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.
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It also lends support to the idea that the fed should be raising rates to put on the brakes when large-scale private indebtedness grows beyond some danger threshold, to prevent the economy from ever hitting the ceiling, while lowering rates as indebtedness falls beyond a second, lower threshold, to try and avoid the floor.
This is, as I understand it, what George Cooper recommends in “The Origin of Financial Crises” — he believes that Fed Governors should act analogously “Mechanical Governors”, that is, mechanical devices that keep the power output of e.g. band saws, steam engines, etc., by modulating input power according to the tenets of control theory.
— Carlo Graziani“then pays that debt down when the private sector is happy to borrow”
HA HA ha ha! HA ha ha ha HA ha hee ha ho ha! HA ha ha ha ha heeee!
But seriously, how is this different from the basic, non-mathematical Keynes that we learned in macro 101? It recognizes that practically all of the money in the recent system was debt rather than coinage, leading to a systemic contraint when the debt needs to be paid rather than rolled over. But will that be the situation going forward with all the newly printed Geithner dollars in the system, and the taxpayer being the only party actually required to repay debts?
— albrtThe problem I see with this approach is that the big player you are referring to (government) during times of economic strength most of the time does not do what you suggest. Budget deficits were the norm throughout the Reagan and Bush II years. Clinton was a rare exception.
You are correct that IF government would act countertrend in terms of paying down debt while the private sector is expanding and expanding debt when the private sector is contracting, total debt growth would follow a steadier rate of increase rather than the massive swings that dominate boom / bust cycles.
Ah, if things were only that simple. If the debt instruments were held entirely by private individual investors there would be no other issues. However, because credit quality and duration matching play a role in pension plans, life insurance funds, many bond funds, and of course financing our trade deficit, a complete elimination of government debt during a business cycle can lead to very conservative investment funds being forced to take on more risk than they would like to.
— Frank RestlyAs to that last paragraph — surely the amount of existing public debt does matter? Household debt to income can’t ramp up now and nether can public debt to GDP. If we had come into this period with less public debt and more fiscal credibility (and not sent trillions into the black hole of the financial system) things would be different. Maybe there is no fix.
— PsittakosKoo is saying nothing new. It is in Minsky already.
— MarceloThe proper theory is exactly the opposite of those two theories. Increased debt is not attractive when the economy is on the rise. And when the economy declines debt can be justified if the opposite was applied during the increase in the economy. Private investment should fund debt in the decline, public funding should be applied in expansion.
In that theory, which eventually must be incorporated both publically and privately, severity of cycles will gradually moderate and eventually disappear. if you draw down on an expanding economy, continuously and with progressively greater demand, it will take much longer to reach a peak where it subsides. When it does reach a peak, and begins to contract, public and preferably private investment will mitigate the decline and rise and at some point, “cycles” will disappear completely.
— Joseph O’ShaughnessyIt has always seemed to me that one of the biggest mistakes we make is to ignore the need for feedback loops to help to govern our systems … especially market systems. We need to make sure that when things appear to be going well we don’t automatically rush to remove laws, policies, etc. that apply normal negative feedback and bring them back to the mean. Negative feedback has an unfortunate name since negative feedback is usually good and positive feedback is too often bad. Positive feedback is usually the culprit in booms and bubbles.
— Paul KobulnickyRichard Koo’s analysis is very valuable (and I’m proud to be the person who started his latest link cascading through the blogosphere!)
For a previous (October 2008) presentation by Koo that covers some of the slides he skips in the March 2009 one, search the CSIS site for ‘Koo’.
When reviewing alternate business cycle theories please also check out Steve Keen (who builds on Hyman Minsky’s work among others).
An interesting tid bit from this video from Koo is that he claims to have had a two hour debate in the 90s with Paul Krugman in which Krugman apparently did not see eye to eye. Let’s hear it for evolving one’s views!
— hblOne difference between Koo’s description of Japan and the current state of markets in the US is the level of credit spreads. Koo asserts that in Japan there is a lack of credit demand at any interest rate level, and I think you can see that borne out by the narrow credit spreads and Japanese banks’ inability to make money.
In the US, the situation seems different to me. There is a private sector demand for funds — if there wasn’t then credit spreads over treasuries wouldn’t be so wide. As a result, the Fed ought to have an easier time getting out of the problem — it just needs to find a way to get the money to the people who want to borrow it.
What do you think? If you’re uncomfortable using credit spreads because arguably there is a bubble in treasuries even larger than the one in JGBs, then I think the same argument holds if you just substitute the outright level of corporate borrowing rates for corporate credit spreads.
— Robert LaraghThat’s plain Minsky, who was even more sophisticated in his approach, by integrating the role of the state to the cycle.
— stagellIt’s too bad our Gov’t wasn’t playing the appropriate role for the last 10 years, a “big market player” actively paying down debt during the housing boom.
— SmittyThe problem is that it is the very rare circumstance when Gov’t pays the debt down. It requires a level of discipline that is challenging for a politician trying to get reelected.
— Rick MandlerOne factor buoying up the economy, in good times and bad, is the need to keep a step ahead of technological obsolescence. Technological obsolescence seems to occur more quickly nowadays, and may force an early end to the recession. Inventories of unsold obsolete goods are not waiting to be sold – they are junk. And no company is going to work off its debt by selling obsolete products. I think technological obsolescence tends to damp the oscillations you describe in your post.
If company B comes out with a revolutionary new product, it can take over an entire market, unless company A invests in a new product to match company B’s. This will happen even if the size of the market is stagnant. So even in a recession, there is an incentive to invest in product development.
Also, if company B invests in better manufacturing equipment making it more productive, it can drive company A out of business unless company A matches the investment. Again, this will happen even if the total market is stagnant. So even in a recession, there is an incentive to invest in capital equipment.
Finally, consumers only live once. People sometimes just need to have that new outfit, car, cellphone, or appliance. It may be for a totally frivolous reason, but frivolous stuff is often what makes life worth living. A teenager isn’t going to wait till the recession is over to be a teenager. Young couples aren’t going to wait till the recession is over to start a household. And old people don’t have time on their side. So even in a recession, there will be demand for new consumer goods, no matter how frivolous.
This recession is a bummer, but it is also an opportunity for companies to invest to get an advantage over weakened competition. And it is a challenge for the weakened competition to prove that they have the will and means to survive.
For the U.S., it is important that the companies making the investments include American companies. If U.S. companies invest, the recovery here will come more quickly, and the U.S. economy will be more competitive afterwards. If U.S. companies do not invest, we will emerge from the recession a weaker nation, with even more of our jobs, technology, and wealth transferred overseas.
— Peter BaldoDoes Koo cite Minky’s financial instability hypothesis, and other Post Keynesians who have already written extensively in this area?
— TLNo need to post this. Just curious if you have given any thought to creating a wonkish rating system.
Nothing elaborate, just a 1-5 on the PKW scale. (That would stand for Paul Krugman Wonkish, since I know how much ‘em yanks love their acronyms).
Just an observation from the Swedish curb.
All the best,
— Patrick Stahl/Patrick
There’s a fascinating little article from 1897 (!)explains exactly that:
http://optionarmageddon.ml-implode.com/2009/03/11/panics-and-booms-1897/
— G. NolinI personally think we are in for five progressively less awful but still tough years so I agree. However the economy, while interrelated, is now so subject to global effects that I think that speaking of ‘the economy’ may not be relevant any longer. Or at least not to the degree it once was. Fiscal stimulus and international preferences will enable some segments to get healthy quicker, and some probably faster than expected. Other may well languish for a decade.
Also it seems that the repayment of debt is unevenly incentivized so this velocity of repayment should have some startling effects on the final shape of the post crash world. Equally interesting will be possible wide spread cases of preferential lending and insider deals, much as Sachs discussed previously.
Incentives are not only different in size but in kind and in vector. (My term for the general direction of movement of cash, business sector development and reward.) A behavioral danger of non alignemnt of rewards/goals and potential “me too” group think permeates this. I wonder what Taleb would say?
Mike Dayton
— MDaytoni can’t believe Koo didn’t say anything of the accumulated effect of prolonged inflation period and the rigidity of salary.
either fiscal or monetary intervention at the economic downturns are effectively harmful to the capitalistic system, because they postpone the natural cure by the system itself. in this case, the invisible hand is totally invisible, because people just don’t want that hand to do its job. sorry to professor Stiglitz.
in other words, plain english though, intervene when the bubble is swelling, not when it’s bursting. but that’s easy said than done since the bubbles in illiquid asset classes are usually hard to spot in the first place. Koo didn’t mention that either. anyway, he’s from Taiwan. exactly the same problem as Japan and Hong Kong, now U.S.
— hohoTreasury Secretary Timothy Geithner Affordable Housing Support and Foreclosure Prevention program; yet, noticeably absent from the plan was one obvious approach to fixing the current crisis in the housing and housing finance market was the option for individual homeowners to extend the terms of their mortgage. Why has no one suggested creating new mortgage products with longer repayment terms as a solution to stopping foreclosures, thawing credit markets and increasing consumer spending, all results that would help stabilize the economy.
Offering homeowners the option to extend their mortgages for 1-10 years would:
1) Relieve middle class families who are struggling to both maintain their jobs and remain current on their mortgage. New mortgages could be constructed to allow homeowners who are behind on their mortgage payments to pay the amount they are behind in payments later in the life of the mortgage. In addition, regardless of whether homeowners are behind on their mortgage payments, a longer term loan should allow homeowners to refinance into loans that allow them to temporarily pay lower monthly payments in exchange for extending the loan.
If mortgage payments are temporarily lower for the next 1-5 years, then families will have more money to spend on other necessities and consumer goods, which would stimulate the economy.
2) Lower the federal deficit and national debt would benefit because the federal government would not have to risk having to pour more money in the economy. This will allow free up valuable resources to use for education, healthcare, and foreign aid, areas where substantial government investment is needed.
3) Diffuse political arguments because Republicans would not likely object to allowing individuals to bear the burden of their participation in the housing market rather than taxpayers having to bail them out.
4) Benefit President Obama because he would have found a way to increase consumer spending, lower the federal budget deficit, and dedicate more resources to further job creation and address urgent human needs such as alleviating poverty, fixing a broken education system and proving healthcare insurance to those who cannot afford it.
Joseph Williams
— Joseph WilliamsProf Krugman,
Thank you for what you write.
I understand what has been written about how this crisis happened, but am very wary of the future.
You give far more insight than anyone else I read.
I am one of the well educated persons baby boomers who is not employed . I expect to die before my student loans are paid.
But at the very least, I can get pleasure out of trying understand what is happening. Thank you again.
— AnnFor sure there’s a substantial balance sheet contribution to this recession, but what motivated the balance sheet excesses to begin with? For example, much household borrowing was an attempt to compensate for labor-market failings – like a long history of wage stagnation, and, more immediately, the very slow growth in labor income between 2002 and 2007. And household borrowing has also provided a substitute for the lack of a civilized welfare state – medical crises and spells of unemployment were financed through VISA cards and home equity loans. How will the economy, and the broader society, adapt to the closure of this escape outlet?
— Doug Henwood> the problem isn’t so much excessive debt as the fact that everyone tries to increase or reduce debt at the same time
thanks for this wording. i have been trying to explain this to people for a while; maybe this wording will help get the idea across.
— babargWhat is the nature of the “floor” here? In the capacity driven economy it was that investment cannot be negative. In the debt driven economy, it is that new debt cannot be negative.
But if nobody takes on any debt, this economy will die a quick death. Most people cannot buy a car for cash.
Politics is consistent with that. For this reason, or another, the political mantra is to “get credit flowing again” even though we all know in our gut that we’ve had too much of credit for a good long time. Because without credit, people won’t eat.
I think this is worse than a capacity-driven economy in that respect. In the GD we built no new capacity. “Use it up, wear it out, make it do or do without.” What is the slogan now when debt service exceeds income?
— DavidOn fiscal policy side, Paul is describing an ideal situation. Ideally, fiscal policy should be counter cyclical. However, adding people, e.g., politicians, to the equation during the actual implementation of the policies, it is almost impossible to do it right. Given the entitlement culture, what you give almost cannot be taken back. You do not promise less to get elected. So the reality is that government has to keep the mst of the fiscal policy in place even after the crisis, and it eventually becomes pro-cyclical. Further, it is difficult to do timing right (look at the interest rate decisions of Fed), especially for longer term type of infrastructure projects frequently used in fiscal programs.
— Xi LiThe issue with deficit spending, as I see it has to do with the Law of Diminishing Returns. One needs to determine when additional spending provides little benefit and may be crowding out other investment spending. Coupled with this is cost of capital. Can a government spend at elevated levels and for what period of time before its cost of capital becomes too high to sustain spending?
— Terry Sams