Friday, February 20, 2009

"Balance sheet deflation" and the need for fiscal expansion

Martin Wolf draws attention to the analysis of the Japanese deflation of the nineties by Richard Koo of Nomura Securities who argues that a combination of falling asset prices with high indebtedness forces the private sector to stop borrowing and pay down debt, and the government then inevitably emerges as borrower and spender of last resort.

He describes this a "balance sheet deflation" (and here), where the values of assets purchased with debt plunges, driving the economy into virtual bankruptcy as borrowers start defaulting. When faced with a massive fall in asset prices, companies typically jettison the conventional goal of profit maximization ("yang") and move to minimize debt ("yin") in order to restore their credit ratings. He feels that when faced with "yin" phase of the business cycle, fiscal policy alone will be of any utility.

The situation is made even worse when interest rates are close to zero, thereby rendering conventional monetary policy irrelevant. This happened in Japan and is now happening in the US, though the learnings from Japan appear to have been misinterpreted.

The figures show that US is in a much worse macroeconomic situation that Japan, despite the much larger destruction of wealth there, and the stuttering world economy is in no position to bailout the US economy by volunteering to buy up American exports. Total outstanding consumer credit has risen from $1.7 trillion in 2000 to $2.6 trillion now, residential mortgages rose from $5.6 trillion in 2000 to $12 trillion by end of 2008, and national debt increased from $5.7 trillion to $10.8 trillion in the same period. To top it all, US has both massive public debt (internal) and current account deficit (external) problems.

This means that the US economy will have to emerge out of the present crisis without any external support (Paul Krugman emphasizes this point while drawing on its role in pulling Japan out of its slump) and with the expected long period of suppressed private sector - both households and financial and non-financial businesses - consumption and investment. This leaves the ball squarely in the court of the Government, which despite its own indebtedness, is left with no choice but to engage in fiscal pump-priming in an unprecedentedly massive scale. And government spending too not in the form of tax cuts, which invariably will end up being saved or used to pay off debts.

Wolf points to the inevitable twin challenges for the US economy - reduce private sector debt and current account deficits. He opines that the former can be achieved with relatively lesser pain by forced write downs of bad assets in the financial sector and either more fiscal recapitalisation or debt-for-equity swaps and also mass bankruptcy of insolvent households and forced write downs of home mortgages. This, while increasing public debt, will usher in a slimmer and better-capitalized financial system and a healthier non-financial private-sector balance sheet in reasonable time, and will be better than a decade or more of continuous "deleveraging", with running fiscal deficits, and sustained pain. Addressing the current account deficit will be more a challenge of global economic diplomacy and co-ordinated action by the major economic powers, so as to remedy the grossly unsustainable structural imbalances in the world economy.

Wolf also spotlights on Koo's claim that contrary to the widespread misconception, Japan emerged out of the nineties thanks to the massive fiscal deficits, which prevented the economy slipping into a full fledged depression. In fact, Japan emerged out of the bad decade of nineties in the 2003-07 period, before the present crisis started taking its toll. However, like the US now, Japan too had problems in swiftly responding to the failing banks with their distressed assets and let the zombie banks continue functioning for a decade. The "public hostility to bankers rendered it impossible to inject government money on a large scale, and the power of bankers made it impossible to nationalize insolvent institutions".

Interestingly, Richard Koo finds that the Indian economy is in the yang phase, with the economy healthy, the private sector regaining its vigor, and confidence back.

Update 1
Awkward Corner sums up the balance sheet deflation debate here.

Update 2
Mostly Economics points "to an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis."

Update 3
Paul Krugman says Koo's theory of balance sheet deflation is similar to John Hicks' "non-linear" theory of the business cycle with its emphasis on the unstable short run nature of the economy - "an economic boom causes rising investment spending, which further feeds the boom, and so on, while a slump depresses investment spending, deepening the slump, etc". Krugman says that Hicks’s big contribution was to add limits to the boom and slump: a "ceiling" set by the economy’s capacity, a "floor" set by the fact that investment can’t go negative.

Update 4 (26/12/2010)

Mark Thoma writes about the way out of such balance sheet recessions - "use the federal government’s balance sheet as a means of offsetting the deterioration in the private sector’s financial position".

No comments: