Balance sheet recessions — a massive case of fallacy of composition problems11 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.