Noam Scheiber on Richard Koo’s Balance Sheet Recessions

Noam Scheiber has a fantastic piece this morning, Handoff, or Fumble?, which is about the handoff “between temporary boosts to growth, like government stimulus, and more lasting drivers, like spending by consumers and businesses”, a handoff that needs to occur in order for even feeble growth to take off.

Administration economists believe such a handoff, weak as it may be, will take off due to consumer spending. They base this on well modeled historical data. The other side in this argument is the idea of a “balance-sheet recession”, which is primarily associated with Richard Koo. In this side’s mind historical data won’t be of much use to us because the nature of this recession is different. This article by Noam is a great introduction to Koo’s thinking:

The question—really more like a nagging terror—is whether something has happened since the recent financial crisis to fundamentally change the way consumers behave, rendering the administration’s model moot. As it happens, there’s a school of wonks that worries this is the case.

The godfather of this group is a Japanese economist named Richard Koo, whose framework for thinking about this appears in a book he modestly titled The Holy Grail of Macroeconomics. (Paul Krugman, among others, has identified himself with some of Koo’s ideas.)

Koo’s view is that consumers and businesses who take on enormous debt during a bubble abruptly shift gears once the bubble bursts, spending very little while they pay off loans. Moreover, this stinginess continues until the process of debt-repayment (economists call it “deleveraging”) is complete, creating a huge drain on the economy. In the case of Japan, whose real estate and stock markets collapsed in the early ’90s, this took over a decade. During that time, Koo argues, the only force propping up the economy was massive amounts of government stimulus. He tells a similar story about the Great Depression.

Whereas Carroll assumes people base their saving decisions on the same factors both before and after the crisis, Koo says the way they make decisions beforehand tells you little about their behavior afterward. The crash doesn’t just pummel the value of their assets (like housing). It creates a kind of psychological trauma that preoccupies them with paying down debt before they can think about borrowing again. If you accept Koo’s premise, the data of the last 40 years is of little help in guiding us through the current situation. The episodes we’re talking about—Koo calls them “balance-sheet recessions”—simply didn’t happen at any point in that time-frame.

Noam then goes on to tell how we’ll know in about a year who was right.

A few extra points on Koo’s thinking.  Here’s Richard Koo presenting his argument at the kick-off INET conference:

When we think of household balance sheets being underwater, it’s important to remember that the middle-class is the most underwater. As we discussed here, the middle-class, normally the engine that drives consumer spending out of a recession, is so underwater they need some life preservers thrown their way:

It’s tough to see them leading a consumer spending driven recovery.

We talked about how Koo compares and contrasts the early 1980s here. Here’s a graph from his book:

As we mentioned back then, Japanese interest rates are at 0%, yet the corporate bond market is shrinking. Repeat that again: interest rates are at 0%, so debt is essentially free, yet corporations are choosing to net pay off debt.

If you went to the textbooks and case studies of every business school you wouldn’t find good answers for this. This means that corporations can’t find a good use of money. If the business has no profitable opportunities, it should close and return its money to businesses. It has no reason to exist, given that its reason for existing is that it knows what to do with shareholder’s money better than the shareholders, which in this case it does not.

How does that look for the United States’ market?  From the Fed Flow of Funds:

This was updated in September, and we see yet another quarter of households paying off debt and de-leveraging, and it doesn’t seem to be trending upwards anytime soon.  Meanwhile businesses are hovering, uncertain whether there will be demand for their products.   This points to Koo’s argument.  We’ll be watching the data as it comes in to see which side’s argument is winning, and what kind of policy mechanisms can be put into place one way or the other.

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8 Responses to Noam Scheiber on Richard Koo’s Balance Sheet Recessions

  1. Mike, if I may bring a short interview with Richard Koo into your attention:

    interview

  2. Scott Free says:

    I have read that a lot of the household de-leveraging is in fact debt write-off and not actual savings. I don’t know how this effects the argument but it is hard to imagine that its a good sign relative to eventual increase in consumer spending.

  3. joel bernard says:

    Question about Koo’s talk (and book):

    Koo calls the Lehman failure a policy mistake, evidently because it pricked the Bubble. Do we assume that the Bubble would have deflated less rapidly and caused less economic pain on its own?

    I ask this because if the main problem post-Bubble was reducing — or squeezing — debt out of the economic system, it might have been more efficient to let banks and brokerage houses fail. The shareholders and bondholders would have borne the financial burden of bad debt. The underlying assets would have been more quickly marked to their market value, and a great deal of uncertainty eliminated. Liquidity would have been provided directly to borrowers by the Fed, or by smaller banks.

    There will be arguments about the costs and benefits of allowing these failures, but it seems to be unarguable that deleveraging would have occurred more rapidly. The alternative is Koo’s (low) estimate for deleveraging of fifteen years of general economic stagnation. . . .

  4. joel bernard says:

    I’m not a subscriber to the New Republic, and I don’t care to subscribe in order to comment. But I do want to remark on Scheiber’s misunderstanding of Koo’s point:

    “Whereas Carroll assumes people base their saving decisions on the same factors both before and after the crisis, Koo says the way they make decisions beforehand tells you little about their behavior afterward. The crash doesn’t just pummel the value of their assets (like housing). It creates a kind of psychological trauma that preoccupies them with paying down debt before they can think about borrowing again. If you accept Koo’s premise, the data of the last 40 years is of little help in guiding us through the current situation. The episodes we’re talking about—Koo calls them “balance-sheet recessions”—simply didn’t happen at any point in that time-frame.”

    “Psychological trauma” suggests irrational behavior. Koo’s point is that when the value of assets falls below indebtedness you risk bankruptcy if you don’t pay the debt down as fast as you can. Deleveraging is eminently rational. And there is plenty of historical evidence in Koo’s book. Within the past 40 years there is the case of Japan; before that, there is the Great Depression. Koo’s point is that this is *not* uncharted territory.

    Finally, Scheiber’s piece doesn’t make clear what figures as Savings. The Savings rate is calculated as a residual of income minus expenditure. Savings represents money initially taken out of the stream of consumption and investment. It includes not just money you put in the bank, but money you use to repay debt (deleveraging) that goes back to the bank. If there are no borrowers it doesn’t return as demand. Low income groups are not increasing their bank deposits, they are paying down their debts — and they are not getting new loans. The increase in Savings is largely repayment of debt (for the poor) and forgoing investment (for the well-to-do).

    In any case, this is well-explained in the video presentation by Koo. It’s well worth a viewing.

  5. Pingback: Yglesias » Deleveraging

  6. John Prosise says:

    How does Koo’s model–and the myths it identifies in current, conventional thinking–square with Robert Reich’s reasoning in his book, Aftershock? How does Koo’s model view a growing concentration of wealth? I apologize for naive questions …

  7. Paul Meinhardt says:

    As recently as 2007 middle income (middle class) spending-consumption sustained the economy as it did since the 1950s. Obviously, the availability of jobs and income fueled an optimistic middle class.

    The vast concentration of property wealth by global banking and corporations has deprived the middle class of sustainable income. In effect, the 80% of families that were the middle class supporting the economy are now “low-income” families.

    Since the main wealth of middle class families was the value of their homes, the destruction of home values has transformed middle class families into low-income families.

    The only hope is a massive infusion of cash for low-income families. Perhaps a Victory Bond program as in the 1940s, but with the bond proceeds distributed to low-income families as a “Low-Income Family Economic Supplement” (LIFES), paid to LIFES families on a monthly basis.

    LIFES bonds might be commercial, paying interest to investors of up to 3%, redeemable in ten years. LIFES bonds would provide a non-government bond investment opportunity for investors in search of bonds that are not pegged to the value of the declining dollar (as are Treasury Bonds).

    The purpose of LIFES bonds is to provide family supplemental income to low-income families, who will spend it and reignite the “consumer driven economy.”

  8. Pingback: BEA Numbers Show the Fumbled Handoff of Obama’s Recovery Plans | Rortybomb

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