By James H. Nolt
Economist Richard C. Koo coined the term “balance sheet recession” to refer to the unusual problem faced by Japan since the 1990s, and subsequently by many other countries. He has written a series of excellent books applying this idea to the worldwide economic problems of the last couple decades, culminating in his most recent one, The Escape from the Balance Sheet Recession and the QE Trap. I rank him, along with Hyman Minsky, as one of the most important macroeconomists of the last half-century. He deserves the Nobel Memorial Prize in economics, but given the heterodox tenor of his arguments, he may never receive it.
A balance sheet recession occurs when net private savings is high despite near-zero interest rates. Net private savings are total private savings minus total private borrowing. Private savings include both household and corporate savings. According to economic textbooks and typical historical experience, households are net savers but non-financial businesses should be net borrowers, leading to a rough balance of borrowing and saving in the private sector, with financial companies as the intermediaries.
However, in the aftermath of a major asset bubble, such as the one that burst in Japan during the early 1990s, many households with mortgages and bullish corporations become intensely worried about bankruptcy because the value of their assets are falling with the end of the bubble but their debts remain unchanged. They might have to reduce their debt to avert bankruptcy. Thus borrowing falls and may become negative if more old loans are repaid than new ones made. Savings increase to provide a cushion against bankruptcy. Financial institutions also retain more reserves so that their own net savings increase. When all private sectors are saving more and borrowing little, their excess savings depress demand, creating a deflationary gap, and therefore a recession. The only way, Koo argues, to replace the lost spending is for the government to borrow and spend. Monetary policy becomes ineffective; expansionary fiscal policy is the only way out.
Koo first discovered the phenomena as chief economist for Nomura Securities, a leading financial company in Japan. His research subsequently identified a balance sheet recession in Germany after the IT bubble burst around the year 2000, then a slew of similar recessions in the U.S. and many European countries after the 2008 world financial crisis. I agree with his diagnosis, however, many conventional macroeconomists do not. They cannot see the logic of why private corporations would refrain from borrowing with interest rates so low. Surely there are profitable projects that could be initiated by borrowing as low as 2 percent.
Koo supplies an unsatisfactory answer. He says firms and households become so debt-averse from the trauma of the previous crash that they forgo profitable investments. Rather than profit maximizers they become debt minimizers. Few neoclassical economics are content with this sort of reasoning, because it violates their assumption that corporations are rational profit maximizers.
My way of understanding polarized political economy supplies a better answer. First of all, there are always bears who expect asset prices to fall and bulls who expect them to rise. A balance sheet recession occurs when bearish expectations dominate. Yet at no time are all interests bearish in every asset class. Koo falls into the faulty habit of nearly all economists in considering dull grey averages rather than the polarized extremes of contending bears and bulls.
Secondly, Koo assumes the standard neoclassical fiction of banking as merely intermediation between savers and borrowers. Koo does not see financial power. He does not consider financial companies as strategic actors. As in conventional textbook economics, Koo allows only governments and their central banks to have strategies and policies. The entire private sector is just a machine that reacts to initiatives of the government rather than launching its own strategic initiatives. Koo lacks any appreciation of my strategic method.
Third, Koo does not understand the true reason for the lack of private borrowing “despite low interest rates.” Contrary to his and the textbook view, there is no market for credit. Advancing or denying credit is always a strategic choice by creditors. Credit is always rationed. That is, there are always more willing borrowers than there are willing lenders. The claim that interest rates are extremely low would surprise many small businesses and startups that would love to borrow, but cannot find any creditors willing to lend at all, let alone at a reasonable interest rate. The problem is not a lack of borrowers, but the bearishness of potential lenders. Aspiring borrowers who would have looked attractive when asset prices were rising and the economy booming become unpalatable risks when the banks themselves face solvency challenges, trading losses, rising loan defaults and non-performing loans. Thus they hold onto more of their own capital as excess reserves rather than lending it. Alternatively, they may employ capital to finance trading, including bearish short positions, rather than as loan capital. Koo rarely considers financial derivatives or other trading business of banks.
Fourth, Koo swallows the textbook Myth of the Money supply, which I have debunked in a previous blog and article. That is, he thinks the money supply is what matters for monetary policy. In fact, the money supply is an intellectual construct necessary only for the neoclassical idea of money as something scarce. What matters for aggregate demand is not money, but, more broadly, credit. Expanding and contracting credit is the heart of credit power, which is wielded primarily by financial firms. Money, variously measured, is just an artifact of the expansion or contraction of credit. Fluctuations in what economists measure as the money supply are always mild relative to the more volatile swings of credit availability.
Fifth, Koo thinks that a balance sheet recession occurs primarily because borrowers cease wanting to borrow. In part, this is true. Those investors and households that were most bullish during the previous bubble, if they survive the crash, they may become extremely debt shy. More typically, they are forced by creditors to repay loans without being offered the chance to roll them over, as would have been routine during the boom. That is, their plight might be caused more by the bearishness of the creditors rather than by their own unwillingness to borrow at low rates. Actually, low interest rates are simply not available to them. Koo believes corporations become irrational debt minimizers, when in fact they may merely succumb to the private power of rationally bearish creditors.
Koo’s solution to a balance sheet recession—heavy government borrowing and spending—may indeed work well. It provides demand for output that induces some bearish creditors to become bullish in the asset classes favored by government spending. But there are other solutions as well, for example, if there is a government-run bank that can lend counter-cyclically it could extend funding to enterprises that are viable but debt-strapped and thus unappealing to private lenders. Borrowing at 2 percent such a bank could find thousands of worthy projects to fund at 3 percent or more without any cost to current taxpayers. Despite his weak micro foundations, Koo’s diagnoses are on target. If he would incorporate my strategic method and bull-bear polarized interests, he would hit a home run.
This blog will return in September, since the World Policy Institute will be closed for the next two weeks.
James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.
[Photo courtesy of Toomore Chiang]