Home > debt, depression, RWER > Richard Koo’s RWER paper “has gone viral on the Web” says the New York Times”.

Richard Koo’s RWER paper “has gone viral on the Web” says the New York Times”.

Richard Koo’s RWER paper The world in balance sheet recession: causes, cure, and politics already looks set to become a classic.  In its first two weeks it was full-text downloaded over 30,000 times from www.paecon.net.  Koo’s paper, reports the New York Times, “has gone viral on the Web”

Here are some key passages from Koo’s paper. 

Page 20

A recurring concern in the Western economies today is that they may be headed toward a Japan-like lost decade. Remarkable similarities between house price movements in the U.S. this time and in Japan 15 years ago, illustrated in Exhibit 1, suggest that the two countries have indeed contracted a similar disease.

Pages 21-21

More importantly, when the private sector deleverages in spite of zero interest rates, the economy enters a deflationary spiral because, in the absence of people borrowing and spending money, the economy continuously loses demand equal to the sum of savings and net debt repayments. This process will continue until either private sector balance sheets are repaired or the private sector has become too poor to save (i.e., the economy enters a depression).

Page 23

This government action maintained incomes in the private sector and allowed businesses and households to pay down debt. By 2005 the private sector had completed its balance sheet repairs.

Japan managed to avoid a depression, however, because the government borrowed and spent the aforementioned $100 every year, thereby keeping the economy’s expenditures at $1,000 ($900 in household spending plus $100 in government spending). In spite of a massive loss of wealth and private sector deleveraging reaching over 10 percent of GDP per year, Japan managed to keep its GDP above the bubble peak throughout the post-1990 era (Exhibit 6), and the unemployment rate never climbed above 5.5 percent.

Although this fiscal action increased government debt by 460 trillion yen or 92 percent of GDP during the 1990–2005 period, the amount of GDP preserved by fiscal action compared with a depression scenario was far greater. For example, if we assume, rather optimistically, that without government action Japanese GDP would have returned to the pre-bubble level of 1985, the difference between this hypothetical GDP and actual GDP would be over 2,000 trillion yen for the 15-year period. In other words, Japan spent 460 trillion yen to buy 2,000 trillion yen of GDP, making it a tremendous bargain. And because the private sector was deleveraging, the government’s fiscal actions did not lead to crowding out, inflation, or skyrocketing interest rates.

Page 25

Today private sectors in the U.S., the U.K., Spain, and Ireland (but not Greece) are undergoing massive deleveraging in spite of record low interest rates. This means these countries are all in serious balance sheet recessions. The private sectors in Japan and Germany are not borrowing, either. With borrowers disappearing and banks reluctant to lend, it is no wonder that, after nearly three years of record low interest rates and massive liquidity injections, industrial economies are still doing so poorly.

Flow of funds data for the U.S. (Exhibit 9) show a massive shift away from borrowing to savings by the private sector since the housing bubble burst in 2007. The shift for the private sector as a whole represents over 9 percent of U.S. GDP at a time of zero interest rates. Moreover, this increase in private sector savings exceeds the increase in government borrowings (5.8 percent of GDP), which suggests that the government is not doing enough to offset private sector deleveraging.

Page 27

Yet policymakers in both countries, spooked by the events in Greece, have pushed strongly to cut budget deficits, with the U.K. pushing harder than the U.S. Although shunning fiscal profligacy is the right approach when the private sector is healthy and is maximizing profits, nothing is worse than fiscal consolidation when a sick private sector is minimizing debt. Removing government support in the midst of private sector deleveraging is equivalent to removing the aforementioned $100 from the economy’s income stream, and that will trigger a deflationary spiral as the economy shrinks from $1,000 to $900 to $810.

Unfortunately, the proponents of fiscal consolidation are only looking at the growth in the fiscal deficit while ignoring even bigger increases in private sector savings. Indeed these governments are repeating the Japanese mistake of premature fiscal consolidation in 1997 and 2001, which in both cases triggered a deflationary spiral and ultimately increased the deficit (Exhibit 11).

Page 30

There is thus a tendency within the eurozone for fund flows to go to extremes. When times are good, funds flow into booming economies in search of higher returns, thereby exacerbating the bubbles. When the bubbles finally burst, the funds shift suddenly to the countries least affected by the boom.

The problem with these shifts is that they are pro-cyclical, tending to amplify swings in the economy. Countries that are in the midst of a bubble and do not need or want additional funds experience massive inflows. Meanwhile, countries facing balance sheet recessions and in need of funds can only watch as money flows abroad, preventing their governments from implementing the fiscal stimulus needed to stabilize the economy.

Page 33

In a democracy, however, where most people see only the trees and not the forest, even those few political leaders who understand the need for stimulus end up arguing endlessly about which projects the money should be spent on. In the meantime, the economy continues to shrink in the $1,000-to-$900-to-$810 deflationary spiral described above. Only during wartime, when it is obvious where the money should be spent, can democracies implement and sustain the kind of fiscal stimulus needed to overcome a balance sheet recession in the shortest possible time.

Even those who manage to prevent an economic meltdown by implementing necessary fiscal stimulus before the crisis are likely to be bashed instead of praised by the public. This is because the general public typically cannot envision what might have happened in the absence of fiscal stimulus. Seeing only a large deficit and no crisis, they assume the money must have been wasted on useless projects. That is exactly what happened to Liberal Democratic politicians in Japan, President Barack Obama in the U.S. and former Prime Minister Gordon Brown in the U.K. Although their actions saved their economies from devastating deflationary spirals, they were bashed because the public is unable to contemplate the counterfactual scenario. The man or woman who prevents a crisis never becomes a hero. For a hero to emerge we must first have a crisis, as Hollywood movies will attest.

Richard Koo’s paper can be downloaded here The world in balance sheet recession: causes, cure, and politics

  1. December 28, 2011 at 12:12 pm


  2. ezra abrams
    December 29, 2011 at 11:42 pm

    I found the first sentence of the second paragraph (The key difference between an ordianary recession and..)
    the phrase maximizing profits ….price bubble makes no sense whatsoever to me

    I would also say, that if you have any interest in a wide audience, words like “balance sheet” “deleverage” etc are to be avoided; these are technical terms that don’t mean anything to an ordinary person

  3. January 2, 2012 at 7:42 pm

    Good stuff but one has to note that it’s pretty much exactly what Krugman has been chanting all along…

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