Home > Uncategorized > The other half of macroeconomics – Richard Koo

The other half of macroeconomics – Richard Koo

Four possible states of borrowers and lenders

The discussion above suggests an economy is always in one of four possible states depending on the presence or absence of lenders (savers) and borrowers (investors). They are as follows: (1) both lenders and borrowers are present in sufficient numbers, (2) there are borrowers but not enough lenders even at high interest rates, (3) there are lenders but not enough borrowers even at low interest rates, and (4) both lenders and borrowers are absent. These four states are illustrated in Exhibit 2.

Of the four, only Cases 1 and 2 are discussed in traditional economics, which implicitly assumes there are always borrowers as long as real interest rates can be brought low enough. And of these two, only Case 1 requires a minimum of policy intervention – such as slight adjustments to interest rates – to keep the economy going.

The causes of Case 2 (insufficient lenders) may be found in both financial and non-financial factors. Non-financial factors might include a culture that does not encourage saving or a country that is simply too poor and underdeveloped to save. A restrictive monetary policy may also qualify as a non-financial factor that weighs on savers’ ability to lend. (If the paradox of thrift leaves a country too poor to save, this would be classified as Case 3 or 4 because it is actually due to a lack of borrowers.) 

Financial factors weighing on lenders might include an excess of many non-performing loans (NPLs), which depresses banks’ capital ratios and prevents them from lending. This is what is typically called a credit crunch.

When many banks encounter NPL problems at the same time, mutual distrust among lenders may lead to a dysfunctional interbank market, a state of affairs typically known as a financial crisis. Over-regulation of financial institutions by the authorities can lead to a credit crunch as well. An underdeveloped financial system may also be a factor.

Cultural norms discouraging savings, as well as income (and productivity) levels that are simply too low for people to save, are developmental phenomena typically found in pre-industrialized societies. These issues can take many years to address.

Exhibit 2. Borrowers and lenders: four possible states



Non-developmental causes of a shortage of lenders, however, all have well-known remedies in the literature. For example, the government can inject capital into the banks to restore their ability to lend, or it can relax regulations preventing financial institutions from performing their role as financial intermediaries. In the case of a dysfunctional interbank market, the central bank can act as lender of last resort to ensure the clearing system continues to operate. It can also relax monetary policy.

The conventional emphasis on monetary policy and concerns over the crowding-out effect of fiscal policy are justified in Cases 1 and 2, where there are borrowers but (for a variety of reasons in Case 2) not enough lenders. 

A shortage of borrowers and the other half of macroeconomics

The problem is with Cases 3 and 4, where the bottleneck is a lack of borrowers. This is the other half of macroeconomics that has been overlooked by traditional economists.

As noted above, there are two main reasons for an absence of private-sector borrowers. The first is that they cannot find attractive investment opportunities that will pay for themselves, and the second is that their financial health has deteriorated to the point where they are unable to borrow until they repair their balance sheets. An example of the first case would be the world that existed prior to the industrial revolution, while examples of the second case can be found following the collapse of debt-financed asset price bubbles. 

Exhibit 3. Massive liquidity supply and record low interest rates after 2008 failed to increase credit to private sector



Borrowers who have absented themselves because their balance sheets are underwater will not return until their negative equity problems are resolved. Depending on the size of the bubble, this can take many years even under the best of circumstances. Furthermore, the economy will enter the $1,000–$900–$810–$730 deflationary scenario mentioned earlier if the private sector as a whole is saving money (or paying down debt) in spite of zero interest rates.

When borrowers disappear, there is very little that monetary policy, the favorite of traditional economists, can do to prop up the real economy. Exhibit 3 shows that the close relationship between central-bank-supplied liquidity, known as the monetary base, and growth in private-sector credit seen prior to 2008 broke down completely after the bubble burst and the private sector began minimizing debt. This exhibit makes it clear that the monetary base and credit to the private sector were closely correlated prior to 2008, just as economics textbooks teach. In other words, the private sector was utilizing all the funds supplied by the central bank, and economies were in Case 1 of Exhibit 2.

But after the bubble burst, forcing the private sector to repair its balance sheet by minimizing debt, no amount of central bank accommodation could increase borrowings by the private sector. The US Federal Reserve, for example, expanded the monetary base by 357 percent from the time Lehman went under. In an ordinary (i.e., textbook) world, this should have led to similar increases in the money supply and credit, driving corresponding increases in inflation.

Instead, credit to the private sector increased only 19 percent over seven and a half years. A central bank can always add liquidity to the banking system by purchasing assets from financial institutions. But for that liquidity to enter the real economy, banks must lend out those funds: they cannot give them away because the funds are ultimately owned by depositors. A mere 19 percent increase in lending means new money entering the real economy from the financial sector has grown only 19 percent since 2008. Similar patterns have been observed in the Eurozone and the UK. This explains why inflation and growth rates in the advanced economies have all failed to respond to zero interest rates or astronomical injections of central bank liquidity since 2008.

Richard Koo





  1. graccibros
    July 21, 2016 at 5:05 pm


    Thanks very much for your work. I remember learning about you from your writings in the wake of the US near collapse, in 2008-2009, your term “balance sheet recession” entering the economic vocabulary.

    If you’re following, I wonder if you could say a word about credit cards in the creation of credit, since at one time the average number for Americans was seven, and may still be close to that. I was also wondering if L. Randall Wray is listening, in because that was the question I had after reading most of his Modern Monetary Theory, that the ability of banks to create money via credit cards was not addressed in his work…a way of purchasing power divorced from the limitations that you say ordinarily restrains banks…and a 19% growth in credit over 8 years is just over 2%…maybe inflation hawks like that…but who else? How far does that rate deviate from a “normal” situation…if there is any “Normal” left?

  2. jlegge
    July 22, 2016 at 7:32 am

    Good stats and lovely pictures. HOWEVER there cannot be a shortage of savers since the banks don’t need deposits in order to lend. The relevant CB will lend them any shortfalls after four to six weeks depending on jurisdiction.

    When a bank creates a loan as with the credit card example used by graccibros the credit card entry becomes an asset of the bank and the payment to the vendor (a credit to the vendor account) is a bank deposit and a bank liability. The interbank market resolves the balancing issues for vendors who use banks; the CB will make it up for any payments that wind up as cash. http://www.johnmlegge.com/blog/money-banking/

  3. graccibros
    July 22, 2016 at 1:04 pm

    Thanks very much for the clarification, jlegge. That seems consistent with the framework as L.Randall Wray lays it out in his book.

    I wanted to call economists’ attention to a historian from outside the profession, James Livingston, from Rutgers, who wrote “Against Thrift: Why consumer Culture is Good for the economy, the Environment, and Your Soul,” in 2011, a work which defies easy categorization or placement on the political economy spectrum. He achieved brief fame or notoriety with Op-Eds in the NYTimes and I think the Wall St. Journal…then faded.

    At the heart of the controversy generated by his work is a challenge to the importance of saving, and investment, or more precisely, where the sources of investment funds come from. In a boldly titled Appendix – “Capital in the American Economy: Kuznets Revisited” he lays out his challenge:

    “…one of the central claims of the book – that net private investment has been declining in importance for almost a century, even as economic growth has occurred.”

    And from his third Chapter, “Their Great Depression and Ours…”: …economic growth since the 1920’s does not require net private investment or net capital formation – because the mere replacement and maintenance of the existing capital stock, which is financed out of retained earnings and depreciation funds, increases the productivity of capital and labor. I n other words, net additions to the capital stock – private investments in new plant and equipment financed out of profits – are unnecessary to drive growth.”

    Needless to say, the number of major heresies that flow from this framework, it seems to me, challenges conservative and centrist notions of tax cutting to stir investments, and the constant urgings upon our society in America that “we don’t save enough” and reinforces Richard Koos deeper explanations for balance sheet recessions, and here’s why: Livingston is saying that falling consumer demand, whether from the psychological shock of panics and recessions, or paying down high level of debts, will affect some of ability of businesses to replace their capital stocks from their own income/profit/expenses flows…this also, it seems to me, challenges Alan Blinders dismissal of income inequality, that is, maldistribution skewed upward, saying it doesn’t influence GDP growth rates, that the social location of “demand”/consumer spending doesn’t matter…

    It’s a shame Livingston’s work didn’t seem to enter into some very crucial discussions, affecting matters at the heart of how most of us say capitalism operates. A true heretic, he deserved better. I don’t know him personally, but I invite Richard and L. Randall Wray to take a look into what he put forth…for quants and others deeply involved in these matters, he’ll be a quick read.

    I won’t take sides for now, just wanted to put this on professional radar screens, because if Livingston is right then much of what passes for public discourse in political economy rests on foundations of sand.

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