DEFICITS ARE GOOD DURING A BALANCE SHEET RECESSION
He’s had it right all along. Deficits are good during a balance sheet says Richard Koo. Many thought the exploding budget deficit would drive the USA into hyperinflation or even just high inflation. Others said the austerity measures in Europe were going to generate a turnaround. But the one thing we’ve learned from the recent economic downturn is that fiscal deficits during a balance sheet recession are good deficits (via Richard Koo;s latest note):
“This (austerity) is akin to a doctor telling a patient suffering from pneumonia to go on a diet and get more exercise. While exercise is important, it assumes a healthy patient. If the patient is sick, he must build up his strength until he is physically capable of exercising again.
No matter how overweight a patient with pneumonia might be, the doctor’s first task is to give him the treatment he needs to fight the disease. After all, the pneumonia patient can die if treatment is delayed for too long.
Balance sheet recessions, which occur when businesses and households rush to pay down debt in spite of zero interest rates, are a kind of pneumonia. The only way to treat them is for the government to become the borrower and spender of last resort with fiscal stimulus aimed at propping up aggregate demand.
Fiscal deficits during balance sheet recessions are good deficits
All fiscal deficits are good deficits during this type of recession. Once public and private investors realize this, I suspect their decisions will no longer be influenced by the views of those rating agencies that do not understand balance sheet recessions.”
Source: Nomura
The claim that fiscal deficits are good in a balance sheet recession on the face of it would appear to be a sensible argument and I don’t think I would disagree. While I agree there is a balance sheet recession, making the claim that all fiscal deficits are good during a balance sheet recession, focuses too narrowly on cause and effects.
My argument would be that we are not just in a balance sheet recession, but facing some structural changes in the way the economy works. Here I am particularly thinking about the way banks treat risk. The question then becomes do you tackle potential structural fiscal deficits and when. Once the balance sheet recession is over those who have tackled structural problems probably have an advantage, provided of course tackling the problems has not trashed your economy in the mean time. This I think is the risk time frame (when the balance sheet recession begins to end) for the US in terms of inflation. Conversely accelerating resolution of your balance sheet recession ahead of others can mitigate this. Perhaps I should not worry about structural fiscal deficits, but looking at places like Pakistan and Kenya it does and I guess in the UK we are still haunted by 1976.
If the balance sheet recession is caused by govt overindebtment in countries where houses and firms are under-leveraged and banks overleveraged ( Italy, France..)this medecine doesn’t work, you have to go to the gym ( gov spending cuts).
Charles,
Sorry if I’m misreading you, but are you saying that a BSR is caused by ‘excessive’ Federal debt?
Not in the US of course but in other countries like the ones I mentioned. I just want to say that austerity is not always bad or good.look first at the disease
How, exactly, are the economies of those countries supposed to rally when money is being summarily withdrawn by the government? It doesn’t make mathematical sense in their current currency regime.
The budda would say if you are sick then this is the time to rest. I take that to mean stop spending.
The UK is more or less following similar path as USA. Inflation there reported at YoY 4.2%
For those in the 1% or those lucky or skilled enough to have a 17% return this inflation is not significant but it may be time to imagine those without any increase and how they accommodate to 4.2%.
In Canada, the personal debt to income ratio is now 153% and all Mark Carney does is say people should be cautious of taking on debt.
He is responsible for this policy and is keeping a bubble going because he will not allow deflation to “check” the malinvestment.
This is the direct result of incorrect economic theory. He is trying to serve too many masters. He loves the inflation master and will in the end hate the price stability master.
Economic growth can only be appreciated because there is also economic decline. This is nature and the longer one ignores nature, the more one will experience it.
Things do not feel real now with all this CB intervention and manipulation. I just don’t think all the unintended consequences will be covered. I wish for solution but worry the wrong technicians have been called
As long as the tax base keeps up with with the deficits, normal inflation and economic growth will do the rest. Either CR or RC pointed out that the WWII deficits were dealt with this way, they were never paid off, they just shrank to insignificance. Somebody said that the big worry is that every time the economy starts to recover the balance-the-budget crowd, not understanding the role of gov’t in a balance sheet recession, will attempt to do just that. That could turn a six year event into a Japan-like event.
Deficits is a recognition of the BSR, and a recognition by the government that the value of previous credit creation has been destroyed.
Whether the deficit is “good” or not also hinges on:
- is it fair? … (i) on the liability side, this is extend and pretend, fair or not? (I don’t know), and (ii) is the money going to those who are most affected … i.e. sub-prime borrowers with oppressive mortgage payments, … is a bit trickier as I don’t want the deficits to go into high-paid government employees, but it’s difficult to target. (This is why TPC likes the payroll tax cut probably.)
The problem with this analysis is that while greater government spending can keep the economy moving during a balance sheet recession, the money spent by the government will do so little to grow the economy or preserve productivity. New spending by the federal government rarely vanishes when the crisis is over. New entitlements, mandates, sustidies, and agencies, once created, tend to become protected and to grow, creating a permanent drag on the economy. It is so easy to spend more and have the government do more; but it is so difficult to have the government spend less and do less (and to return our freedom and our money).
I believe the idea is that the gov’t spending buys the private sector *time* to rebalance, to eventually become the driver of growth again
I mean “gov’t DEFICIT”, not (necessarily) “spending”
Can someone explain how extra government debt helps sustain and improve the productivity of the private sector?
More importantly, how does extra government debt directly effect wages of the middle class, helping to keep pace with inflation?
With all the increased debt over the last 10 years, the income disparity has widened, not shrunk.
If we don’t deal with the income disparity of those who actually have jobs,how will extra debt begin to solve our problems?
Don Levit
This guy has a few cogent remarks on the matter:
http://pragcap.com/resources/understanding-modern-monetary-system
My figures may be off a bit but even with Japan’s inefficient handling of it’s BSR deficits yielded something like a 10 to 1 in GNP, something like 400B in debt yielded +4T in GNP. If Japan had not run deficits they (and the US) could easily have gone into a depression.
Hi Cullen,
A little off topic, but something I am trying to wrap my head around.
1) During pomo ( QE ), the fed swaps the assets ( treasuries for deposits.)
2) For the purpose of targeting reserves
3) This helps devalue the dollar, lower interest rates, and forces investors to spend (hopefully anyway)
4) The fed’s M-1 balance sheet skyrocketed after swapping assets.
5) The fed obtained ( cash ) EX-Nihilo, and the Treasury didn’t spend it into existence.
6) So in essence, it seems they did create new money.
Where did I go wrong….
Thanks for your dedication,
pat
Pat,
QE swaps reserve balances for bonds. Stick to the pvt sector side of things here because the Fed’s balance sheet is rather unimportant. Think of it like a black hole like that of a scorekeeper (scorekeepers don’t have buckets of points, they have a blackhole of points that they can add to a scoreboard). So, the pvt sector gets reserves in place of bonds. What have they done? They’ve essentially swapped a checking account for a savings account. That’s it. I argue that the market effects are largely psychological. People think QE is inflationary so they buy risk assets. But because no one is richer than they were before, the Fed hasn’t really changed the buying power of the pvt sector. You don’t spend less money when you put money in a savings account, do you? No, this was your savings desires relative to income. QE didn’t change that. You don’t become rich when you sell bonds to someone else.
See where I am going with that? I hope it helps.
Cullen
Got it.
To further connect the dots.
( 1 During a balance sheet recession this policy won’t work. Pushing on a string is what comes to mind
( 2 Another policy is required, such as fiscal spending.
Thanks
pat
There was an article in Reuters yesterday.
Insight: Recovery at risk as Americans raid savings
http://www.reuters.com/article/2012/01/17/us-recovery-risk-idUSTRE80G08320120117
Is it good to solve the balance sheet recession problem suggested by Richard Koo?