But you know that I can never just stick to two words, so let me continue.

    What’s missing from the Keynesian economist is an understanding of basic economic forces

    Why do people pay such high prices for diamonds? Is it because getting diamonds often requires exploring very deep underground at great expense to those involved? It would be easy to think that was the reason but in fact the relationship between those two phenomena is precisely the opposite: the truth is that explorers go deep underground at great expense because people are willing to pay such high price for diamonds, and not the other way around. The causation flows from the strong desire for diamonds to the efforts to get the diamonds. In other words, we do not make efforts to produce random things and then want those things that we produced in proportion to how much effort it took to produce them. Instead, we as society and an economy allocate our efforts to produce those things which we want the most, in the context of the resources and means available to us.

    There are very many different ways to think about how an economy works, of course, but I would argue that any viewpoint which denies that value is imputed from the consumer back through the structure of production is indefensible. Don’t let the word “imputed” put you off. This is all that I mean: consumers value certain goods, those goods therefore being marketable at particular prices in the marketplace. Producers therefore also value these consumer goods and are willing to pay for the production goods which will enable them to bring the consumer goods to market. Other producers therefore also value those production goods and are willing to pay for second-order production goods enabling them to bring the first-order production goods to market. And so on and so on until we get back to the most basic highest-order raw materials such as land, seawater and iron ore. The point is that the cause of economic activity is consumer desire, and the effects are valuations rippling through the structure of production back to the goods of highest order.

    How is this relevant to the critique of Keynesianism? For starters, Keynesians simply don’t appreciate the unfathomable complexity of the structure of production. The spinning machine vision of the economy fails to account for what actually produces economic value. If you consider the range of consumer products in any room of your house and try to trace their origins, not just the component parts of each good but the component parts which were used to manufacture the component parts of each good and all the ancilliary support services which were required to make the process possible, the distribution systems involved, the financial analysis which so many people must have undertaken for each big project, the investors who put up the initial money to fund everything, the salesmen and negotiators and lawyers behind every deal, you would begin to see the incredible human coordination which is achieved by a modern economy.

    Once we begin to understand this complexity, we have a greater respect for the structure of production underpinning it. Furthermore, interest rates are seen not just as indicators of risk premia attached to investment projects but also as the outcome of time preference: we prefer to enjoy goods now rather than in the future. The lower valuation we attach to future goods manifests itself in the discount we will pay for them as compared to present goods, and in the context of money instruments this is manifested by the interest rate.

    So what is the fundamental problem with the Keynesian analysis? I think there are several fundamental problems, but they are all related to this neglect of capital theory and I would begin by pointing out that a general slowdown in spending might be exactly what an economy needs. A credit boom implies the misdirection of capital – not just financial, but real capital. Factories, service companies and labour have been put to work on projects which could never have been profitable in the long-run.

    This is where an appreciation of the structure of production comes into its own. If you understand it, you see that it is necessarily going to take time for society to redirect resources to their most productive uses. Labour will need to be retrained with skills more appropriate to the opportunities which genuinely exist. Machines for projects attempted as a result of the misdirection of capital need to be replaced with tools more suited to projects which could actually succeed. That’s not going to be instantaneous; it takes time for all of this to be analysed and then for the new factories and new tools to be produced. New businesses need to be formed but it may take months or years for the process to complete even if there are no unnecessary barriers in the way.

    When we understand this, we begin to see a recession not as something which should be avoided, but as something which is unfortunately inevitable. There is no magic way that the government can fix the structure of production. Printing money does not achieve it. Borrowing money and spending it does not achieve it. Bailing out the institutions which failed does not achieve it, and in fact slows down the fixing process. What fixes is it is allowing people to move on from the mistakes of the past as quickly as possible.

    Does it matter that spending drops, that GDP drops? No. Those are effects of the problem (too much misdirected credit in the system), not the cause. On the contrary, they are part of the healing process: spending and GDP had been falsely pumped up during the credit boom, and bringing them back down means getting the economy back onto a stable footing from which it can grow again.

    But one person’s spending is another person’s income? Again, this completely neglects capital theory and the true nature of economic growth. This is a victim of the obsession with watching money flows instead of looking at what is actually happening in an economy. Suppose I earn €1 million by discovering a new way of boosting corn output, and I decide to burn the money I’ve earned instead of spending it. The Keynesian economist thinks that I’ve damaged the economy, when the truth is I’ve acted in an unbelievably altruistic manner. I have provided great value to everybody else who gets to enjoy plentiful corn supplies, but I personally have not used up the value which anybody else produced. The €1 million disappears from the economy with the result that everybody else enjoys a benign deflation, able to enjoy the extra corn as a result of my discovery but without having to compete against my new spending power for other goods and services.

    “But your spending is someone else’s income”. It’s true that the local car dealership might have ordered a very expensive car in anticipation of my purchase after I earn all this money from my discovery. The car salesman will be very disappointed that I don’t show up and might have to sell the car at a loss. He’ll be even more disappointed when he realises that I plan to burn the earnings from all of my future discoveries. In fact, without my purchases, he is going to have to close his dealership and get into some other kind of work. What a terrible person I am!

    But if you trace the total effects of my money-burning programme, you see that I am still a perfectly benign influence on society as a whole. I have freed up the labour of the car salesman for the rest of society. Other people do not have to compete against me for the labour of the car salesman, and so he is now going to serve other people instead of me. This is exactly how my altruistic money-burning strategy produces benign deflation and enriches society as a whole.

    As we can see now, the truth is that one man’s spending is another man’s lost opportunity, as the person who was outbid for the good in question (such as the labour of the car salesman) goes without it. After a credit boom, we want spending to fall so that resources can be freed up for those who are really going to be able to use them productively. We need businesses which waste capital to get out of the way in favour of businesses which don’t. Since the boom was based on excessive credit, and since that credit is now thankfully dissipating, the transition process will naturally involve falling prices. This is the economy which flew too high getting back onto a flight path of stable growth.

    1. Your comments are so detailed you should have a blog of your own! ha I’m always glad of you dropping by and sharing a different opinion.

      I think we seem not only to have different opinions but also seem to be looking at different parts of the economy in different ways.

      “Factories, service companies and labour have been put to work on projects which could never have been profitable in the long-run.”
      The main mistake think you make is that you ignore time and context. For example you seem to suggest that there is one fixed long term profitability. Over investment leads to returns below this level. However, profits depend hugely on context. I build a hotel, it does great in the boom but terribly in the bust. However this is no guide as to whether or not the hotel should stay open. If times are good it might still make a profit. So the success or failure depends on the state of the economy which is always changing.

      The second problem is that recessions are not temporary re-adjustments. If so we wouldn’t still be stuck in one. The people who lost their jobs aren’t retraining and as soon as their done the economy will return to normal, rather many of them are idle. For many there is no readjustment, just emptiness. The same goes for capital. A lot of it is sitting idle in banks. If companies were readjusting then investment rates would be high, instead they’re still quite low. The recession is not a necessary readjustment. It is like falling down a hole, the longer we wait, the longer we’re stuck here.

      Also recessions are not as painless as you suggest. It is not simply a matter of reducing spending, there is also the problem of higher unemployment and similar problems (poverty, foreclosures etc).

      If you burnt 1 million the resulting deflation would be so slight that it would have no effect, whereas the loss of 1 million would have an effect.

      “I have freed up the labour of the car salesman for the rest of society.” This presumes that the salesman can find another job and not be wasted in useless unemployment. It also presumes that he will find a better job (in terms of pay or societal benefit) that as a salesman, a contention I see no reason to be true.

      A reduction in spending will not fall proportionally so there is no reason that those who waste money will be punished while those who are prudent will be spared. Its just as possible it will be the other way around. In recessions, reckless businesses may fail but they often bring down responsible ones. The nature of modern business means many borrow and lack the cash flow to repay this debt quickly. In a recession insolvency can destroy good and bad businesses.

      1. Hi there. Perhaps the same as for yourself, real life prevents me from writing back as quickly as I might.

        Let me explain the sense in which I claimed that projects undertaken could never have been profitable.

        Suppose that you are a house builder (unlikely, I know). Suppose that you have a particular supply of concrete which you think you can convert to 1,000 bricks. Each house you build requires 100 bricks, so you set to work on building 10 houses.

        However, suppose that you had overestimated how much concrete was available to you, and in reality there is only enough concrete to make 500 bricks. At some point along the construction process you run out of concrete and are left with 10 half-finished houses, none of which are of any use to anybody.

        This is essentially the core of the point that projects undertaken during the boom could never have been profitable: they were impossible in the context of the capital stock which was available in the economy on a forward-looking basis. They were the product of a credit boom in a fractional-reserve banking system, not real savings (this is why some economists refer to credit creation as a process of “forced savings”). I am not ignoring time and context – I am saying that the credit boom put Ireland’s capital stock to use in ways which had nothing to do with the context of the investment and consumption opportunities available at the time. This process destroys capital, making the country much poorer in real terms.

        (Note incidentally that while the 10 houses are being built, your house building company’s share price will probably be very strong and you will probably be spending freely on your own personal consumption in anticipation of the payoff from selling 10 houses; this is of course analogous to what happened during Ireland’s credit boom.)

        Secondly, you write about the current recession as if it is the fault of the authorities not doing enough, when you should agree that all the major central banks are pursuing “unconventional” (experimental and ultra-loose) monetary policies. After stabbing their economies in the ribs with loose policy during the 2000s, they are now attempting to abolish interest rates and threatening to print infinite amounts of money if the markets don’t do what they want them to do.

        Re-adjustment to life after the credit boom was always going to be very difficult, but it is made much harder by the fact that entire Western economies are now built on the fantasy of near-0% central bank interest rates. Our real capital stock is being attacked and depleted like never before; why bother to save when getting real after-tax rates of return are so low or in many cases even negative? Further, it is almost impossible to make long-term plans in this environment. We all know that these policies will have to end some day and that when they do, it is going to be very ugly.

        Re-adjustment is painful, but more loose monetary policy and government deficits do nothing to help the process. In fact, they retard the process by perpetuating the conditions which caused the problems in the first place.

        Moving on, I did not presume that my used car salesman would get a better job if I decided not to buy any cars. He might very well be worse off as a result of my decision. Clearly, the people along my own personal supply chain would prefer if I spend as much as possible. The point is that without my demand for the car salesman, the rest of society as a whole, apart from me, is better off, since his labour is freed up to serve them. It is part of the set of resources available to society and it was not available before.

        If you disagree with this, you may also think that if the reason I burned the money I earned was because a genie in a bottle had given me an infinite supply of luxury cars for my own personal use, then the genie would also be responsible for hurting the economy.

        If you do think that, I suggest you reflect on the following Petition from Candlemakers:

        Your final paragraph states that good and bad businesses both fail in a recession.

        I detect a fatal conceit here; how do you know which businesses are good and which ones are bad? If a company is prudent and stable, but its major customers are over-leveraged and engaged in capital consumption in a credit boom, then the stable company unfortunately also needs to fail as part of the re-adjustment of the economy.

        Remember that every business uses up capital (both real and financial) and in doing so prevents that capital from being used elsewhere. When a business fails it liberates the capital it was consuming for new uses which are more appropriate to the capabilities of the economy. What you call “responsible” businesses may be businesses which didn’t realise that they were part of a chain of suppliers and buyers in the structure of production which itself was unsustainable and doomed to failure. As painful as it is, entire chains of businesses may need to be liquidated in a recession. Rather than letting the economy get on with this process, governments through monetary, regulatory and fiscal measures tend to try to prevent it. This makes sense from the perspective that governments will tend to defend and support status quo interests. What makes it ironic is that allegedly “alternative” and even “revolutionary” political people tend to defend these measures too.

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