The subtitle is Lessons from Japan’s Great Recession and the author is Richard Koo (2009).
After seeing the author interviewed on RealVision TV, I decided to pick up his book. He is an economist most well-known for formulating the concept of a balance sheet recession, and then convincingly ascribing it to be the cause of both Japan’s lost decades and America’s Great Depression. What it describes is in the aftermath of a large bubble bursting, balance sheets are damaged – and whereas all classical, mainstream economists assume that economic actors are always profit-maximizing, Koo understands that borrowers prioritize paying down debt in these moments, not further borrowing, and so monetary stimulus holds no weight to turn the economy around until balance sheets are repaired. Therefore, the answer must be fiscal policy to maintain aggregate demand and to avoid a deflationary gap. The government must be the borrower of last resort to keep the economy on a steady plane during these periods.
What are the implications and particular nuances of this theory relative to anything else that gets tossed around?
For starters, it tells us that quantitative easing will not create economic growth, because low interest rates are not an impetus to borrow and invest when the priority is simply to pay down debt. Koo implies that the current global recession is also a balance sheet recession, which might explain why QE has not had the consequences that were hoped for. But I am not sure that his theory offers a complete explanation – specifically, it sure seems like QE has led to another bubble in financial assets, and nowhere do I see an explanation in his theory for why that is happening. Unless we aren’t really dealing with a balance sheet recession.
He distinguishes himself from Keynes in explaining the liquidity trap – which is the effect of zero rates causing bonds and cash to be substitutes for one another. But, Keynes still assumed that economic actors were profit maximizers, and therefore identified the logjam in borrowing to be with the lenders rather than the borrowers. More generally, in contrasting himself to the acolytes of Keynes, Koo understands that the fiscal policy solution is only appropriate for a downturn that qualifies as a balance sheet recession, not just any and all recessions, otherwise government borrowing will crowd out private investors and cause inflation and rates to rise.
With respect to gold, and the idea that the gold standard exacerbated the great depression by preventing the creation of needed reserves, Koo’s theory obviously suggests that where there are no borrowers that the creation of new gold-backed reserves was not the problem – the demand for funds was not there. As a corollary of that point, Koo acknowledges that the Central Bank system requires confidence, and even though the gold standard has been eliminated, it is important that central bankers operate as if such a restraint was still in place.
Overall, another tool and theory to understand the world.
