Central Banks, Impotent or Incompetent? Koo vs Monetarism, UK Edition
This is how Richard Koo explained his “balance sheet recession” theory in December 2011:
More importantly, when the private sector deleverages in spite of zero interest rates, the economy enters a deflationary spiral because, in the absence of people borrowing and spending money, the economy continuously loses demand equal to the sum of savings and net debt repayments. This process will continue until either private sector balance sheets are repaired or the private sector has become too poor to save (i.e., the economy enters a depression).
To see this, consider a world where a household has an income of $1,000 and a savings rate of 10 percent. This household would then spend $900 and save $100. In the usual or textbook world, the saved $100 will be taken up by the financial sector and lent to a borrower who can best use the money. When that borrower spends the $100, aggregate expenditure totals $1,000 ($900 plus $100) against original income of $1,000, and the economy moves on. When demand for the $100 in savings is insufficient, interest rates are lowered, which usually prompts a borrower to take up the remaining sum. When demand is excessive, interest rates are raised, prompting some borrowers to drop out.
When an economy is in this “balance sheet recession” state, Koo says fiscal deficits are required to take up the slack. Koo presents the flow-of-funds data for the UK and the US, and berates these countries for not running expansionary fiscal policy:
Yet policymakers in both countries, spooked by the events in Greece, have pushed strongly to cut budget deficits, with the U.K. pushing harder than the U.S. Although shunning fiscal profligacy is the right approach when the private sector is healthy and is maximizing profits, nothing is worse than fiscal consolidation when a sick private sector is minimizing debt. Removing government support in the midst of private sector deleveraging is equivalent to removing the aforementioned $100 from the economy’s income stream, and that will trigger a deflationary spiral as the economy shrinks from $1,000 to $900 to $810.
This seems like a clear and testable claim – fiscal consolidation will “trigger a deflationary spiral”, which Koo explains in terms of a falling “income stream” or “aggregate expenditure” – phrases synonymous with nominal GDP. If you’d looked only at the Japan NGDP data, that is not a surprising conclusion to make – Japan’s nominal GDP has not risen over the last twenty years. It looks like Japan hit a “hard stop”.
Let’s look at the “deflationary spiral” induced by the “balance sheet recession plus ZLB plus fiscal austerity” policy combination in the UK, for those who are slow in etching the UK NGDP data to their retinas. Here’s the path of UK nominal GDP since it’s pre-recession peak in Q1 of 2008; you can date “fiscal austerity” to 2010 or 2011 as you please, tax rises (VAT) began in January 2010:
The UK economy’s “income stream” – nominal GDP – hit a record high in the second quarter of 2010. Then another all-time high in the third quarter. And another in the four quarter. And again in the first quarter of 2011. You get the picture. It went up not down, as predicted by Koo’s theory.
An alternative theory is this: by virtue of its monopoly control over the value of money, the Bank of England has been perfectly able to keep the UK “income stream” rising in a manner which has been more than sufficient to hit – and overshoot – its nominal target, the CPI rate. Neither the ZLB nor “fiscal austerity” have been a major obstacle in this exercise, except in that printing money and indirect tax rises both present a crisis of faith for conservative central bankers stuck fighting the battles of the wrong generation.
Which theory is more consistent with the UK macro data? It seems pretty obvious from here. Defenders of Koo might soften his argument, and claim that “fiscal austerity” has merely slowed the growth rate of nominal GDP – an argument at least worth engaging in. But this puts Koo’s “Crude Keynesians” at odds with the real Keynesians, who argue that UK fiscal policy is unambiguously contractionary – I’ll be better off staying clear of that debate.