Balance sheet recessions — a massive case of fallacy of composition problems

11 April, 2015 at 17:43 | Posted in Economics | 3 Comments


The way I understand Richard Koo, he maintains that interest rates and monetary policy don’t really matter when we’re in a balance sheet recession where, following on a nationwide collapse in asset prices, more or less every company and household find themselves carrying excess debt and have to pay down debt. The number of willing private borrowers is strongly reduced – even when interest rates are at zero – and as a result of this “debt minimization” monetary policy by itself therefore loses all power. To get things going, the government has to run a fiscal deficit,  by increasing borrowing producing an increase in money supply and thereby making monetary policy work.

Paul Krugman had a post up earlier this year, basically maintaining that this argument can’t be right, since if there are some people – debtors – in the balance sheet recession that pay down their debt, there also have to be other people – creditors – that a fortiori strengthen their balance sheets, and who are susceptible to being influenced by what happens to interest rates and inflation.

To be honest, I have some problems seeing the great gulf between them – at least on the level of general principles – that one is lead to believe ought to be there, considering all the heated discussion there has been on this issue between them for a couple of years now.

For although it’s true, as Koo says, for those firms that try to minimize debt, no injections what so ever that the central bank makes will generate inflationary impulses. For others – and probably not even in the worst balance sheet recessions imaginable are all firms debt-constrained – there might be room for some (limited) inflationary generation by monetary means. So ultimately, it looks like more of a differences in degree rather than in kind. To Koo monetary policy has by itself no power, and instead we have to put our trust in fiscal policy. Krugman on the other hand says that some private actors might not be  balance sheet-constrained and therefore susceptible to (inflationary) monetary policy, and that besides fiscal policy anyway can work. And more importantly – both definitely agree that increased liquidity will not not always and  everywhere get the economy out of a slump, and that neither fiscal, nor monetary policy, in itself is capable of solving the problems created in a balance sheet recession.



  1. Krugman: . . . this argument can’t be right, since if there are some people – debtors – in the balance sheet recession that pay down their debt, there also have to be other people – creditors – that a fortiori strengthen their balance sheets . . . .
    I may be missing the mark here, but I think this might be a symptom of Krugman’s apparent inability to see why he should reject the loanable funds doctrine. In a loanable funds world, debtors and creditors are in symmetric balance, because debtors borrow from creditors: one’s liability is someone else’s asset. Paying back the debt doesn’t create or destroy the funds; it just transfers them. That’s not the world we live in, and economists should have rejected loanable funds as a false model of how the world operates.
    In the world, we have financial intermediaries, who are both lenders and debtors — who borrow short to lend long, bootstrapping credit creation. In practice, banks lend businesses back their own funds and create “money” and credit in the processes of underwriting, deposit-taking and payment processing. In the actual world, with financial intermediation, it is possible that businesses trying to pay down debt effectively cancels out both debt and asset, deflating the credit bubble, so to speak. The symmetry of business “debtor” and bank is the symmetry of a mirror image: if the debt disappears, the asset disappears as well. Paying back a loan actually “destroys” the funds involved, which were conjured out of credit creation in business expansion, and, in a business contraction, disappear into the realm of a banker’s imagination.
    What monetary policy might be able to accomplish in the case of sustained contraction of business activity associated with a “balance sheet recession” is keep the banks from financial failure. The extent to which that is a desirable policy objective is open to separable analysis.
    Wondering whether some firms are “not debt constrained” is employing the wrong terms of analysis. It seems to me that a more classical analysis is called for: what is the position of those firms with the largest and most unaffected economic rents? Firms in possession of substantial economic rents are in possession of substantial discretion, discretion that may be enhanced in the context of a general contraction of business activity. Their economic rent claims may mean that they have privileged access to opportunities to invest at low financial risk, but they also may be associated with a capacity to generate cash by strategic dis-investment or to exercise market power to the disadvantage of less powerful actors.

  2. A possible flaw in Krugman’s argument is thus. The world can be divided into households and firms with a tendency / need / desire to borrow, and second, households and firms with a tendency / need / desire to lend. Thus a finite amount of borrowing is bound to take place. Indeed, it will take place both in barter and money economies. But at the same time there must be a natural limit to the total amount of borrowing: few people or firms want to get too far into debt, and as to lenders, lending in a totally irresponsible manner leads to financial loss or even insolvency.

    Now assuming borrowers have borrowed as much as they want (at the ZLB or any other rate of interest), it does not follow, as Krugman seems to suggest that there are loads of POTENTIAL borrowers out there in the form of lenders. Reason is that lenders are lenders, not borrowers!

  3. This is a gross misrepresentation of Krugman. He states very clearly that he 100% agrees with Koo in balance sheet recessions, but not in normal times.

    In fact, Krugman writes:

    “Koo argues further that deficit spending can play a useful role in a balance sheet recession, not just by providing a temporary boost, but by providing a favorable environment for debtors to deleverage, setting the stage for durable recovery.

    This is a very useful insight, and one that many of us have taken on board, fully acknowledging Koo’s contribution.

    But Koo hasn’t just argued for the usefulness of fiscal stimulus in balance-sheet recessions; he has engaged in a relentless jihad against any attempt to use monetary policy, either as a supplement to fiscal policy or as the best you can do if fiscal policy is paralyzed by politics. And it’s very hard to see why.”

    and then comes your quote.

    Thus, Krugman argues that monetary policy can be effective, or at worst neutral, in normal times.

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