A Balance Sheet Recession

The most compelling explanation to me for the shape of the US economy is economist Richard Koo's "balance sheet recession" idea. If you have the time, I encourage you to read his full paper [PDF] on the topic. Here is an hour-long lecture he has given on the topic. This video embedded here is a quick 10-minute explanation.

Monetary policy is insufficient to solve the current US economic problems, as the real interest rate has been near zero for years now with no dramatic turnaround. The reason, as given by Koo, is simple: providing even the cheapest possible credit won't make a dent when people have no appetite for borrowing whatsoever.

Demand among the citizenry will be depressed as long as the people, on the whole, are deleveraging. Increased saving and debt repayment rates necessarily mean that consumption rates will fall. Koo suggests that governments should run a deficit during times of balance sheet recessions, as a government running a budget surplus is basically doing its equivalent of saving.

This is paradox of thrift territory, and the concept is more compelling here than under normal conditions. Generally, saving doesn't necessarily have to be a bad thing; banks lend out deposits, which then gets those funds back flowing through the economy. Except that, remember in a balance sheet recession that the demand for credit is low. When you have wounded and vulnerable banks (who are facing stricter capital requirements to boot) as we have now, the supply of credit falls too. Declining private sector credit demand and supply would only be made worse by the government running a surplus.

Koo therefore warns against austerity by governments during balance sheet recessions. After all, governments with their own currencies have more options for dealing with debt than individuals and businesses do (and many of those that don't are causing the Euro debt crisis). The fact that the US, which went with stimulus in 2009, is doing better than European countries that went the austerity route lends credence to this prescription. An economy simply can't grow if everyone from consumers to businesses to the government all pay down debts at the same time.

Koo developed his balance sheet recession idea while studying Japan's problems of the last 20 years, he believes it describes the US in the Great Depressions well, and it seems to fit for the current US as best as I can tell.