Rediscovering the obvious

A book by Richard C. Koo immodestly entitled 'The Holy Grail of Macroeconomics: lessons from Japan's Great Recession' is a good example of how mainstream economists are rediscovering what those outside the mainstream having been saying for years.

In this case the obvious is that when the private sector (households and businesses) are heavily in debt and their income drops they try to repay their debt rather than borrow more. The main contribution from this book is to provide empirical evidence for this by looking at actual behaviour during the Great Depression in the USA and the Great Recession in Japan. He shows that during these periods companies and household were reluctant to borrow and instead tried to reduce their debt or 'repair their balance sheet'. When the aggregate private sector does this demand remains depressed, resulting in what he call a 'balance sheet recessions'. He points out that this contradicts mainstream economic thinking, which is revealing about how wrong this thinking is.

The current stagnation across the developed world is exactly this kind of balance sheet recession. Aggregate private sector debt reached record levels just before the onset of the crisis and remains very high.

The practical importance of this is that during balance sheet recessions policies that try to stimulate growth by encouraging more borrowing are doomed to fail. Yet these are the main policies that have been promoted by mainstream economists today. They are not working and so central banks are coming up with ever more desperate measures to stimulate borrowing, such as quantitative easing. Banks are being accused of failing to lend when the real problem is the absence of any desire to borrow. Why should businesses take out loans to expand their businesses when demand is stagnant and there is excess capacity?

The experience in Japan, where 15 years of unprecedented loose monetary policy has failed to stimulate growth, is compelling evidence that this policy won't work. Japan has only managed to grow by remaining a net exporter.

So what is his solution? His big idea is that during balance sheet recessions fiscal stimulus is needed. He calls it the Holy Grail of Macroeconomics because it reconciles monetarism and Keynesianism, which have long been at odds.

Surely this is just common sense? As Wynne Godley and, more recently, proponents of Modern Monetary Theory have been saying for many years, the simple accounting dictates that the aggregate private sector can accumulate net financial assets and thus 'repair its balance sheet' only if the the government sector spends more into the economy than it removes through taxes. The government is the only possible source of net financial assets for the private sector. This is no theory. It is simple reality. Or should be to anyone who understands the monetary system and the constraints of sectoral balances as shown by Godley.

However mainstream economist do not understand sectoral balances. Instead of recognising that it is an absolute NECESSITY for government to run deficits in order to enable the private sector to save they argue that the government should borrow the private sectors savings and spend them. This sound like something that is optional and therefore open to challenge. It also sounds like a call to get the government to expand relative to the private sector. Since many people are, with good reason, skeptical about governments expanding, this line of argument is unconvincing.

The way to explain the need for deficit spending is that government should not remove all the money that they spend into the economy through taxes. Instead they should reduce taxes, thereby enabling the private sector to deleverage quickly while maintaining demand. It is not about expanding the government. Instead it should be about enabling saving, reducing private sector debt, and repairing balance sheets.

Conversely cutting the deficit by decreasing spending and increasing taxes PREVENTS the private sector from saving. Since they have no choice but to try to save they simply cut spending further, resulting in a deeper recession. This is why austerity has been such a dismal failure wherever it has been tried. When you understand the problem it is fairly obvious that it is almost exactly the wrong thing to do.

Those who worry that excessive government borrowing could lead to default should be reassured that in countries with their own currencies government can never default as they create the currency. There may be a risk of inflation, but there is no risk of default.