Stella
Book Title: The Escape from Balance Sheet Recession and the QE Trap
Author: Richard C. Koo
Year of Publish: 2015
Chapter 1: Balance Sheet Recession Theory ---- Basic Concepts
In the first chapter of The Escape from Balance Sheet Recession and the QE Trap, Koo introduces the concept of Balance Sheet Recession (BSR), and proposes a remedy for the recession: Fiscal Stimulus. In this article, I would like to summarize the concept and potential solution for BSR discussed in the chapter.
1. What is a Balance Sheet Recession (BSR)?
i. Traditional Financial Crisis
One will grasp the concept of Balance Sheet Recession easily when it is compared with the traditional textbook financial crisis. While sometimes both referred to as "financial crisis", the underlying causes for the two types of crises are completely different. The cause of a textbook financial crisis is insufficient supply of funds, while the main driver of a BSR is insufficient demand for funds.
A traditional financial crisis happens after a huge and sudden decline of asset prices. During normal times, when depositors deposit or withdrawal cash from their bank accounts, banks receive or provide funds based on their clients' need, and it is hard for individual bank to accurately estimate how much it would receive or pay. As a result, an interbank money market is formed, where banks can either lend excess funds out or borrow funds if needed. However, when asset prices plunge, the value of assets owned or held as collateral declines, leaving banks large inventories of bad loans. When this is the case for most financial institutions, banks will become reluctant to lend in the interbank money market because they may not get the money back. As a result, a bank-run in the interbank market can happen, drying the liquidity up, and forceing banks that fail to meet cash withdrawals to go bankrupt. Fortunately, this textbook financial crisis can be easily resolved by monetary policy: central banks can provide liquidity (money) for solvent but illiquid banks, thereby solving the problem of insufficient supply of funds.
ii. Balance Sheet Recession
Similar to that of a traditional financial crisis, BSR also happens because of severe decline in asset prices. However, while almost every burst of bubble can cause a textbook financial crisis, BSR only happens when the bust bubble is financed by debt. The problem in a BSR is contrasted with a textbook type financial crisis: in BSR, banks are willing to lend money out, but private sectors (firms and consumers) refuse to borrow no matter how low interest rates are. Let's take an example to understand why that is the case. Suppose a firm borrowed $1 billion to buy a land to establish a new factory, and by the time the firm buys, the value of the land was $1 billion. However, asset bubble bursts after the firm's purchase, and the value of the land falls by 50% to $500 million. Unfortunately, notional values of loans do not adjust with that of assets. As a result, the firm technically holds an asset of $500 million while bears a debt of $1 billion after the bubble bursts, making it technically insolvent (asset < liability).
Under such a circumstance, there are two options left for the firm: 1. Declare bankruptcy; 2. Hide the insolvency and pay down debt using cash flows (as soon as possible). As long as a company's core business operates healthily, the most rational and responsible decision the firm can make is to hide the insolvency and pay down debt secretely: this option protects its employees and prevents further instability that may rise if the firm collapses. Therefore, when a debt-financed bubble bursts, firms will switch from maximizing profits to minizing debts, which means no matter how low the interest rate is, it is unlikely for them to carry out new debts before solving the technical insolvency problem. This is a reasonable decision: who would seek profit if he/she is technically insolvent? Fortunately, as long as a firm generates consistent cash flows (which is especially true for Japanese firms in the 1980s), debt can always be payed down someday. So far, everything sounds manageable, if one forgets about the collective impact of firms not conducting new borrowing.
Let's recall what traditional economics say about national income and expenditure. Suppose person A receives $1000 as income of the year, and he spends $900 while saves $100 at his bank. Person A's bank then lend the $100 to individual B, who invests using the borrowed $100. As a result, the total expenditure of the year would be $900 (consumption of A) + $100 (Investment of B) = $1000. Nonetheless, as described in the previous paragraph, firms and individuals will not conduct new borrowing before they pay down existing debts (i.e. There will be no individual B to borrow and invest the $100) when a debt-financed bubble bursts. As a result, the total expenditure will only be $900 instead of $1000, creating an unborrowed saving (which is also a deflationary gap) of $100. What's more, let's say individual C who receives the $900 (spent by individual A) as income only spends $810 and saves $90, without any borrower, the expenditure will become $810, and then $729, $656... The consequence is clear: when firms and individuals save collectively leaving no one as a borrower, the economy contracts and falls into a deflationary spiral.
So, can monetary policy solve this problem? Unfortunately, the answer is no. To understand why this is the case, one needs to recall how monetary policy works. Textbooks tell us when a central bank conducts an expansionary monetary policy, it lowers interest rate, making it easier for firms and households to borrow. As firms and households borrow to conduct new consumptions or investments, total expenditure increases, and the economy recovers. This mechanism relies on the assumption that firms and individuals increase borrowing when interest rates are reduced. However, as elaborated in previous paragraphs, this assumption is hardly true when private sector faces balance sheet issues. As a result, after the burst of a debt-financed bubble, banks find it hard to lend out money despite exceptionally-low interest rates, and traditional monetary policy fails to stimulate economy. As the author shows using the flow of funds data, starting from 1991, when the burst of the Japanese asset bubble became evident, corporate sector started to cut their borrowing. In addition, from 1998 to 2014 (the time when the author wrote), the corporate sector has even become a net saver: that is, firms save instead of borrow, a phenomenon against traditional wisdom.
2. The Solution for BSR: Fiscal Stimulus
i. The "Borrower of Last Resort"
As elaborated in the previous section, after the burst of a debt-financed bubble, the private sector faces a serious solvency problem which discourages it to borrow regardless of interest rates. A contraction in private sector borrowing means less investment, which deteriorates total expenditure. As a result, countries after such a burst of bubble can easily fall into deflationary spirals and suffer from serious recessions. Is there anyway to mitigate the problem? Koo believes the answer is yes, and the solution is fiscal stimulus.
The argument that Koo provides is straightforward: the unborrowed $100 needs to be borrowed by someone to fill the gap and push total expenditure back to $1000. When the private sector is down, the only one left would be the public sector, the government. In addition, Koo argues that government needs not only to fill the gap of unborrowed savings, but also to continue to do so until private sector solves all banalance-sheet problesms. The reasoning goes as follows: when private sector becomes net saver, there always exists an unborrowed saving (the $100 deflationary gap) if the public sector does not borrow. Therefore, as long as the private sector continues to fix their technical insolvencies, the public sector should fill the gap by borrowing and spending the $100, or the economy will fall into a deflationary spiral, making it even harder for the private sector to pay down its debt. That is, the public sector is the last borrower the economy can count on. While Koo did not create such a term for the public sector, I believe one can call the government the "Borrower of Last Resort" in contrast with the central bank, who is the "Lender of Last Resort".
ii. What about Fiscal Deficit?
Whenever one mentions fiscal stimulus, everyone concerns the fiscal deficit immediately. Koo, in contrast with traditional economists, believes the question of reasonable fiscal deficit levels should be viewed based on relative measures rather than absolute ones. Specifically, he believes opinion leaders have ignored an important factor when considering the level of fiscal deficit: the level of (net) private saving. Traditionally, economists would view a fiscal deficit of 10% of GDP relatively high, and some would call for fiscal consolidation. However, Koo argues that if the country is running a fiscal deficit of 10% of GDP, while the (net) private saving is 15% of GDP, the counrtry should in fact increase fiscal spending. This is because when the private sector is saving 15% of GDP but the government is only borrowing 10%, there remains a 5% of GDP unborrowed savings. If the 5% is left unborrowed, it will put deflationary pressure on the economy and contracts total expenditure. Therefore, Koo believes high levels of fiscal deficits are warranted as long as they are relatively the same levels as the (net) private saving.
In addition, Koo believes that financing fiscal stimulus in a Balance Sheet Recession is relatively easy. The reason also goes back to the fact that private sector becomes a net saver during a Balance Sheet Recession. When the private sector saves, excess saving needs to go somewhere. For instance, when banks receive new savings, they need to lend the new money they received. However, as banks will find it difficult to lend when the private sector deleverages (i.e. Paying down debts), they are left with another choice: lend to the government (buy government bonds). As a result, there will be substantial funds available for the government to borrow, which enables the yields on government bonds to decline even when the public sector spends more. When the private sector finishes fixing its balance sheet problems, savings will leave the government bond market and move to private sector, raising the yields on government bonds. This signals the government that now is the time to conduct fiscal consolidation. Then, during the process of fiscal consolidation, monetary policy should serve as the key tool to smooth cyclical fluctuations out. Koo calls this process the "self-corrective mechanism" for economies under Balance Sheet Recessions.
3. Recovery after BSR: Why is it So Slow?
i. Unstable Fiscal Stimulus
Another question in debates of Balance Sheet Recession is: why is the recovery so slow after such a crisis? While he did not provide a comprehensive explanation for the question, Koo sheds light on one of the possible reasons: unstable fiscal stimulus may be one of the main reasons why economies stagnate after BSR.
As discussed in the previous section, Koo believes that media and some economists are setting the level of "healthy fiscal deficit" too low because they fail to recognize how large net private saving is. As a result, when the level of fiscal deficit goes "too high", advocators for fiscal consolidation stand out and call for spending cuts. When an economy is still recovering from a Balance Sheet Recession (i.e. Private sector still saving), a reduction in fiscal spending equals an increment of unborrowed saving (and a wider deflationary gap). As a result, economies without sustained government spending will fall into recessions, making the recovery process even longer. Koo cites the recovery of US in contrast with that of Europe and Japan as an example. Immediately after the Great Recession, most developed countries agreed to carry out fiscal stimulus in 2009. However, only a year after, the G20 leaders decided to halve fiscal deficits in three years despite the fact that private sectors are still facing balance sheet problems. On the other hand, United States, thanks to the advice of the former Fed chairman Ben Bernanke, decided to be the first country to renege on the agreement. This effort made the US the only country in the developed world to post consistent and moderate growth after 2009, while Japan and Europe fell again into recession after 2010.
Interestingly, Koo believes that democratic countries are especially vulnerable to secular stagnation during the recovery from a balance sheet recession. This is because politicians need to convince the majority of the population that a fiscal spending is warranted, while autoritarian countries do not. When a economy seems to be recovering (thanks to previous fiscal stimulus), it is hard for voters to realize that the government needs to conduct fiscal stimulus continuously. As a result, fiscal spending is likely to be cut, which pulls the economy back again into recession.