The American-Taiwanese economist Richard Koo, is the chief-economist of the Nomura Research Institute.
He distinguishes between the “Yang” phase of the economy and the ”Yin” phase (the so-called “balance sheet recession”). In “Yang” times companies want to increase profit and people consume a big part of their pay rises. The mainstream economic principles are fully valid (for details see short-run, medium-run, long-run). In the “Yin” phase, however, economic actors give a higher importance to debt reduction than to profit increases.
Koo’s Theory: The Balance Sheet Recession
Koo’s theory is related to economists like Walter Bagehot, Hyman Minsky, Charles Kindleberger, who similarly to Austrian economists introduced a “Boom and Bust Cyle” or “Financial Instability Theory“ caused by excesses of the financial sector. The boom phase is often visible in excessive appreciation of assets price (see below) and high debt. The sharp distinction to Austrians, however, is that Koo’s recipe against a balance sheet recession is public spending.
In the “balance sheet recession /Yin” phases economic actors want to reduce costs and debt. Many economic principles are only partially or not valid at all. Their underlying assumptions, that firms want to maximize profit and that the propensity to consume is considerably higher than zero, are not valid.
The way economies get into the balance sheet recession is the following (extracts from here):
- The private sector builds up massive debt levels to buy property and speculative assets.
- The asset prices rise as demand rises but then eventually the bubble bursts and the private sector is left with declining wealth but huge debt. Often richer, informed investors are able to sell the property early, but the ordinary Joe is often left with his asset “under-water”.
- The private sector then start restructuring their balance sheets – and stop borrowing – no matter how low interest rates go.
- All effort is devoted to paying back debt (de-leveraging) and households increase their saving and reduced spending because they become pessimistic about the future.
- For borrowers who are under-water, a credit crunch might emerge – not because there is enough funds but because banks cannot find credit-worthy borrowers to lend to.
- Attempts at pumping liquidity into the banks will fail because they are not reserve-constrained. They are not lending because no-one worthy wants to borrow.
- According to Koo, the only way out of the “balance sheet recession” is via sustained public sector deficit spending.
- The faltering spending causes the economy to grow very slowly. Especially when public spending helps, a recession and Irving Fisher’s debt deflation does not happen, but it leads to disinflation taking place over years and potentially to deflation, but not to a sudden deflationary spiral.
Koo expects all countries who got stuck in a real estate bubble before 2008, to live a long-lasting balance sheet recession (Yin phase), whereas in 2010 Japan and Germany were about to leave the balance sheet recession.
Here the April 2008 version, when Koo thought that even China could see a balance sheet recession.
Central bankers and economists especially in the English-speaking countries and very influential papers like ”The Financial Times” or “The Economist” strongly rely on the economic principles valid in the “Yang” phases and reckon that monetary policy is able to solve the issue of weak demand.
Koo’s new “general theory” of macroeconomics
Richard Koo created a new general theory of macroeconomics along the Yang and Yin phases.
Balance sheet recession in regular economic data
The following news shows how the balance sheet recession affects daily life. British home owner continue to pay down their mortgages, instead taking loans against it as before the crisis. This reduces the ability for spending and therefore the GDP.
WEDNESDAY, OCTOBER 3, 2012 – 04:52
BOE: UK Q2 Housing Equity Injection Largest Since Q2 20l1
LONDON (MNI) – UK homeowners continued to inject substantial amounts of equity into their properties in the second quarter of this year, Bank of England data show.
Second quarter housing equity withdrawal was -stg9.829 billion, a net equity injection, the largest injection since the -stg10.187 billion HEW outturn in Q2 2011. Since June 2008 the BOE data have shown net injections, with the onset of the financial crisis rapidly reversing the previous trend for UK homeowners to borrow against their properties.
With mortgage rates and volumes low by historic standards the data have shown homeowners increasing their equity. HEW as a share of post-tax income held steady at -3.6% in Q2 and was last lower at -3.9% in Q2 2011.
Housing equity withdrawal is a measure of secured borrowing not invested in the housing market. It is the net result of increases in mortgage lending and capital grants minus household investment in housing
or the following from a FreddieMac analysis:
As we noted above, our analysis also shows that more borrowers are paying their principal down faster than the scheduled amortization prior to refinancing. Before the Great Recession this segment represented between 3 and 9 percent of all borrowers by year; since then about 11 to 19 percent have paid down additional principal prior to refinance. (source Freddie Mac)
The Balance Sheet Recession in the United States
Thanks to the St. Louis Fed (direct link)
Germany and Japan reduced private debt since year 2000, while others accumulated
Balance Sheet Recession becomes mainstream, four years too late
Influential main stream economist have a long rejected the balance sheet recession theory. Here an answer from Krugman to Koo’s theory: He disagrees because there must be “also creditors, not only debtors”. Certainly, Mr Krugman, there are now creditors, most of them are in the US or the UK, but they are in the countries with strong trade balances (like China and German) and those with rising real estate prices (Germany or Switzerland or soon Japan). Krugman partially agrees and distinguishes between “patient and impatient market participants”, creditors and debtors.
“The standard approach in economics has been to assume that households consume about the same fraction of the increase in their wealth each year, regardless of its source… The severity of losses experienced during the recession that began in December of 2007 in both national output and in labor markets makes these estimates appear too small…
A growing economics literature highlights the importance of household debt balances in influencing the severity of economic slumps… A series of empirical papers attempts to quantify the effect of such deleveraging on consumption (Mian and Sufi 2010; Mian, Rao, and Sufi 2011). These papers broadly suggest that the levered nature of household housing assets amplified the effect of pure wealth losses from the crash in housing prices.”
And finally Mr Mainstream Keynesian, Paul Krugman:
Mike Konczal has an excellent survey of the recent literature on balance sheet recessions; as he says, there is now a lot of empirical evidence supporting the view that we are mainly facing a slump in aggregate demand, which in turn is largely driven by debt overhang. There are strong implications for, among other things, mortgage relief; and in general, macro policy is different under these conditions.
And this is the presentation from the Roosevelt Institute, the application of Koo’s theory to the United States.
Some first econometric evidence
Here some extracts of institutes and blogs who support Koo’s balance sheet recession theory:
|The Roosevelt Institute||The Capital Research Institute||The Institute of New Economic Thinking||The Real World Economic Review|
|Blog of the Roosevelt Institute fellow Mike Konczal||The big picture here, here and many more||Even John B. Taylor with this||Zerohedge|
|The Boom Bust Blog||Keiser RT||Economic Times||Pragmatic Capitalism: here and here and here and here.|
|Alternative Economics||The Motley Fool||Bill Mitchell's Blog||Mish's Global Economic Trend Analysis|
An overview of recent economic papers give this slide from Mike Konczal:
Details and more on recent economic research
McCulley, Poszan provide a similar division between yin and yang, between de-leveraging and leveraging of the private sector and explains possible solutions. As opposed to Koo they do not claim that monetary policy is useless during a yin phase.
Case, Quigley, Shiller (2011): Wealth Effects Revisited
Mian, Rao, and Sufi (2011): Household Balance Sheets, Consumption, and the Economic Slump
Doms, Dunn, Vine (2008): Changes in Housing Wealth and Consumption: Did the linkage increase in the 2000s ?
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