Why The World Is Headed For A Balance Sheet Recession

In my post Koo, White, Soros and Akerloff videos from inaugural INET conference I highlighted four speeches from the recent George Soros-sponsored pow-wow. I have already written up a post based on the one by William White in "The origins of the next crisis."

This post serves to give you some colour on another of those speeches, the one by Richard Koo and his balance sheet recession.


Koo believes the US, Europe and China are headed for a period of incredibly weak consumer spending not unlike what Japan has been through. Let me say a few words about this balance sheet recession theme, private sector deleveraging, and the related sovereign debt crises. Then, at the bottom, I have embedded a recent paper of his which has a bunch of graphs that explain what Japan has been through as a cautionary tale for the global economy.

I have described Koo’s thesis this way:

Nomura’s Chief Economist Richard Koo wrote a book last year called “The Holy Grail of Macroeconomics” which introduced the concept of a balance sheet recession, which explains economic behaviour in the United States during the Great Depression and Japan during its Lost Decade.  He explains the factor connecting those two episodes was a consistent desire of economic agents (in this case, businesses) to reduce debt even in the face of massive monetary accommodation.

When debt levels are enormous, as they are right now in the United States, an economic downturn becomes existential for a great many forcing people to reduce debt. Recession lowers asset prices (think houses and shares) while the debt used to buy those assets remains. Because the debt levels are so high, suddenly everyone is over-indebted. Many are technically insolvent, their assets now worth less than their debts.  And the three D’s come into play:  a downturn leads to debt deflation, deleveraging, and ultimately depression.  The D-Process is what truly separates depression from recession and why I have said we are living through a depression with a small ‘d’ right now.

Weak consumer spending will last for years

Now, what US policymakers are trying to do is to both increase asset prices and consumption in order to short circuit the D-Process i.e. prevent the debt deflation that results from deleveraging and asset and price deflation. Almost all measures taken to date are attempts to prop up asset prices (artificially I believe).

The mortgage modification programs are but one example. Here is what economist Arnold Kling says about them in his prepared testimony before Congress:

Perhaps one goal of the mortgage modification program is to keep homes off the market that otherwise might be subject to foreclosure and sale. The idea might be to keep home prices higher than they would be if foreclosures were to proceed. This attempt to maintain artificially high prices for houses also will create arbitrary winners and losers.

Suppose that mortgage modifications succeed in temporarily boosting home prices. That is, suppose that in a neighborhood where the price of homes would be $180,000 if foreclosures took place, the mortgage modifications allow prices to be maintained at $200,000. What that means is that people who sell homes now will do better than they would otherwise, while people who buy homes now will do worse. Somebody who buys a house at $200,000 has much less chance of enjoying appreciation than someone who pays $180,000.

Maintaining home prices by preventing foreclosures does not create wealth. Instead it simply takes away wealth from those who at the moment are seeking to buy and gives that wealth to those who are seeking to sell. How do we know that today’s sellers are more deserving than today’s buyers?

What I’m Saying – Arnold Kling, EconLog

This is a market distortion that not only creates winners and losers, but also has macro implicationsregarding the allocation of productive resources within the economy. Read Why the housing market is about to turn to see the perceived benefit to homebuilders for example. Left unsaid here is what sectors are not receiving capital as a result of this implicit subsidy for the housing market.

But all of this is an outgrowth of a wish to avoid a balance sheet recession and the dynamics I spoke of in "The origin of the next crisis", what Ray Dalio calls the D-Process. He says:

The D-process is a disease of sorts that is going to run its course.

When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?

The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the ’90s, that occurred in Latin America in the ’80s, and that occurred in the Great Depression in the ’30s.

Basically what happens is that after a period of time, economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.

A conversation with Bridgewater Associates’ Ray Dalio

Long story, short, we are in for a debt restructuring across Europe, and in America and China because of the accumulation of debt and malinvestment. Policy makers are reverting to the same old game of asset price inflation to stave this off, what William White has called short-termism.

For his part, Dalio calls the D-process a debt restructuring not unlike what GM has gone through:

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes — the cash flows that are being produced to service them — or we are going to have to raise incomes by printing a lot of money.

It isn’t complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.

This has mostly to do with the private sector. But, there is a relationship to the public sector here. In China, remember, that China’s local municipalities have been speculating on land and property during the stimulus-induced property bubble. The municipalities have a lot of debt associated with this. Listen to Jim Chanos’ conversation with Charlie Rose to get a sense of the debt land mines there.

Also, you should notice that printing money is not an option in Greece or Portugal or anywhere in the Eurozone.  This and the fact that Greece has the largest public sector external debt to GDP in the entire world means they have a hard road to hoe. See this Wikipedia list of countries by public debt for aggregate amounts.  Zimbabwe tops the list. The first developed country, Japan is in second place. They have funded their deficits internally. So that is a cushion. In Greece’s case, the overwhelming majority of the debt is owned externally by foreigners – a problem for Greece and its foreign creditors, mostly in Europe.

Where does this leave us?  It leaves us with chronically weak consumption trends acutely exacerbated by the demographic trends of an aging populace. It is no coincidence that Germany and Japan have such weak consumption growth given these countries have the highest average population ages in the world (outside of tiny Monaco).

In my view, these dynamics are particularly problematic for Europe because of the strictures imposed by the Euro, the large public sector debt-to-GDP ratios and the advance age of the populace. The Greek problem is the tip of the iceberg and the Europeans are seriously deluded if they think their troubles are over.

I said my piece on the US and why I think we are experiencing a cyclical upturn in the William White article. So I will leave you with Koo’s recent presentation which puts some numbers on what the U.S., Europe and China can learn from Japan.

What Post-2008 World Can Learn From Japan

  1. Plan B Economics says

    Koo’s a great guy.

    What about interest rates? Some argue that deficits don’t matter in this type of environment. Take a look at some of these charts from the depression.


    1. Edward Harrison says

      The jury’s still out on interest rates. In his presentation, Koo shows that interest rates really haven’t been a problem in Japan. But of course their debt is internally funded. Greece is in a completely different world. The question for the US is whether the US would find a large increase in internal funding of the deficit in a balance sheet recession. The answer is likely yes which is a major reason to be wary of arguments focused on China as America’s banker.

      1. Marshall Auerback says

        Whether the debt is internally or externally “funded” is irrelevant. The key is whether the debt is denominated in the domestic currency (as well as being non-convertible and free floating) versus foreign debt which creates external constraints. Functionally, Greece’s debt is akin to external debt. The euro dilemma is somewhat akin to the Latin American dilemma, such as countries like Argentina regularly experienced. Deficit spending in effect requires borrowing in a “foreign currency”, according to the dictates of private markets and the nation states are externally constrained. That’s why Iceland and Latvia are in a mess and suffer from solvency issues. It’s also why California suffers from a solvency issue or Italy or Spain. Not the US or Japan.So despite the mainstream claim that expansionary fiscal policy has a positive effect on government bond yields the Japanese economy doesn’t validate that conjecture. But eventually when these “trends” assert themselves it will become consistent with the mainstream theory – that is the line we are being sold. Just you wait, seems to be the thinking. It’s wrong.

        1. Edward Harrison says

          The funding is relevant because of exchange rates. If foreigners expect a
          weak currency they will demand greater return for this risk.

          1. Marshall Auerback says

            Foreigners can’t “demand” anything. The currency can certainly gyrate as a consequence of shifting private portfolio preferences, but the central bank sets the term rates. Japan’s experience makes that clear. In the US, while it is often said that China might suddenly decide they do not want US treasuries any longer, at least one but more likely many of these other relationships would also need to change. For example it is often said that China might decide it would rather accumulate Euros. However, there is no equivalent to the US treasury in Euroland. China could accumulate the euro-denominated debt of individual governments—say, Greece!—but these have different risk ratings and the sheer volume issued by any individual nation is likely too small to satisfy China’s needs. Further, Euroland taken as a whole (and this is especially true of its strongest member, Germany) attempts to constrain domestic demand in order to run trade surpluses. If the US is a primary market for China’s excess output but euro assets are preferred over dollar assets, then exchange rate adjustment between the dollar and euro could destroy China’s market. I’m not arguing that the current situation will go on forever, although I suspect it will last much longer than most commentators presume. Simply pointing out instead that changes are complex and that there are strong incentives against the sort of simple, abrupt, and dramatic shifts that are posited as likely scenarios. The complexity as well as the linkages among balance sheets and actions ensure that transitions will be moderate and slow. And there is always the possibility of a central bank performing something along the lines of Operation Twist (which I wrote about here: _https://neweconomicperspectives.blogspot.com/2010/03/operation-twist-part-deux.html_ (https://neweconomicperspectives.blogspot.com/201…)

        2. Edward Harrison says

          As I said in the last comment, the jury is out on rates. Koo has shown thatJapan’s rates did not increase. However, when the yen was at 150 this wouldhave been a big problem if Americans had been holding Yen debt because ofthe currency loss. It is entirely speculative to assume the low rates wouldprevail if the debt had not been internally funded.Sent from my mobile phonetwitter.com/edwardnh

          1. Marshall Auerback says

            The “jury” has been out for 20 years on Japan. Every time we get a story
            about how Japanese bond yields are about to blow out because of the sky
            high levels of debt, there’s never been a follow through. The IMF has just put
            out a paper taking a similar line, arguing that the factors behind the low
            and steady JGB yields, including Japan’s large and growing pool of
            household savings, stable institutional investors, and strong home bias were likely
            to persist helping to keep down JGB yields, but that over time, the market’
            s capacity to absorb public debt would likely diminish as population aging
            reduces savings inflows and financial reforms enhance risk appetite …
            But as I said before, despite the mainstream claim that expansionary
            fiscal policy has a positive effect on government bond yields the Japanese
            economy doesn’t validate that conjecture. If “the jury is still out” it might
            have to wait another 20 years, for all we know.
            In a message dated 4/14/2010 8:57:34 P.M. Mountain Daylight Time,

            As I said in the last comment, the jury is out on rates

          2. Edward Harrison says

            your comments regarding Japan are simply not germane to my statement. I said that the jury is out on rates in AMERICA because the debt is not internally funded – thus drawing a distinction to Japan which I still believe is relevant.

            The reason I used the 150 yen to the dollar example is for this reason. I was not talking about rates gaping out in Japan because I said the internal funding was significant.

          3. Marshall Auerback says

            Whether it’s America or Japan, the fact that the debt is internally funded
            is not relevant. It’s only relevant, as I indicated earlier, if you are
            borrowing in a foreign currency. You’re missing the point of the argument.
            That the debt might be externally HELD (not funding anything) impacts on
            income leakage, but not the term structure of rates. As I said, read the
            link I sent earlier. It explains it in more detail.

            In a message dated 4/14/2010 9:12:09 P.M. Mountain Daylight Time,

            your comments regarding Japan are simply not germane to my statement. I
            said that the jury is out on rates in AMERICA because the debt is not
            internally funded – thus drawing a distinction to Japan which I still believe is

        3. Edward Harrison says

          Let’s agree to disagree here.

          I think it’s factually incorrect to say foreigners cannot make demands via portfolio preference and to ascribe term rates to the central bank. If the central bank controlled term rates then they could not have a conundrum of why the yield curve was flattening as they raised the short end in the middle of the last decade.

          The fact is people DO have portfolio preferences and foreigners (and Americans) can choose which assets they want to buy. This has a real impact on rates.

          1. Marshall Auerback says

            Not necessarily. The point is that it’s much more complex than you suggest. And the idea that somehow we have to raise rates to satisfy the funding demands of the “markets” is not borne out by the experience of Japan, where they have had virtually 0% interest rates for decades and no discernable impact on the exchange rate. So it’s fallacious to argue that by virtue of raising rates to “satisfy” the markets demand for a higher risk premium in the US that the dollar would necessarily strengthen or that rates would necessarily come down. Also you have to consider the impact of paying interest rates on reserves, which also undermines the causality you are seeking to imply here.

          2. Edward Harrison says

            No one is talking about raising rates. We are discussing rates that go up because of supply and demand. Now I am off to bed.

  2. Kirk Kinder says

    I want more Edward vs. Marshall…steel cage match of two very bright men. Great stuff.

    I would love your opinion on Koo’s ideas. He is a hard core Keynesian (as Marshall seems to be as well), but I am hard pressed to agree that Japan should be seen as an example of success. While they may not have bread lines as we did in the 30s, they still asset prices substantially below the peaks. I think this outcome will be more painful to Americans than the Japanese since they had a higher savings rate. The Boomers are in no position to retire without asset price appreciation…and lots of it.

    Also, Greece does face a tough time since their debt is denominated in a currency they don’t control (or print), just as the Latin American countries were. But, couldn’t that be seen as a good thing. The Latin American countries were forced to default or restructure and have turned it around much quicker than Japan. This also happened in a smaller sense in Asia in 98, which is now seen as shining star in the economic world.

    1. Marshall Auerback says

      Japan is not an example of success by any means, but I merely have used the
      example to dispel the myth that somehow large and growing public
      indebtedness leads inexorably to inflation and higher rates. In fact, contrary to
      the popular caricature, Japan has not been consistently conducting a
      proactive fiscal policy. Instead it has been characterised by too much stop and
      starts. Initially, post the bubble, the government did nothing to deal
      with its banking problem (there was virtually no attempt by the authorities to
      get a proper read on the banks’ bad loan exposures, a problem that went on
      for 8 years). The Japanese government was overly cautious with respect to
      the provision of fiscal policy stimulus. They initially adopted an
      expansionary role which delivered modest real GDP growth. But, over this period the
      Ministry of Finance was constantly worrying about “fiscal consoldation”
      and in 1997 succumbed to the pressure and introduced a contractionary budget.
      The economy, which was showing some signs of recovery given the fiscal
      support, nose-dived.

      Ironically, the provision of public funds to the banks in 1998 exacerbated
      the problem insofar as the banks (which had hitherto hid the extent of
      their bad loan exposures) finally had the ability to begin serious write-offs.

  3. David Pearson says

    Great discussion between Marshall and Ed.

    I would point out that Brazil and Argentina have both flirted with domestic currency debt default in the form of freezing of bank deposits at a time of devaluation, as well as mandating that domestic retirement plans buy government bonds. I agree with Ed that whether one is forced to take a direct haircut on debt; or take one indirectly through inflation; is irrelevant. Therefore, the possibility of default/inflation will show up in term rates in a similar manner. If the ultimate impact on the bondholder is the same, why should the bondholder differentiate between the two in terms of risk-adjusted return expectations?

    Finally, I think Japan is more the exception that the rule for a couple of reasons. First, Japan had a high private domestic savings rate, unlike the chronically low savings rate of the U.S. and Latin America. The practical impact of high savings is the ability to finance fiscal deficits without running current account deficits. It is these deficits that ultimately provided the “breaking points” in Latin debt credibility. From personal experience I can tell you that sovereign analysts would start with the Argentine current account deficit, subtract FDI (i.e. privatizations), and then step back and gauge how realistic it was for Argentina to issue $xx amount in bonds. If the answer was, “not realistic”, then that was the beginning of the end.

    So the U.S. finances its current account in dollars. Big deal. From the foreign creditor’s standpoint, its irrelevant whether debt is written down from $1 to $.9, or whether his dollar buys only $.90 of goods due to inflation. The end result, should that expectation come to pass, will be to require a higher term premium, which is the beginning of a process towards monetization of structural deficits, which in turn leads to Latin America-type inflation/hyperinflation. Also, its not just the foreign creditor that is important: given the possibility of capital flight, all savers — including private domestic — are capable of impacting supply of current account financing, and therefore its price.

    Why didn’t the above happen in Japan? First, because the BOJ, despite all its efforts, never produced sustained negative real interest rates which might lead to forward-buying and higher inflation expectations. This was partially because they allowed deflationary expectations to take hold, which is something our Fed did not. Second, because Japanese savers have a cultural preference for JGB’s (try finding an Argentine with a cultural preference for peso bonds!). Third, because Japan was able to escape the impact of deflation expectations on employment and the real economy through robust export growth. Had that growth not been available, I would argue the BOJ would have faced a stark choice between self-reinforcing deflation and inflation fueled by monetization fears.

    In short, the question is whether the U.S. and Japan are similar enough in along key variables to produce the same outcome. Having lived in Latin America, I would argue the key variable the distinguishes inflation-prone countries is a low private domestic savings rate. The U.S. is quite similar to Latin American economies, with the exception of the dollar being the reserve currency. What that buys you is a much more abrupt, discontinuous loss of faith in the currency’s value than you would see in a non-reserve country. Reserve status is only as good as a country’s promise to favor the currency over domestic employment. This tacit promise is one we abandoned roughly a decade (or more) ago.

    1. Marshall Auerback says

      David, inflation is not the same as “default”. If I buy a credit default
      swap on a country, I cannot collect simply because the country has a rising
      rate of inflation. You can’t simply conflate inflation with national
      insolvency and default. My other point was simply that whether the debt is held
      by locals or foreigners is irrelevant. The US government, for example,
      has no foreign currency-denominated debt. It has domestic debt owned by
      foreigners – but that is not remotely like debt that is issued in a foreign
      Likewise, Japan has no foreign currency-denominated debt. The UK has very
      little foreign currency-denominated debt. Many other advanced nations have
      no foreign currency-denominated debt.
      It turns out that many developing nations do have such debt courtesy of the
      multilateral institutions like the IMF and the World Bank who have made it
      their job to load poor nations up with debt that is always poised to
      explode on them. Then they lend them some more.
      But it is very clear that there is never a solvency issue on domestic debt
      whether it is held by foreigners or domestic investors.

      In a message dated 4/15/2010 3:14:32 P.M. Mountain Daylight Time,

  4. David Pearson says

    One question for Marshall:

    In the case of Argentina, why couldn’t their Central Bank print pesos, buy foreign currency with it, and use that to service foreign currency sovereign debt? Of course, that would just lead to devaluation. In the same way, if a Central Bank printed money to service domestic currency debt, this could lead to a fall in the currency’s purchasing power. I think that MMT adherents tend to think of devaluation scenario as “automatic”, whereas the a “fall in purchasing power” scenario, for some reason, is “highly unlikely”. This is nothing but a “bet” on the nature of inflation expectations of different classes of debt holders. In the case of foreign currency holders, they are thought to have highly sensitive inflation expectations. In the case of local currency holders, you imagine their inflation antennae to be virtually absent.

    Imagine a local currency debt issuer with a global creditor base. If it could issue debt at will without impacting inflation expectations, it could simply print money to finance the government’s purchase of all the real assets in the world at zero cost. Now, somewhere between monetizing structural deficits of 5-12% of GDP and “buying up all the real assets in the world”, inflation expectations would eventually set in. The question is, where along that continuum?

    1. Marshall Auerback says

      The answer to your question is that you get the central bank to continue to
      print pesos and buy foreign currency and clearly you risk running into an
      inflationary spiral, by virtue of the fact that you need more and more
      pesos to make up the equivalent amount of dollars. It’s obviously not the same
      if you are buying goods and services in your own currency. There’s a
      fundamental difference and I’m sure you know that. Yes, it’s true that the
      resultant fall against other currencies does probably mean a deterioration in
      the relative terms of trade, but in the case of Argentina, for example, the
      resultant fall in the peso led to a substantial turnaround in the current
      account, meaning more dollars coming into the country, which ultimately
      enhanced the private savings position. That’s a straight accounting identity.
      Same thing would happen here. You’d get a temporary decline in
      purchasing power (any MMT theorist would honestly recognise that), but the likely
      improvement in the external account would ultimately offset that. If you
      consider the Latin American crises in the 1980s, as a modern example, you
      cannot help implicate the IMF and fixed exchange rates in that crisis. The IMF
      pushed Mexico and other nations, such as Argentina to hold parities against
      the US dollar yet permit creditors to exit the country. For Mexican
      creditors this meant that interest returns skyrocketed (the interest rate rises
      were to protect the currency) and the poor Mexicans wore the damage.
      It was clear during this crisis that the IMF and the US Federal Reserve
      were more interested in saving the first-world banks who were exposed than
      caring about the local citizens who were scorched by harsh austerity programs

      In a message dated 4/15/2010 3:52:34 P.M. Mountain Daylight Time,

  5. Element says

    I’ve been watching pro-con deficit debates especially in the US case. But the ultra pro-deficit position has a very strong emphasis on tax increases, for example;

    “The government is the creator of a currency. It can spend now. It can also spend later. And it can service and pay back the debt without compromising anything. A government, unlike a household or a private business, can choose to exact greater tax revenues by imposing new taxes or raising tax rates.” – Marshall Auerbeck ‘The President Remains Trapped in the Talons of the Deficit Hawks’, 02/1/2010

    So tax does not “compromise anything”, you can relax, your personal budget will be fine.

    Then there’s the much more measured position of Bill Mitchell on Christmas day 2009.

    “Each generation is free to select the tax burden it endures through the political system. Taxing and spending transfers real resources from the private to the public domain. Each generation is free to select how much they want to transfer via political decisions mediated through political processes. When I say that there is no intrinsic financial constraint on federal government spending in a modern monetary system, I am not, as if often erroneously claimed, saying that government should therefore not be concerned with the size of its deficit.” – On voluntary constraints that undermine public purpose, Bill Mitchell, 25th Dec 2009.

    And then there’s the research view of Romer, that 1% GDP increase in taxation results in a 3% drop in GDP growth – as a rule of thumb (I don’t strictly buy this, it’s too cute, too mythos, too media-dumbed).

    But as voters decide these matters all such views quickly become irrelevant, in a polling booth. The fact is, tax leads to a smaller personal budget, and also smaller business budget, so less jobs, and this leads to proportional economic contraction. But tax is one thing that reduces my own budget and limits my earning potential, and my ability to pay my bills in my real economy.

    So naturally deficit spending, off-set by tax increases, is not for me thanks, and not likely to be for you either.

    Hence spending policies that lead to tax increases will not win elections (and God help you if you lie about it to the electorate this time). So there’s certainly lots of political rhetoric and smoke about the need to cut spending, ASAP. Meanwhile, back on planet Earth, US deficit spending has not decreased at all. On the contrary, the deficit is bigger, and so is the Fed’s balance sheet.

    In February 2010 the US ran the biggest monthly deficit on record, at $221 billion USD, or $7.9 billion per day. In case the penny did not drop, February is the shortest month of the year. What that means is the average spending per day was way above even ‘Obama-normal’ rate. So the spending stimulus has not decreased at all, it actually intensified.

    So then, if there’s QTR2 weakening and QTR3 stagnation then QTR4 negative growth, if anything, we’d have to blame it on the intensified deficit spending of QTR1 – right? I mean, let’s not make false excuses that there was not enough stimulus spending, or that the stimulus was withdrawn – because it wasn’t, OK?

    At least not thus far. And nor have your taxes gone up nor interest rates.

    Uncle Sam is pedal-to-the-metal more than ever before. And I want to make that point especially clear, so bankers, politicians, media and especially economists can not turn around an say, “well, if the taxes had not been increased, or if the stimulus had not ended, or if the Federal deficit had not shrunk, or if we had not moved away from stimulatory policy settings we would not be back in recession soup”, etc.

    And nor is a decline in inventory restocking to blame if there is negative growth, which as far as I can see there’s not been a lot of. Seems to me it’s been more like a simplification and re-adjustment downward of stock levels (a lower new normal, so not the full boost expected).

    So let’s not permit such myths later in the year, eh?

    It needs to be clear that any resumed negative growth this year was not caused by those factors. If it does occur late this year it was the product of other causes that have not been resolved. Disguising real causation with mindless excuse leads to things not being understood, so not getting fixed, and that would be real bad.

    So please keep this in mind, if/when negative growth returns, before the end of 2010. There has been zero US austerity or contractionary policy implemented, so far, at the Federal level (though states and cities have).

    So, is another $500 billion USD really going to propel the US out of persistent malaise? Or even stop it sinking slowly? That’s a question that really deserves a sensible empirically-based reply (not theory) and there is one in this paper:

    ‘Growth in a Time of Debt’
    by Carmen M. Reinhart and Kenneth S. Rogoff
    January 2010 – JEL No. E44, E62, F30, N20
    (Google the 26-page .pdf)

    We study economic growth and inflation at different levels of government and external debt. Our analysis is based on new data on forty-four countries spanning about two hundred years. The dataset incorporates over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate arrangements, and historic circumstances. Our main findings are: First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. We find that the threshold for public debt is similar in advanced and emerging economies. Second, emerging markets face lower thresholds for external debt (public and private)-which is usually denominated in a foreign currency. When external debt reaches 60 percent of GDP, annual growth declines by about two percent; for higher levels, growth rates are roughly cut in half. Third, there is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the United States, have experienced higher inflation when debt/GDP is high.) The story is entirely different for emerging markets, where inflation rises sharply as debt increases.”

    Some body-text quotes:

    “III. Debt, Growth, and Inflation – Of course, the efficacy of the inflation channel is quite sensitive to the maturity structure of the debt. Whereas long-term nominal government debt is extremely vulnerable to inflation, short term debt is far less so. Any government that attempts to inflate away the real value of short term debt will soon find itself paying much higher interest rates.”

    “From the figure [2], it is evident that there is no obvious link between debt and growth until public debt reaches a threshold of 90 percent. The observations with debt to GDP over 90 percent have median growth roughly 1 percent lower than the lower debt burden groups and mean levels of growth almost 4 percent lower”

    “Interestingly, introducing the longer time series yields remarkably similar conclusions. Over the past two centuries, debt in excess of 90 percent has typically been associated with mean growth of 1.7 percent versus 3.7 percent when debt is low (under 30 percent of GDP), …”

    Now that is not mere theory. That’s measured correlation of public debt levels to growth rates, revealing mean growth about 4% less with respect to total GDP growth per annum, once you get to where the US is arriving this FY.

    i.e. growth that’s sluggish much of the time, and routinely goes negative more often, than when less indebted.

    That qualifies as an empirical answer. It’s not incontestable, of course, but it’s certainly far better than postulates “based in economic theory” or axiomatic conjectures.

    Higher public debt is observed to generate aggregate demand weakness, and recessionary episodes (and apparently slow business and job creation in the US case).

    So, will $500 billion USD more debt growth be likely to turn it all around? Or ease the pain of delevering and prevent you sinking? I can’t see why it would, given that it will then take longer to resolve one of the major contributing sources for slower growth, low employment, low profits, and general business weakness.

    So we have some actual evidence to differentiate between the available bad choices.

    But I’m a bit annoyed, and here’s why,

    1) Everyone knew high debt would slow down rather than speed up the economy. 2) Everyone knew that defacto deregulation would lead to inefficiency and crisis, not to efficiency and stability.

    These were operational myths and I’m convinced everyone really knew these were not true. I don’t accept that anyone honestly believed these things. And frankly I don’t believe anyone who says they really believed this is being honest at all. Not Alan Greenspan, not Ben Bernanke and not Ronald Reagan. No one with brains can honestly believe something this self-evidently faulty and just plain dense. But one thing that’s repeatedly been driven home by the GFC, never ever underestimate the scope and breadth of stupidity of fully-educated, experienced and well-informed people.

    But worse, everyone just lapped this up and repeated it, and acted like perhaps it made real sense. This was a genuine case of ‘The Emperor’s New Cloths’ (I really dislike that, almost as much as I dislike logical theory that’s totally unconstrained by evidence and testability but treated as ‘valid’ simply on the basis of logic. Sorry, even totally wrong formal theories in science are fully logical in 99.9% of cases. Evidence is what matters every time.).

    And I suspect we are having another one;

    The MMT pro-deficit camp’s emphasis on, “sectoral balances must sum to zero”. I think is another misleading notion, that again doubles as a nice excuse for irrational behaviour.

    To me its obviously not that clear cut. You can’t just keep using sectoral relationships as an excuse for running serial massive deficits, via fiat, and paying for it via tax. That’s actually complete mad.

    These ‘balances’ are really just telling you, “hey! pay attention, things are totally unsustainable in your economy”. But surely that’s obvious?

    These almost light-switch-fast sectoral re-balances that we’ve seen lately, are really just screaming that things had better change drastically and fast within economies, or we’re facing economic ruin. It’s a warning, a sign that your corresponding deficit will soon ruin you, if you don’t act.

    The book, “This Time is Different” certainly makes clear what happens when such sudden massive sectoral re-balancing occurs. Sovereign default often follows a few years later.

    So, despite the quantitative fact of the re-balance, why should we be comforted by “sectoral balances must sum to zero” given that in a major systemic crisis, this means high-deficit and debt growth, as accounting requirements … dramatically increases taxes … and the risk of Sovereign default … and of mass poverty and protracted austerity.

    That to me is another “The Emperor’s New Cloths” story.

    I see no ‘new cloths’ on this dude, so has theoretical confabulation monster blinded us to the fact that this is a clear warning? That this evident ‘re-balancing’ is in fact the source of a self-amplifying instability?

    This is what I see, in such graphs; a mad rush from one side of a boat, to the other side of said boat, which may easily capsize the boat. A boat’s intrinsic buoyancy remains unchanged throughout the continuous rebalancing around a moving centre of mass. Well, unless it suddenly discovers a new but less buoyant configuration. The boat’s not thus become intrinsically less buoyant though, it’s just on the bottom of the ocean. Theoretically it still works fine, it’s just not able to work as intended, in the new configuration. You’ll need SCUBA to row that boat.

    But if you were just looking at a time-series sectoral balance graph of the economy, and not considering the implications of the ‘balance’ process, you might think, “oh look, it just automatically shifted around to compensate its balance perfectly”.

    Yeah, that’s true.

    But look at the size of the movements and how fast they moved! Try replicating that sort of rebalancing in a boat and see if you don’t get wet.

    So now consider the fact that the US is suddenly going to be around the danger level of 86% of GDP of public debt during the coming financial year, and it rises 10 to 11% of GDP per annum. In mere mild recessions the size and speed of the sectoral rebalance is no big deal, but in a severe systemic crisis it’s a huge deal-you get swamped fast.

    So you better make some really difficult efforts to systematically reduce your deficits and debt growth rate, as a proportion of total GDP, or you’re good citizens, in a few years, are going to lynch the Emperor. Find policies that make sense or a big chunk of your population is going to end up living in a cardboard box well before the end of the decade.

    Another facet;

    March 27, 2010, Jim Puplava’s Financial Sense Newshour (audio file: fsn2010-0327-2) gives a detailed breakdown of legislated and also recently proposed record-increases in Federal taxation, starting in 2011, and increasing yearly to 2014. What is discussed is not pretty. And then there’s State and Municipal taxes which will also be hitting record or near levels, and State fines will get much bigger, and enforcement, positively mercenary.

    In other words, these are going to destroy personal and business budgeting in the real economy.

    What this brings home is, that eventually, someone really does have to make real budgets with real balances. But what Washington has done is to make sure it’s you who realises the losses.

    So it’s not much good asserting Govt creates dollars so they don’t have to budget like a household. That’s true.

    But every lower-middle class family knows this fact does not help them one bit, each and every payday. So who gives a fig about the Govt being able to spend, if your personal budget is going to get worse for at least 5 years?

    Which is to say, there will be further stagnation and bouts of negative GDP growth. Which is to say, public debt will increase, and revenue drop, and budgets will be hit again (thus export trade disparity and perceived imbalances are going to become red-hot topics).

    So, let’s be honest, you are going to vote for the candidate you think will hurt your personal budget the least, or boost it the most. You will not likely cast your vote for any other candidate. And don’t kid yourself.

    Thus anything more than very limited Govt spending will soon be out altogether.

    The 30-year old Ronald Reagan low-taxed free-market deregulation paradigm has finally got the US running on empty. On top of this, Obama will find it extremely difficult or impossible to pass yet another giant budget after the 2010-11 is passed.

    In other words, quantitative easing is what’s left as the default tool – in more ways than one.

    Given this I don’t see how US Fed reverse-REPO mechanisms can be considered a credible or realistic option as it should be reasonably clear from the above that much more QE is coming.

    I don’t expect exponential inflation unless there’s real scarcity, due to a collapse of production, or trade disruption, and in conjunction with a sharp loss of buying power. That’s several years away, if it occurs, and things have to be really bad for that to develop.

    But a return to shocking deflation like the extreme 2-for-1 car sales of QTR1 2009 is very likely within 18 months. I’ll be surprised if we get to the end of 2011 and it hasn’t occurred. And it will be much more damaging and protracted than in 2009, because this time there will be no floor thrown under it. This is when the main phase of private ‘nuclear-delevering’ will finally ensue, as mass naked-defaults, and thousands of prompt bank failures. The FDIC will be incapable of putting a floor under that either.

    The debt is going bad and so will the bank no matter if deposits are insured. The bank is broke, the FDIC is broke, so Uncle Beni will give you your deposits, or you won’t get them.

    So I’m not even going to make the argument that more debt growth and QE is bad, because, in the circumstances, I suspect it won’t ultimately make things worse than they are already going to be.

    This is how I see it going;

    2QTR 2010 – Real economy weakness appears can no longer be papered-over.
    3QTR 2010 – Near zero GDP growth stagnation.
    4QTR 2010 – Weak negative GDP growth.
    2011 – Sharply negative GDP growth with massive bank failure, but growth tends back towards zero (after a double digit fall) as many hundreds of billions in private debt are completely eliminated because those banks no longer exist.

    After the second fall, equities try to bounce, mid to late-2011, but world-trade is deep-fried this time, and does not come back with equities, so equities begin to track something real again, for the first time in decades.

    Unemployment, taxes, homelessness and defaults characterise everything thereafter, until unexpected scarcity flips deflation to inflation. The Fed Balance Sheet will grow way beyond $4 trillion USD and will only cease once the currency is also fried. Everyone will blame Bernanke for inflation, but CNBC will say how it may relieve debt problems, and declare it a green-shoot. But you can’t end physical scarcity unless you produce more than you need. Only sufficiency can head-off uncontrolled inflation. In all other cases, inflation can be controlled, but in protracted scarcity, with trillions of dollars in the system, you’d be safer mowing the lawn in a minefield.

    If you see less choice and less quantity of remaining goods on store shelves, that’s when uncontrolled inflation may emerge. Given the implications of what the Fed will be doing I do not rule out that things could get really desperate-but I doubt hyperinflation will be allowed to develop via scarcity. Effective rationing can prevent it.

    Politically: mid-2011 Hilary will resign and eventually win Dem nomination, because Obama will be unelectable. Hilary will be electable if she gets out early enough. The Reps will clean up in the mid-terms but totally fail to do anything constructive. Obama will be the lamest of lame ducks. What he will do with his final two years is, nothing that requires House or Senate approval.

    1. Marshall Auerback says

      “The MMT pro-deficit camp’s emphasis on, “sectoral balances must sum to
      zero”. I think is another misleading notion, that again doubles as a nice
      excuse for irrational behaviour.”

      Well, I suppose that depends on whether you consider 7 centuries of double
      entry bookkeeping to be a “nice excuse for irrational behaviour”. Strikes
      me that ignoring basic accounting identities is pretty irrational. As for
      Rogoff/Reinhart, debt to GDP is a ratio and the ratio value is a function
      of both the numerator and denominator. The ratio can rise as a function of
      either an increase in debt or a decrease in GDP. So to blindly take a
      number, say, 90% debt to GDP as Rogoff and Reinhart have done in their recent
      work, is unduly simplistic. It appears that they looked at the ratio, assumed
      that its rise was due to an increase in debt, and then looked at GDP growth
      from that period forward assuming that weakness was caused by debt instead
      of that the rise in the ratio was caused by economic weakness. In other
      words, they have the causation backwards: Deficits go up as growth slows due
      to the automatic counter cyclical stabilizers.They don’t cause the slow
      down, etc.

      In a message dated 4/15/2010 10:52:51 P.M. Mountain Daylight Time,

      The MMT pro-deficit camp’s emphasis on, “sectoral balances must sum to
      zero”. I think is another misleading notion, that again doubles as a nice
      excuse for irrational behaviour.

      1. Element says

        “…Well, I suppose that depends on whether you consider 7 centuries of double entry bookkeeping to be a “nice excuse for irrational behaviour”. Strikes me that ignoring basic accounting identities is pretty irrational. …”

        No Marshall, it’s not about it ignoring accounting identities at all, it’s about facing up to what the implications are of this ‘rebalancing’, that’s what I refer to as ‘irrational behavior’. i.e. to note, maintain and increase an actual severe imbalance (like er, about 90% of GDP, a clearly significant level of debt I would say) that then increases instabilities in several ways.

        Or do you deny the recent risk premium on GGBs, or deny it means that anything they retract in deficit cuts is then consumed in interest? … and of course, tax.

        It’s not rational to allow yourself to get in that position, but sometimes these things hit, ok, not good. But to then make it worse.

        Ignoring accounting identities has nothing to do with it. This ‘rebalancing’ is not a balance, it’s a warning.

Comments are closed.

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