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.