True Keynesianism – Richard Koo edition

“Unfortunately there was a period in the economics profession, from late 1980s to early 2000s, where many noted academics tried to re-write the history by arguing that it was monetary and not fiscal policy that allowed the US economy to recover from the Great Depression. They made this argument based on the fact that the US money supply increased significantly from 1933 to 1936. However, none of these academics bothered to look at what was on the asset side of banks’ balance sheets.”

Richard C. Koo

Do you want to know what ‘Modern Keynesianism’ is all about? Read Richard Koo.

First, an excerpt (for the ‘exhibits’: see the link). Below that some meta which you might want to skip. Important: Keynesian economics is very much about all kinds of interconnected monetary flows and stocks, powered and owned by individual households, companies and the government who are however restrained by the interconnectedness. Think: wages, profits, consumption, real investments, financial investments, lending, borrowing, taxes, debt, assets, whatever. It’s only indirectly about a just economy, ‘real’ prosperity or a green economy. But we are living in a monetary world – most of us do work for profit or wages. And most of us do depend on this. Low unemployment is a prerequisite for prosperity – and an important element of a just society.

A flavour of the text:

These are extraordinary times for central banks. Near zero interest rates and massive liquidity injections are still failing to bring life back to so many economies in the developed world. If we set the pre-Lehman Shock level as 100, the Federal Reserve has increased monetary base to 347 today, while the Bank of England increased its monetary base to 433 during the same period, all under the lowest interest rates in their modern histories. Yet, the US is still suffering from an unemployment rate of 7.7 percent after four years of zero interest rates, and the UK is in the midst of a double-dip recession. The Bank of Japan has increased its monetary base from 100 in 1990 to 363 today, but instead of facing a triple digit inflation rate, it is facing a deflation. The European Central Bank has brought interest rates down to the lowest level in modern European history, but the unemployment rate at 11.9 percent is at the highest since the introduction of Euro. The increases in monetary base are shown in Exhibit 1.

Private sector is minimizing debt instead of maximizingprofits

These unusual phenomena are all caused by the fact that private sectors in all of these countries are massively increasing savings or paying down debt despite record low interest rates. According to the flow of funds data, the US private sector (household, corporate and financial sectors combined) today is saving whopping 6.9 percent of GDP (four-quarter moving average ending in Q4, 2012) at zero interest rates The comparable figure for the UK is 3.8 percent, for Ireland 8.6 percent, for Spain 8.1 percent and for Portugal 7.0 percent of GDP (Exhibit 2) all with record low interest rates. In Japan, where the bubble burst two decades earlier, the private sector is still saving 8.8 percent of GDP at zero interest rates (Exhibit 3). Moreover, in all of the above countries, not only household sector but also the corporate sector is increasing savings or paying down debt at these record low interest rates. This behavior of the corporate sector runs totally counter to the conventional framework of neoclassical economics where profit maximizing firms are expected to be increasing borrowings at these record low interest rates.
Private sectors in all of these countries are increasing savings or paying down debt because their balance sheets were damaged badly when asset price bubbles burst in those countries. In the case of Japan, where the bubble burst in 1990, commercial real estate prices fell 87 percent nationwide (Exhibit 4), destroying balance sheets of businesses and financial institutions all over the country. The collapse of housing bubbles on both sides of the Atlantic after 2007 (Exhibit 5) also devastated millions of household and financial institution balance sheets. The resulting loss of wealth reached well into tens of trillions of dollars and Euros while the liabilities incurred during the bubble days remained on the books at their original values. With a huge debt overhang and no assets to show for, the affected businesses and households realized that they have no choice but to put their financial houses in order. This means increasing savings or paying down debt until they are safely away from the negative equity territory. A failure to do so would mean a loss of access to the credit if not to the society altogether. This means they are forced to shift their priorities away from the usual profit maximization to debt minimization. The shift here has been nothing short of spectacular. The US household sector, which had been the key provider of final demand for the global economy, stopped borrowing money altogether after 2008 (Exhibit 6). The US private sector as a whole went from a net borrower of funds to the tune of 4.8 percent of GDP in Q4 2008 to a net saver of funds to the tune of 8.7 percent of Q1 GDP in 2010, all with the lowest interest rates in the US history. This means the US economy lost private sector demand equivalent to 13.5 percent of GDP in just five quarters, pushing the economy into a serious recession. The UK lost private sector demand equivalent to 9.7 percent of GDP from Q2 2006 to Q2 2010. Spain lost 20.0 percent of GDP from private sector shift between Q3 2007 to Q3 2012, also with record low interest rates. In a national economy if someone is saving money, there better be someone else borrowing and investing those savings in order to keep the economy running. In the usual world, the task of ensuring that the saved funds are borrowed and spent falls on the financial sector which takes in the saved funds and lent them to those who can make the best use of the funds. And the mechanism which equates savings and investments is the interest rate. If there are too many borrowers, interest rates are raised which prompts some potential borrowers to drop out, and if there are too few borrowers, interest rates are lowered which prompts some potential borrowers to step forward to take the funds. Today, however, the private sector as a whole is saving money at near-zero interest rates. This means those savings generated by the private sector will find no borrowers because interest rates cannot go any lower. The saved funds therefore are stuck in the financial sector unable to re-enter the economy. This means those unborrowed savings become a leakage to the income stream and a deflationary gap of the economy. If these unborrowed funds are left unattended, the economy enters a deflationary spiral as it continuously looses aggregate demand equivalent to the saved but unborrowed amounts. This process, now known as balance sheet recession, will continue until the private sector either repairs its balance sheet or becomes too poor to save (i.e., the economy enters a depression). Although that may sound outlandish at first, it was precisely this deflational spiral from private sector deleveraging that resulted in a loss of 46 percent of GDP in the US from 1929 to 1933 during the Great Depression. Debt minimization nullifies effectiveness of monetary policy Those businesses and households with balance sheets underwater are not interested in increasing their borrowings at any interest rates. There will not be many lenders either, especially when the lenders themselves have balance sheet problems. The lenders will also run afoul of government bank regulators if they knowingly lend to those with balance sheets underwater. This private sector shift to debt minimization is the reason why near zero interest rates by the Federal Reserve and European Central Bank since 2008 and by the Bank of Japan since 1995 failed to produce expected recoveries for those economies. In acts of desperation, central banks in the developed world have flooded the financial system with liquidity in a policy known as quantitative easing or QE. In spite of massive injection of liquidity, however, credit growths in all of these countries, the key indicator of the amount of funds that was able to leave the financial system and enter the real economy, have been absolutely dismal.

Some meta: Keynesian economics is generally understood to be the boring, mechanical Keynesianism of the undergraduate textbooks or the incoherent (see below) ‘new Keynesianism’ of the graduate textbooks. Both kinds of so-called ‘Keynesianism’ are naïve. ‘Mechanical Keynesianism’, though based on well-defined concepts, for one thing assumes a constant ratio between growth of income and growth of consumption. This is, considering the declining share of wage labor in total income, way to simple. It also does not take sectoral shifts into account: growth (even a recovery from a slump) always has a ‘Schumpeterian’ side to it as some sectors grow (or decline) faster than others. Long story short: nobody believes that reviving the Spanish or Irish construction sector to its former glory is a smart thing to do. ‘New Keynesianism’ makes things worse because it assumes that when government cuts expenditure, lowers wages and pensions and dismisses teachers during a downturn this will actually boost confidence and spending by businesses and also by households, a sector which includes these pensioners and teachers, which are included in the ‘representative consumer’. But this hyper rational ‘representative consumer is mortally ill as it suffers from the Arrow paradox (when wealthy households have other preferences than poor households, as well as more power, it is impossible to construct any kind of neo-classical ‘representative consumer’ which can be used to explain total consumption in a consistent way). For wonks: J.P. Mason is more philosophical about this. New Keynesianism is i.e. not based upon coherent, well-defined concepts (see also the ergodicity discussion on this blog). And both kinds of so-called Keynesianism lack a monetary sector.

Richard Koo makes up for much of this. He does pay a lot of attention to the difference between expenditure on new goods and services, which leads to work and income and which is included in GDP (income, production and expenditure side), vis-a-vis expenditure on financial assets which, to use the phrase coined by Keynes, have a ‘zero elasticity of production’ and which does not lead to work and income. Buying (or holding!) existing assets like legal tender, bonds, stamps, Swiss franks, houses, art or paying down debt might drive up the price of an asset – but generally this price increase does not lead to increased production (houses in areas without zoning are an exception). And even when the production of a financial asset does increase this does not lead to more income and work. As the Swiss know, who use the electronic printing press to satisfy the rather large demand for new franks at a stable 1,20 Euro price. Koo even mentions the decline of the amount of money caused by paying back debts to money creating banks. It is a coherent story, based on well-defined and estimated concepts and allowing for differences in behavior which lead to low-level equilibria which, in my view, captures the essence of Keynesian thinking. See also here.

An important cherry: Koo shows that the increase in the amount of money in the USA after 1933 (which followed a disastrous 30% decline after 1929) was not caused by private sector borrowing from banks but by government borrowing from banks – the government as borrower (and money creator) of the last resort. Low interest rates alone did, at that point in time, not revive the private sector.