“New Keynesian” gimmicks

2 Feb, 2014 at 18:37 | Posted in Economics | 18 Comments

holy-grail-of-macroeconomics-lessons-from-japans-great-recessionIt was frequently argued that the Great Depression was the ultimate recession, implying that the difference between ordinary recessions and the Great Depression is simply a matter of degree. To produce prolonged recessions while assuming that companies are always forward looking and profit maximizing, the profession had turned to the so-called (New) Keynesian school, with its heavy reliance on various sorts of price “stickiness.” … But although price rigidities or stickiness can be used to explain short-term unemployment and recessions, they cannot explain longer-term downturns …

By incorporating the concept of debt minimization, the economics profession is finally freed from its reliance on gimmicks such as price and wage stickiness and rigidity to explain long-term recessions.

Richard Koo has maintained for years 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.

To Koo, fiscal stimulus is the only effective remedy. As he writes in Central Banks in Balance Sheet Recessions: A Search for Correct Response:

With monetary policy largely ineffective, the only policy left to keep the economy away from a deflational spiral in this type of recession is for the government to borrow and spend the unborrowed savings in the private sector. In other words, if the private sector firms and households cannot help themselves because they have no choice but to repair their balance sheets, the government, the only entity outside the fallacy of composition, must come to their rescue.
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From the perspective of central banks, the importance of deficit spending by the government is multiplied by the fact that it is also indispensible in maintaining money supply from shrinking when the private sector is minimizing debt. This comes from the fact that money supply, which is a liability of the banking system, starts shrinking when the private sector as a whole starts paying down debt. This is because banks are unable to lend out the money paid back to them by the deleveraging borrowers when the entire private sector is deleveraging at the same time. During the Great Depression, the US money supply shrunk by over 30 percent from 1929 to 1933 mostly for this reason (85 percent due to deleveraging, 15 percent due to bank failures and withdraws related to failures.)
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Deficit spending is not only absolutely essential in fighting balance sheet recessions, but also essential in maintaining the effectiveness of monetary policy when the private sector is minimizing debt. It is therefore essential that the government bolster the economy while the private sector is repairing its balance sheets, while in the longer term it should provide tax incentives and undertake deregulation to create an environment in which businesses want to borrow.

It was the private sector rush to repair its balance sheets that caused the economic implosion. And the private sector had to repair its balance sheets because it realized that it was chasing wrong asset prices and that bubble-level prices will not come back anytime soon. The fact that the private sector was chasing wrong asset prices also means that the sector was grossly misallocating resources during the bubble. The traditional assumption that private sector can allocate resources better than public sector was violated long before the bubble burst. Far from being a necessary evil, therefore, government borrowing and spending becomes absolutely indispensible in saving the economy and helping the private sector recover from its own madness that created the bubble. By keeping the GDP from shrinking, the government ensures that the private sector has the income to repair its balance sheets. Since asset prices never turn negative, as long as private sector has the income to repair its balance sheets, at some point, its balance sheets will be repaired. Once that point is reached and the private sector is ready to borrow money again, the government should embark on its balance sheet repair.

Although deficit spending is frequently associated with crowding out and misallocation of resources, during balance sheet recessions, the opposite is true. When the private sector is minimizing debt by deleveraging, government borrowing and spending causes no crowding out because the government is simply taking up the unborrowed savings in the private sector. The issue of misallocation of resources does not arise either because those resources not put to use by the government will go unemployed in this type of recessions which is the worst form of resource allocation.

Paul Krugman 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.

Paul Krugman presents his basic argument in the following parable:

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.

Although I wouldn’t describe the gulf between Koo and Krugman as unbridgeable – I think it’s true that, 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. 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 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.

Still, even though it looks like more of a difference in degree rather than in kind, I would say that what we have seen happening during the last couple of years gives more credit to Koo than to Krugman. Despite huge monetary easing going on in the West for years now, private sector credit is still not taking off. The only really effective remedy is fiscal stimulus.

18 Comments

  1. “no injections what so ever that the central bank makes will generate inflationary impulses”

    Koos & Krugman’s arguments are moot. The gov’t is the largest creditworthy borrower. The transition from non-earning assets to earning assets was created by introducing an interest rate differential in favor of the CBs. Whereas “pump priming” would have been activated, it was instead deactivated by Bankrupt you Bernanke.

    Comment by flow5— 22 Feb, 2014 #

  2. Digital Cosmology: Why is deleveraging bad? It need not always be bad, as we know high degrees of leverage can introduce increased financial fragility and increases financial instability, as Hy Minsky demonstrated in his economic research. But when the private sector attempts to deleverage – that is, reduce debt by spending less than it earns (i.e. net saving, or running a financial surplus) in order to pay down debt – nominal income flows in the economy will tend to fall. They will fall unless some other sector (government and/or foreign) tries to deficit spend at a pace equal to or greater than the private sector is trying to net save. If nominal income flows fall, you have income deflation. When you have income deflation, it becomes harder for many existing debtors to service debts which usually have fixed nominal payment stream associated with them well into the future. These private households or firms then find themselves cutting back further on expenditures on current output in order to try to service the debt. The result can be a debt/deflation spiral. A debt/deflation spiral, much as we witnessed in the 1930’s can undermine economic and political systems. As in game over, Mein Fuhrer. If you are not familiar with the issue of debt deflation, there is good summary article by Irving Fisher from 1933 on the topic. You may wish to familiarize yourself with the argument. Having said that, it is supposedly one of the benefits of a well running capitalist system that “good” deflations can occur as labor productivity increases when profits are plowed back into capital equipment, and so prices of final products can fall. Nominal income flows need not fall then, as employment and output may be growing faster than final product prices are falling, but even then, probably best to have an all equity financed private sector.

    Comment by Rob Parenteau— 11 Feb, 2014 #

  3. This is ridiculous Krugman has argued for stimulus and acknowlledged the limited traction of monetary policy all the time.
    I have no idea how QE can NOT help private player deleverage and how you and Koo cannot see this.

    Comment by Keynes Still Matters— 5 Feb, 2014 #

    • May be you should try to explain how does It help private sector to deleverage. Do you accept endogenous money? Or do you think central bank controls interest rate and money supply at the same time? As a monopoly supplier of reserves It can do one or the other but not both at the same time.

      Comment by Kristjan— 5 Feb, 2014 #

      • Unreasonable assumptions generate unreasonable conclusions. Why is deleveraging bad? Everyone assumes that. Socialist parties want to inflate the money supply so that borrowers gain at the expense of the lenders. In deflation the borrowers gets punished and the lender/saver gains purchasing power. This system that rewards excessive borrowing because it increases consumption is a vicious circle and leads to bubble creation and bust through credit expansion. They think they can do this a few more times in the next 20 years but every time it happens a large part of the population that saved is badly hurt and become voluntarily unemployed. This erases all gains from increased consumption and it is a long-term effect. Economics is ideology and income redistribution.

        Comment by Digital Cosmology (@DCosmology)— 6 Feb, 2014 #

        • “Unreasonable assumptions generate unreasonable conclusions. Why is deleveraging bad? ”

          The assumpion that deleveraging was bad was made by you, not me.

          Comment by Kristjan— 6 Feb, 2014 #

          • So what do you think of that? Do not be afraid to express your beliefs. Nobody will attack you here. There are no bitbulls in this blog. It is civilized. Nobody will tell you that you say garbage. What is your belief then? And if you have a belief, how do you justify its truth? Is deleveraging good or bad? Here is your chance to go beyond plays of words.

            Comment by Digital Cosmology (@DCosmology)— 6 Feb, 2014 #

            • Digital Cosmology: Banks cannot be reserved constrained when central banks target a nominal policy rate. Why? This is microeconomics 101. As Kristjan noted, a monopolist (which is what a central bank is – a monopolist supplier of reserves, or high powered money as it is sometimes called) can either set price OR quantity of the product supplied, but not both. Surely you are familiar with this logic? You can elect to ignore all the quotes of people involved in commercial banking, central banking, and economics that Kristjan supplied to you – that is surely your choice to do so. But do you really want to ignore introductory level economic logic in your argumentation? I doubt it – but again, it is completely your choice.

              Comment by Rob Parenteau— 11 Feb, 2014 #

  4. What Koo (and on some days, Kruggie) cannot seem to get his head around is 1) that the private sector cannot net save financial assets (as it tries to do when households and/or firms are “paying down debt”) unless and until the public sector/government deficit spends, and relatedly 2) the public sector/government creates the net financial assets of the private sector, which the private sector must use to settle tax liabilities and purchase government liabilities. The net private sector saving does not exist until and unless some other sector in the economy spends more money than it earns. This is a point of accounting logic, not high theory. It is also a practical matter. Yet the New Keynesians, even those with a whiff of Minsky or Irving Fisher (after he got evicted from his house at Yale) in their noses, are still insisting on depicting economic reality in a loanable funds rather than an endogenous credit money fashion. It is absurd – beyond absurd. And the New Keynesians, who are really Old Friedmaniacs/Wicksellians/and pre-Great Depression Fisherites, refuse to engage on this fundamental point, one based on over seven centuries of double entry book keeping, not high theory. They refuse to question their loanable funds theology, and it causes serious defects in their macro financial diagnosis, both during the period of build up of macro financial instability, and after the nearly inevitable crashes that we experience with increasing frequency and destructive force. Truly twisted.

    Comment by Rob Parenteau— 3 Feb, 2014 #

    • Completely agree with Rob Parenteau here. Keynes argued the same thing that private sector as a whole cannot save without government being in deficit or foreign country being in deficit. Keynes argued that savings for the entire nation would even decrease. He must have not meant net savings.
      Even Koo wrote recently that all these bank reserves QE has created might cause inflation in the future when banks start lending again, he doesn’t understand how the system operates either. The whole blogosphere was full of It, Koo goes kukuu and so forth 🙂 He thinks bank lending is constrained by reserves. Krugman was arguing against banks creating money out of thin air, It was really embarrassing, Nobel prize winner didn’t understand basic banking. Scott Fullwiler wrote an article in response to him: Krugman flashing neon sign I don’t know what I am talking about.
      http://www.nakedcapitalism.com/2012/04/scott-fullwiler-krugmans-flashing-neon-sign.html
      Krugman read that article and responded that he does understand double entry bookkeeping 🙂
      I don’t know, probably not all the people understood the mistakes Krugman made but the endogenous money crowd and MMT people all understood.

      He seems like a smart guy how come he doesn’t get It? And if he doesn’t get It who will? People respond usually ok, so you are smarter than the Nobel Prize winner? What can I say, he might be very smart but he gets this wrong. With that ISLM he never ends.

      Comment by Kristjan— 5 Feb, 2014 #

      • “He thinks bank lending is constrained by reserves.”

        Practically it is. A bank can try to create deposits out of thin air but after a certain point there can be problems, especially if the money flows to other countries to finance local consumption and it is not locally deposited. More importantly, the market watches the reserve level of banks versus their assets and liabilities and can exclude one from overnight lending especially during period of financial turmoil and possibility of a bank run.

        Therefore, although in theory banks are not constrained by reserves in the real world they are and in several ways. This reminds of rational expectation in an ideal world versus actual agent behavior in a real world.

        This argument of no reserve constraints is like an empty one and a straw man. Only people who have not worked in banking can make such statements.

        Comment by Digital Cosmology (@DCosmology)— 5 Feb, 2014 #

        • ““He thinks bank lending is constrained by reserves.”

          Practically it is. A bank can try to create deposits out of thin air but after a certain point there can be problems, especially if the money flows to other countries to finance local consumption and it is not locally deposited.”

          Currencies don’t leave currency zones. If central bank doesn’t provide banking system with enough reserves then It loses It’s target interest rate. In worse case It creates full blown liquidity crises. Central banks don’t do that.

          Alan R. Holmes, Federal Reserve Bank of New York (1969):
          Operational Constraints on the Stabilization of Money Supply Growth

          Click to access conf1i.pdf

          ‘In the real world, banks extend credit, creating deposits in the process , and look for the reserves later.’

          Nobel prize winners Finn Kydland en Ed Prescott , Federal Reserve bank of Minneapolis (1990):

          Click to access qr1421.pdf

          ‘There is no evidence that either the monetary base or M1 leads the [credit cycle], although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the [credit cycle] slightly.’

          Charles Goodhart, member of the Monetary Policy Committee of the Bank of England (2007):

          Click to access paper_6goodhart.pdf

          ‘The money stock is a dependent, endogenous variable. This is exactly what the heterodox, Post-Keynesians, from Kaldor, through Vicky Chick, and on through Basil Moore and Randy Wray, have been correctly claiming for decades, and I have been in their party on this.’

          Piti Distayat en Claudio Bori, Bank for International Settlements (2009):

          Click to access work297.pdf

          ‘This paper contends that the emphasis on policy-induced changes in deposits is misplaced. If anything, the process actually works in reverse, with loans driving deposits. In particular, it is argued that the concept of the money multiplier is flawed and uninformative in terms of analyzing the dynamics of bank lending. Under a fiat money standard and liberalized financial system, there is no exogenous constraint on the supply of credit except through regulatory capital requirements. An adequately capitalized banking system can always fulfill the demand for loans if it wishes to.’

          Seth B. Carpenter, Federal Reserve (2010):

          ‘Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected. Specifically, our results indicate that bank loan supply does not respond to changes in monetary policy through a bank lending channel.’

          Vitor Constancio, vice president of the ECB (2011):

          ‘It is argued by some that financial institutions would be free to instantly transform their loans from the central bank into credit to the non-financial sector. This fits into the old theoretical view about the credit multiplier according to which the sequence of money creation goes from the primary liquidity created by central banks to total money supply created by banks via their credit decisions. In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.

          There is a famous statement from a famous monetarist Paul Volcker at a FOMC meeting that I can’t find right now where he states: “we have to supply the reserves”

          Comment by Kristjan— 5 Feb, 2014 #

          • If you really think that banks are not constrained in their lending by reserves then you deny reality. Quoting statements of various people in disconnected or out of context cannot support such unrealistic stand that defies empirical data. In theory banks can create deposits and are not constrained by reserves when they are not constrained by reserves but there is a line a bank cannot cross because the market will react and terminate its overnight lending capability. Then the bank will go insolvent if there are bad assets and it will have to recapitalized. For details see Portugal, Spain, Greece, Ireland, and many other recent examples.

            To summarize: that banks are not constrained by reserves is a condition that applies under ideal circumstances but in the real world these circumstances are briefly or never there and banks are actually constrained by reserves because

            1. There are capital outflows
            2. There are bad loans
            3. There are recessions and depressions
            4. There is a fierce competition
            5. Things that you know you know
            6. Things that you know you do not know
            7. Things that you do not know you do not know

            Comment by Digital Cosmology (@DCosmology)— 6 Feb, 2014 #

            • Garbage, mixing up so many things here. No matter what recessions there are, central banks are monopoly suppliers of reserves and they do supply the system with reserves. Not only is lending not reserve constrained but payment system is going to collapse if central banks don’t supply system with enough reserves. Lack of liquidity and solvency are two different matters. The things that banks are sensitive about is the price of reserves not quantity. Lending is capital constrained not reserve constrained in floating fiat currency system. And even in fix forex the payment system faces danger of collapse if not enough reserves are not supplied. This happened in Sweden for example. Interest rate peaked at 500% if I remember It correctly and central bank let the exchange rate float. It only devalued about 25% initially if I remember correctly. This demonstrates that there is no choice of restricting the supply of reserves, even small disturbancies can cause panic.

              Let’s come back to what I said initially about Koo. I said that Koo was wrong asserting that excess reserves that QE is pumping into banking system might cause inflation problem in the future when banks start lending. This is not the case since banks don’t lend reserves when they make loans and the supply of reserves is not restricted by central banks. If the banks don’t have capital and can’t get It then these banks are shut down by central bank, recapitalized by government etc. That’s It.

              Comment by Kristjan— 6 Feb, 2014 #

              • QE is money printing unless sterilized. You are playing with words.

                “I said that Koo was wrong asserting that excess reserves that QE is pumping into banking system might cause inflation problem in the future when banks start lending. This is not the case since banks don’t lend reserves when they make loans and the supply of reserves is not restricted by central banks.”

                You are involved in a game of words. This “theory” started by Kydland and Prescott in 1990 when they argued that banks are not reserve constrained.

                But reality does not work that way. As this blog has shown numerous time, theory and practice do not go together. Banks are not reserve constrained in theory but in reality they are the same way every other business is constrined in its activity.

                As far as the “garbage” call, I have to remind you that this blog has remained civilized until you showed up.

                Comment by Digital Cosmology (@DCosmology)— 6 Feb, 2014 #

            • It is really the same way in ez. Let’s say a company in Estonia wants to build a factory and the machines in the factory are built in Germany. The company goes to Estonian commercial bank and gets a loan. Deposit is created then and there. This is only in bank’s balance sheet right now. Now there is need to make a payment to German commercial bank. this can be made only by reserve settlement, they have Target-2 system in ez. This means that Estonian central bank creates Target-2 balance and commercial bank in Germany holds that against ECB, these are called euros. In this sense all national banks in EZ are “printing money”, they have been authorized by ECB to do this. They finance current account deficits no matter how large this way in EZ, that is why you don’t see interest rates peaking to 500% in one country. They are prohibited by law ta finance government debt this way. If one country defaults now (exits the EZ) then all countries suffer according to their capital in ECB because the target-2 balance that Estonia created and Germany holds is not bilateral, It is against ECB, It is called euros.

              Comment by Kristjan— 6 Feb, 2014 #

  5. Lars suggests Koo makes the common claim that fiscal policy is needed when interest is near zero and monetary cannot do any more. I suggest it’s a mistake to use monetary alone even when interest rates are well above zero. Reason is that monetary policy is DISTORTIONARY. That is, it channels stimulus into the economy via just borrowing and lending and in the case of QE, money is channelled into the pockets of a narrow section of the population: the asset rich. And I don’t see the logic behind that distortion. Similarly I’d object to channelling stimulus into the economy just via boosting car production and restaurants because that too would be distortionary.

    Comment by Ralph Musgrave— 3 Feb, 2014 #

  6. This is a severe misreading of Krugman.

    Krugman does not in any way claim that expansions in the monetary base can alter either prices or real economic activity. In fact he claims that it is entirely mute. But what he does support is a rise in *perceived* inflation, by a commitment of the central bank to act irresponsibly (inflationary) once we are out of the crisis. Another word for that is “forward guidance”.

    If you’d read his 1998 paper about Japan, you would understand that this is his argument.

    Comment by Pontus— 3 Feb, 2014 #


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