Krugman vs. Koo on macroeconomic policy in a balance sheet recession

from Lars Syll

Imagine first a world in which there are only two kinds of people: Spendthrift Sams and Judicious Janets …

In this world, we’ll assume that no real investment is possible, so that loans are made only to finance consumption in excess of income. Specifically, in the past the Sams have borrowed from the Janets to pay for consumption. But now something has happened – say, the collapse of a land bubble – that has forced the Sams to stop borrowing, and indeed to pay down their debt.

For the Sams to do this, of course, the Janets must be prepared to dissave, to run down their assets. What would give them an incentive to do this? The answer is a fall in interest rates. So the normal way the economy would cope with the balance sheet problems of the Sams is through a period of low rates.

But – you probably guessed where I’m going – what if even a zero rate isn’t low enough; that is, low enough to induce enough dissaving on the part of the Janets to match the savings of the Sams? Then we have a problem. I haven’t specified the underlying macroeconomic model, but it seems safe to say that we’d be looking at a depressed real economy and deflationary pressures. And this will be destructive; not only will output be below potential, but depressed incomes and deflation will make it harder for the Sams to pay down their debt.

What can be done?  One answer is inflation, if you can get it, which will do two things: it will make it possible to have a negative real interest rate, and it will in itself erode the debt of the Sams. Yes, that will in a way be rewarding their past excesses – but economics is not a morality play.

Oh, and just to go back for a moment to my point about debt not being all the same: yes, inflation erodes the assets of the Janets at the same time, and by the same amount, as it erodes the debt of the Sams. But the Sams are balance-sheet constrained, while the Janets aren’t, so this is a net positive for aggregate demand.

But what if inflation can’t or won’t be delivered?

Well, suppose a third character can come in: Government Gus. Suppose that he can borrow for a while, using the borrowed money to buy useful things like rail tunnels under the Hudson. The true social cost of these things will be very low, because he’ll be putting resources that would otherwise be unemployed to work. And he’ll also make it easier for the Sams to pay down their debt; if he keeps it up long enough, he can bring them to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment.

Yes, private debt will in part have been replaced by public debt – but the point is that debt will have been shifted away from severely balance-sheet-constrained players, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen.

The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can – and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve.

Paul Krugman

Now, the way I read Richard Koo, he maintains that interest rates and monetary policy don’t really matter when we’re in a balance sheet recession where, following on a nationwide collapse in asset prices, more or less every company and household find themselves carrying excess debt and have to pay down debt. The number of willing private borrowers is strongly reduced – even when interest rates are at zero – and as a result of this “debt minimization” monetary policy by itself therefore loses all power. To get things going, the government has to run a fiscal deficit, by increasing borrowing producing an increase in money supply and thereby making monetary policy work.

And Paul Krugman, at least in the cited parable above, basically maintains that this argument can’t be right, since if there are some people – debtors – in the balance sheet recession that pay down their debt, there also have to be other people – creditors – that a fortiori strengthen their balance sheets, and who are susceptible to being influenced by what happens to interest rates and inflation.

To be honest, I have some problems seeing the great gulf between them – at least on the level of general principles – that one is lead to believe ought to be there, considering all the heated discussion there has been on this issue between them for a couple of years now.

For although it’s true, as Koo says, for those firms that try to minimize debt, no injections what so ever that the central bank makes will generate inflationary impulses. For others – and probably not even in the worst balance sheet recessions imaginable are all firms debt-constrained – there might be room for some (limited) inflationary generation by monetary means. So ultimately, it looks like more of a differences in degree rather than in kind. To Koo monetary policy has by itself no power, and instead we have to put our trust in fiscal policy. Krugman on the other hand says that some private actors might not be balance sheet-constrained and therefore susceptible to (inflationary) monetary policy, and that besides fiscal policy anyway can work. And more importantly – both definitely agree that increased liquidity will not not always and everywhere get the economy out of a slump, and that neither fiscal, nor monetary policy, in itself is capable of solving the problems created in a balance sheet recession.