DEBT AND DELEVERAGING: A FISHER, MINSKY, KOO APPROACH
The following paper by Paul Krugman is an excellent analysis of the current situation in the United States. Professor Krugman accepts Richard Koo’s “balance sheet recession” and draws similar conclusions to Koo – primarily that government must maintain large deficits in order to offset the lack of spending by the private sector. The key component missing in both Krugman and Koo’s argument is the idea that a nation that is sovereign in its own currency cannot default on its “debt”. Nonetheless, the conclusions we all come to are similar – a temporary deficit is not only necessary, but an economic benefit during a balance sheet recession:
“In this paper we have sought to formalize the notion of a deleveraging crisis, in which there is an abrupt downward revision of views about how much debt it is safe for individual agents to have, and in which this revision of views forces highly indebted agents to reduce their spending sharply. Such a sudden shift to deleveraging can, if it is large enough, create major problems of macroeconomic management. For if a slump is to be avoided, someone must spend more to compensate for the fact that debtors are spending less; yet even a zero nominal interest rate may not be low enough to induce the needed spending.
Formalizing this concept integrates several important strands in economic thought. Fisher’s famous idea of debt deflation emerges naturally, while the deleveraging shock can be seen as our version of the increasingly popular notion of a “Minsky moment.” And the process of recovery, which depends on debtors paying down their liabilities, corresponds quite closely to Koo’s notion of a protracted “balance sheet recession.”
One thing that is especially clear from the analysis is the likelihood that policy discussion in the aftermath of a deleveraging shock will be even more confused than usual, at least viewed through the lens of the model. Why? Because the shock pushes us into a world of topsy-turvy, in which saving is a vice, increased productivity can reduce output, and flexible wages increase unemployment. However, expansionary fiscal policy should be effective, in part because the macroeconomic effects of a deleveraging shock are inherently temporary, so the fiscal response need be only temporary as well. And the model suggests that a temporary rise in government spending not only won’t crowd out private spending, it will lead to increased spending on the part of liquidity-constrained debtors.
The major limitation of this analysis, as we see it, is its reliance on strategically crude dynamics. To simplify the analysis, we think of all the action as taking place within a single, aggregated short run, with debt paid down to sustainable levels and prices returned to full ex ante flexibility by the time the next period begins. This sidesteps the important question of just how fast debtors are required to deleverage; it also rules out any consideration of the effects of changes in inflation expectations during the period when the zero lower bound remains binding, a major theme of recent work by Eggertsson (2010a), Christiano et. al. (2009), and others. In future work we hope to get more realistic about the dynamics.
We do believe, however, that even the present version sheds considerable light on the problems presently faced by major advanced economies. And yes, it does suggest that the current conventional wisdom about what policy makers should be doing now is almost completely wrong.”
My problem with “filling the hole” is: who gets to choose the winners and losers?
Politicians and buearucrats! Talk about a recipie for missallocation and corruption. Dejavu all over again. Does Krugman get to choose? Do we let Barry and Barry give it all to thier cherished unions? Where do I get in line for my share of the plunder?
Hence my position in favor of tax cuts….Govt has proven that they are not a good allocator of capital.
I’m still reading Koo, but so far he does not promote tax cuts at all. Neither does Krugman.
We had that discussion before. I presented a data point that puts the tax cut effectiveness at about 20%. Can you help me understand why do you think tax cuts are as effective as stimulus?
If tax cuts are 20% effective, how effective is random government spending? 5%? 0%? -20%?.
Easy: Effective 100% by definition! The money are spent.
The point is not what is bought with them, although all agree they better be spent on useful things. The definition of useful obviously varies, but is immaterial to the discussion which is how to get out of the liquidity trap.
The money from a tax cut can be spent(good), saved(wasted) or used to pay back debt(wasted short turn and good long term)
Your definition of “100% effective!” will, by definition, have to disagree.
How do I edit my mess. Oh well, I’ll just leave things clear as the driven snow.
How about something like unemployment benefits? Those are almost 100% going to be spent in a useful manner (food, shelter, clothing) and is allocated by individuals.
The one adverse effect of it (discouraging the desire to work) doesn’t even exist in a situation where there are 5 available applicants for every available job.
It would be very undemocratic for PK to promote a supply side or Republican policy such as tax cuts. Not only is a tax cut politically feasible, but it would be an effective form of helping the consumer balance sheet problems. I don’t see why we wouldn’t cut taxes now…..
Do you have a data point to show it is as effective or is your opinion based on faith or hunch?
Also if the solution to all problems are tax cuts, why are we here after the bush tax cuts and why pay taxes at all ?
According to Mark Zandi at Moodys the breakdown on the multiplier effect is as follows:
Since spending is not politically feasible a payroll tax holiday looks like the best option.
TPC, That is not the point.
The discussion is which is the best economic policy, not what is feasible politically.
Thanks for the reference, but you have to agree it is not a reference for tax cuts, but against them.
We have to be realistic Dimm. More fiscal spending is simply not going to happen so it’s not even a discussion worth having. A tax cut looks like a stretch even. It might not be the optimal strategy, but it is probably the last hope for a Congress that has become convinced that it’s going bankrupt.
I agree the public sector needs to spend via payroll tax cuts for people and businesses, direct spending or both.
Though I do wonder if Zandi’s multipliers are as valid concerning our present predicament since the data is most likely drawn from more conventional recessions instead of balance sheet recessions.
We just need to do something.
Well, that may be true, but the past decade has shown that private hands don’t allocate capital very well either. Can anyone say “bondholder haircut”?
The most important issue is that of multipliers and timeliness. What is needed is the biggest bang for the buck. The second consideration is temporal. Every day is brings mounting lost opportunity in terms of GDP, accumulating degradation of national resources, and increasing human suffering and degradation of human resources. In addition, the effect of hysteresis is monumental. These losses cannot be recouped once sustained.
Sorry – need to read this more fully tomorrow nite – BUT!
Bingo! The Fed Gov has displayed an ENORMNOUS INABILITY to SPEND efficiently – long track record there – even going back to Eisenhower wrt the highway system.
That is why the most MMT-based salvation to the HHs is by reducing SPENDING BY NOT TAXING – it is utterly agnostic@!
Take a break for a couple of years and promote TAX preferences for those who SAVE!!
Clearly the IRS Tax Code is a major hitter in social behaviour!
But, we save rather than spend, then we spend a bit more, demand picks up. small (& large businesses) see increased demand and then hiring picks up, AND THEN inflation becomes a true worry!
But let us get there 1st!! Boo-rah!!!!
TPC – Tax cuts seem like a good place to start – put more money in people’s pockets and effect an income increase for consumers.
However, has Koo not convincingly suggested that a tax cut in a balance sheet recession is actually deflationary/recessionary in the near-term to the extent that it sucks income out of the economy, assuming consumers use it to delever, which seems like a likely outcome?
I honestly don’t see the crime in deficit spending at this juncture. I’ll argue about what it should be spent on (i.e. not social engineering as we saw with Obama), but it’s tough to argue against it if spent properly. I’d also like to see it in conjunction w/ some l-t commitment to fiscal consolidation, but politicians will find a way to renig on that promise.
Hey Ferro,
I’d have to look up Koo’s position on taxes. I’ll get back to you over the weekend. Unless you know the answer?
Here’s Koo’s response:
Are there options other than the government spending (and raising deficits), for
example tax incentives for companies to invest?
A tax cut is a fiscal stimulus, right? A fiscal stimulus is needed. Of course, some tax cuts
may be useful, but if a general income tax cut comes when the private sector is
deleveraging, the private sector will take that and use it to pay down debt. It is still better
than nothing, but for the same budget deficit you are incurring, a tax cut will give you much
less fiscal stimulus to the economy, because so much of that will leak out in repayment [as
companies use those tax savings to improve balance sheets].
TPC – I say better than nothing. We all agree spending is off the table, right?
It does not matter how the money are spent. The point is that the public sector has to make up the decline in spending from the private sector.
“it does not matter how the money are spent” sic. That is quite a reckless statment. Someone could start a credit bubble thinking that way.
You totally forget that things are never so simple:
“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.”
Bstiat
” Do we let Barry and Barry give it all to thier cherished unions? Where do I get in line for my share of the plunder?”
The other obvious option is to do the usual “Let the lobbies and corporate criminals chose the winners and losers.
Please enough of this corporate propaganda please.
I chose A.
I agree, the big corporations are part of the problem also. I think lobbying should be eliminated and any politician caught accepting “bribes” from any corporation should be asked to leave Washington immediatly. Of course that would take ethics and morality something that i believe has been outlawed in DC. That is why I agree with Jim Grant. We need to return to a gold standard and remove the power and temptation of money printing and control from the feeble hands that will always use it the wrong way. Gold standard is not perfect but it rewards those who do right(save, invest)automatically and punishes those who do not do right just as surely. Again, not perfect, but way better than our current hodge-podge mess.
BY the way TPC I just want to thank you for the great site, and the steady hand you use to administer it. Great information and great dialogue.
My pleasure.
Great question and the problem.
They should let the market decided.
Krugman is against tax cuts, even though according to his own theory that would help. He is favor of QE, even though according to his own theory it will not help.
So basically, he’s part of the problem. Liberals are against tax cuts, conservatives are against “stimulous” spending, so we get neither.
Krugman is not in charge of the country. And pretty much no-one listens to him(unfortunately), both from the left and right.
Also his model does not talk about QE
Thats absolutely not true. Krugman is NOT against Tax cuts in general (find me the evidence). The only tax cuts he is against is extending the Bush tax cuts for level of incomes above $250,000. He is in favor of extending the tax cuts below this point.
As the above posted Moody’s data shows, extending those Tax cuts is a terrible way of spending the money we have available. Using it instead (as Krugman has advocated) for something like extending unemployment benefits would be a much better use of the money. How extending unemployment benefits when there are 5 people looking for a job for every 1 job available is beyond me.
The sensible tax cut is the payroll tax. Propose a cut, and phased out ending date (ramping back to the norm in about 6 months).
Employers will see it as an incentive to hire (lowering their costs), and the additional spending power will be be put to immediate use.
There needs to be some urgency in Washington regarding having Americans productively working.
Came across this article to share re Bernanke’s response…you’ll probably do a story..
http://articles.moneycentral.msn.com/news/article.aspx?feed=BLOOM&date=20101118&id=12419896
Loved the intentional Palinism “refudiate”
There are a few problems with that, mainly:
* 6 months will not make a difference for the employer. No one will hire long term based on short term intensive
* temp cuts are taken for granted. E.g. the current Bus tax cut rhetoric: Obama want to raise taxes!! The truth is that without legislative effort they will revert to their intended(by Bush) levels.
I was trying to be too brief.
The duration of the payroll tax holiday should be at least 1 year, FOLLOWED by a ramp up phase of 6 months (allowing HH’s to adjust spending accordingly).
Having something between 10 and 20% of employable adults either not working, or working well below capacity is not a good idea, and it needs to be addressed very soon.
Sorry. No one is going to hire a worker long term with the healthcare and 401k costs involved so they can save on payroll taxes (6%??) For 1 to 1.5 yrs. Its enormously expensive and a blunt tool to acco/plish little…zandi or no zandi. These economists live in a textbook. If I run a business I hire (at almost at any cost) when demand necessitates it. I also don’t hire if demand does not. Too many people live in economic textbooks and not the real world.
The point isn’t to just get people hiring. The point is to alleviate pressures in people’s balance sheets so they can start to spend & invest again. We need higher aggregate demand and I find it very hard to believe that the equivalent of a $1T stimulus package via reduced taxes wouldn’t help a huge number of people. If not, what should we do? Nothing?
there’s a bit of “the egg of the chicken” effect i.e. hired people will spent (i.e. create demand). But forcing corp. to hire would be impossible/suicidal. So govt needs to spend and hire to provide useful services (education/health) to trigger a positive feedback circle.
Ahem …
“Nothing is so permanent as a temporary government program.” – Dr. Milton Friedman, Nobel-Prize-winning economist.
How ’bout those temporary Japanese monetary programs. Just sayin’ …
Much of what Friedman stood for has been proven terribly wrong in recent years. Even Friedman appeared to be wavering in his belief just before his death:
“The use of quantity of money as a target has not been a success. I’m not sure I would as of today push it as hard as I once did.”
This is very interesting, but I think does not get at the heart of the debate. I think there is a fundamental difference of opinion on defining the issue. Krugman, et. al (with very good reason) say it’s simply a liquidity/debt deleveraging issue. I have seen other analyses suggesting that the very solvency of our system is at stake. Not that this would or should be a newsflash — simply that this financial crisis has opened people’s eyes to the sins of the past several decades.
I think an analogy to a more common example is instructive — for instance an individual with health problems. If I am an obese individual with diabetes, perhaps it takes a severe bout with the flu before I decide I’m fed up and want to get healthy. That said, I can’t just go out and start exercising up a storm and dropping my calorie intake to very low levels while I still have the flu. I need to rest and get healthy before I undertake my long term health plan (this is what TPC seems to suggest)… But the problem is that we ALWAYS seem to find some kind of flu symptom that keeps us rationalizing “I need rest and recovery now. I’ll start my exercise and diet later.” Once the flu symptoms are gone, there is nothing there to remind us that we still are extremely unhealthy. (This is why I think most Austerity proponents actually keep pushing their agenda right now. Deep down they know that this will actually make things worse right now, but will at least get us on the “diet/exercise” wagon while we are still motivated.)
That’s a very good analogy, but we have to be more precise than that at the same time. Not everyone in the system is obese. Banks never should have been bailed out. But should a child in LA lose his teacher because some idiot made bad bets in CA real estate and now the state revenues are collapsing? I don’t think so. There’s moral hazard in this equation all over the place, but we have to make sure that the enture system isn’t punished just because many participants made bad decisions. It should be a partial austerity plan in my opinion. Losers must lose, but don’t punish the prudent at the same time. It can be done….
100% agreement from me on that one… Unfortunately as has been alluded to above, the allocation mechanisms are far from precise. But I agree that there are better and more creative ways to do it than another round of cash for clunkers, etc.
The reality remains, though, that some will bear pain who don’t deserve it (I know that you already know this)… what’s happening now is that those people are less concerned about being treated fairly (probably because they have given up hope of that by now) and more inclined to be willing to bring the whole system down, because then at least everyone feels the pain.
I applaud your commitment to trying to do what’s BEST for everyone, but from a practical perspective I fear we may have already passed the tipping point to where most individuals are willing to accept a WORSE personal situation (e.g., no job and foreclosed home, as opposed to just struggling to get by) so long as they get to see those at the top taken down with them (e.g., no more bank CEO bonuses). It’s economic jihad out there right now
Forgot to say… Ironically, the current combo of fiscal austerity and monetary easing may just prove to be exactly the recipe for a widening of the gap between the haves and have-nots (a conclusion that I have reached thanks in no small part to your work. So thanks!)
Exactly: all current fiscal and monetary measures are to protect the status quo system and to reward the losers even more. Unless you have some sort of real democracy as opposed to paid by corporations and lobbies politicians, all measures will only widen the fairness gap. Throwing some money crumbles to the poor as food stamps etc. does not make it just.
“Losers must lose, but don’t punish the prudent at the same time. It can be done….”
But it hasn’t and it it won’t. More’s the pity.
Amen…
“The key component missing in both Krugman and Koo’s argument is the idea that a nation that is sovereign in its own currency cannot default on its “debt”
They can and will default on the debt by making the currency WORTHLESS.
Just because you can pay back in worthless paper and avoid using the word “default” does not mean you have not in fact defaulted…..but you know this.
Word games, semantics, financial sophistry.
How is the dollar falling in value Andy? Is it that whopping 1% inflation that’s doing it?
Long-time reader here, first time poster. Thanks for the great site, analysisa, and allowing engaging batter vis a vis the comment section. Can you explain what you mean by ‘a nation that is sovereign in its own currency cannot default on its “debt”.’ particularly with respect to “is sovereign in its own currency?” Thanks
See here: http://pragcap.com/us-default
If that gets you confused see here: http://pragcap.com/mmt-101
Diolated
He means that the government can hire Parker Brothers to print money in virtually unlimited quantities, shove it at some hapless creditor as payment on debts owed and still technically not be in default by a strict semantic/dictionary interpretation of the definition of the word default.
The fact that this money would have zero value is not apparently problematic.
Andy, you’ve been predicting USA default since your first day posting here. Can you explain why you’ve been wrong so far?
…..and I’ve been predicting inflation since that first time and we have been inflating.
Lord Blankfein explains inflation to the kids
“Dont worry kids, we are in a massive deflation, why just look at this swell watch I bought!!”
http://www.tic-tock.com/wingates/watch-detail/38772
Look at their faces, the kids are not getting it, lack of formal training in economics I suspect.
http://www.nigeriamasterweb.com/10mbebe/StarvingBiafranChildren.jpg
Clearly the two most structural parts of our CA deficit are China and energy. I think that you could combine the latter with stimulus to make a difference. Invest massively in nuclear plants–an idea that will have some support on the Right. You thereby lower long term dependence on crude imports and make a positive NPV investment. If you run into environmental protest, then build them on military bases.