Friday, June 24, 2011

Monetary Policy Efficacy During a "Balance Sheet" Recession

Over at Credit Writedowns, Edward Harrison discusses Richard Koo's work on balance sheet recessions.  Koo believes that monetary policy is ineffective in such settings. I disagree and have made the case before against Koo's views on balance sheet recession.  Here is the comment (with some slight edits) I left for Harrison:
U.S. households during the 1920s acquired a vast amount of debt and began a deleveraging process during the Great Depression.  Consequently, there was a "balance sheet" recession in the 1930s too.  Monetary policy, however, was not impotent during this time.  At least when it was done the right way.  FDR's price level targeting from 1933-1936 sparked a robust recovery.  In my view, this experience provides a great example of why Richard Koo's balance sheet recession views are wrong.  Yes, deleveraging is a drag on the economy, but for every debtor deleveraging there is a creditor getting more payments. (And if the debtor is not making payments and defaulting then the debtor still has funds to spend.)  In principle the creditor should increase their spending to offset the debtor's drop in spending.  The reason they don't--creditors sit on their newly acquired funds from the debtor instead of spending them--is because they too are uncertain about the economy.  There is a massive coordination failure, all the creditors are sitting on the sideline not wanting to be the first one to put money back to use. If something could simultaneously change the outlook of the creditors and get to them to all start using their money at the same time then a recovery would take hold.  Enter monetary policy and its ability to shape nominal spending expectations.  That is what FDR did from 1933-1936 when he forcefully communicated that he wanted the price level to return to its pre-crisis level. He backed up the message by devaluing the gold content of the dollar and not sterilizing gold inflows.  (See Mike Konczal for more on this experience.) It could happen here too if the Fed would commit to a level (not growth rate) target, preferably a nominal GDP level target.

QE2's limited success was not because monetary policy is impotent in such situations, but because they failed to properly shape and anchor nominal expectations. Ryan Avent summarized this problem well: QE2 changed the direction of monetary policy, but didn't set the destination.  I supported QE2 and hoped the best for it.  I also acknowledged, however, from the start that in the absence of a well defined level target it was bound to be limited and politically polarizing.  I believe Bernanke knows all this--as is suggested by his work on Japan--but he is faced by political constraints and has burned up most of his political capital on QE1 and QE2. 

11 comments:

  1. On this last sentence:
    I also acknowledged, however, from the start that in the absence of a well defined level target it was bound to be limited and politically polarizing. I believe Bernanke knows all this--as is suggested by his work on Japan--but he is faced by political constraints and has burned up most of his political capital on QE1 and QE2.
    I came to realize Bernanke "fooled" us well!!!
    http://thefaintofheart.wordpress.com/2011/06/23/now-i-get-bernanke/

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  2. Sure about this:
    Yes, deleveraging is a drag on the economy, but for every debtor deleveraging there is a creditor getting more payments...

    Not so sure about this:
    In principle the creditor should increase their spending to offset the debtor's drop in spending. The reason they don't--creditors sit on their newly acquired funds from the debtor instead of spending them--is because they too are uncertain about the economy.

    (Based only on intuition) I think the creditors sit on their funds because that's what they always do, by definition. The way we run our economy, we depend on debtors to recirculate that money. That's why deleveraging is a drag...

    The future is always much less certain than money in the bank. Not just post-crisis.

    ArtS

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  3. Yes, deleveraging is a drag on the economy, but for every debtor deleveraging there is a creditor getting more payments.

    This is an unsophisticated argument. When unemployment is high and/or wages are declining relatative to debt, bank models show a higher propensity to default and so the same debt is worth less. They are not recirculating the money because they are reserving much more capital. The banks, in expected value, are not really getting the "same" money as before.

    In addition, consumers are squeezed as debt is a higher proportion of income, reducing spending.

    Its irrational and illusory to think getting paid (via deleveraging) is better than inflation (also depreciation) since defaults soar. What the U.S. needs is a good dose of temporary 5% inflation that bleeds into the housing market. The Fed target should be closer to 3%, not 2% to avoid falling into this trap again. Finally, the Fed chaor should be elected. Yes, the macro models say an elected Fed leads to higher average long run inflation. Perfect! Besides, the Fed chair would be far less timid if he had the median preferences for UE and inflation as the rest of us and also faced the prospect of UE if he screwed up.

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  4. A New Keynesian, a Quasi-Monetarist, and an Austrian walk into a bar.

    The New Keynesian, a Treasury official, pulls out his work credit card and says "free beer for everyone!" When his friends ask him why he did this, he says, "in the liquidity trap, fiscal stimulus pays for itself."

    The Quasi-Monetarist, a Fed official, then pulls out his company card and says "free burgers for everyone!" When his friends ask him why he did that, he says, "with NGDP expectations running below trend, monetary stimulus pays for itself."

    The Austrian, a dour efficiency consultant, then pulls out a grenade and throws it into the middle of the room, killing everyone in the bar. As the three are floating up to heaven, his friends ask him "What's the matter with you?! You killed us all!" The Austrian replies, "We're in a period of recalculation. Ruining the lives of as many people as possible pays for itself! That grenade only cost me a few dollars, but just imagine the long run productivity gains!"

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  5. Worth mentioning also is the interest on reserves problem. It behooves banks to sit on capital, earning interest from the Fed.

    Everybody talks a lot about the Great Depression, although it was 80 years ago, in an economy much different from today, including international trade, capital flows, currency flows (a trillion in US cash offshore, we think).

    Does the US economy during WWII offers lessons? Somehow we went into overdrive. Due to fiscal stimulus and monetary expansion? Are there more lessons from WWII than from the Great Depression?

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  6. Came here via Krugman's post.

    It is important to realize that (for a closed economy), the public debt is a mirror of net financial assets of the private sector combined.

    In the case of open economies, the stock identity is

    PrNFA = PD + NIIP

    i.e., Private Sector Net Financial Assets is equal to the public debt plus Net International Investment Position.

    Over the years, the PrNFA/GDP was around 35%-40% and this reduced a lot during the 1990s and has come back only recently due to a higher public debt.

    The private sector by itself cannot "deleverage" without a fall in output.

    Part of the huge increase in the public debt has been due to low tax collection due to the recession and some due to some fiscal stimulus provided to the economy. Still, the government can do something more and help the private sector deleverage.

    With the private sector targeting a higher ratio of financial assets to income, monetary policy can hardly do much. The Federal Reserve can just hope to create extra demand by the low interest rate environment.

    Here is a file plotting the private sector net financial assets relative to gdp.

    http://dl.dropbox.com/u/16533182/US%20Three%20Sectors%20Stock-Flow.xls

    (Data taken from
    http://www.bea.gov/international/index.htm#iip
    http://research.stlouisfed.org/fred2/series/FYGFDPUN
    http://research.stlouisfed.org/fred2/series/GDPA?cid=106)

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  7. Sure about this:
    Yes, deleveraging is a drag on the economy, but for every debtor deleveraging there is a creditor getting more payments... (And if the debtor is not making payments and defaulting then the debtor still has funds to spend.)


    The parenthetic finesse is an off-point distraction, or worse. The debtor cannot both pay debt and spend because is is broke, and the creditor is NOT getting the payments. Overall spending declines, whether you will have it that way or not. This has NOTHING to do with uncertainty, and everything to do with a lack of cash.

    The creditor cannot increase spending because he doesn't have the money that, if you will recall, he didn't receive. Your argument is an abstraction, unrelated to reality.

    What is uncertainly compared to a decline in rent receipts?

    QE failed because the money is sitting, useless, in excess reserves.

    Cheers!
    JzB

    Cheers!
    JzB

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  8. The point of deleverging is that both loans AND deposits collapse. It's what MMT describes as the collapse of horizontal money. For every dollar of loans repaid, a dollar of deposits disappears.

    Taxes collapse vertical money. The severe collapse in horizontal money through bankruptcy is replaced by vertical money through government bailouts.

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  9. Anonymous above:

    Deleveraging that leads to collapse of loans and deposits means that the medium of exchange has fallen. For a given money demand this reduction in the money supply by the banking system means that there is an is a new excess money demand problem. That is the point being made above: creditors are creating an excess money demand problem that the Fed could address. Of course, it is not just banks, but all creditors.

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  10. I’m pretty sure I agree with Anon just above. To put Anon’s point in my own words, David Beckworth is not quite correct to say that “for every debtor deleveraging there is a creditor getting more payments”.

    That is true where the creditor being repaid is not a bank. But where someone who has borrowed from a bank repays the bank, the bank just extinguishes the money, or to use Anon’s phraseology, horizontal money collapses.

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    Replies
    1. I think Beckworth agree with you on that point based on his other writings. Just that the creditor here is the bank.

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