Friday, January 21, 2011

Do We Really Have A Balance Sheet Recession?

In the past I said yes, now I say no.  The reason being is that there is something more fundamental going on than household balance sheets being a mess.  To see the real problem, consider the standard story told as to why weakened household balance sheets pose such a problem to a robust economic recovery.  Here is how Ryan Avent tells it:
In the years prior to the crisis, households accumulated a lot of debt, which was offset by rising asset prices. Those asset prices then collapsed and many households are now desperately attempting to pay down their debts. Because they're heavily indebted, efforts to spark a recovery by encouraging household spending or residential investments are likely to go nowhere; people are simply too broke.
Mark Thoma agrees:
Households have no choice but to set aside part of their income to both rebuild the asset side of the balance sheet and to pay down their debts. This is one of the main reasons why recovery from these “balance sheet recessions” is notoriously slow. As households rebuild their balance sheets, resources are directed away from consumption, and the reduction in aggregate demand is a drag on the economy.
Note that the hindrance to a full recovery in this balance sheet recession story is the increased saving being done to repair the balance sheets. But this begs the question, why aren't the creditors who are receiving the increased payments spending the money?  If they were, then aggregate nominal spending would not be disrupted.  The problem, then, is not that balance sheets are a mess but that creditors are not providing offsetting spending.  Because creditors are holding on to the money payments from debtors, what we fundamentally have is an excess money demand problem.  Here is how I explained this problem elsewhere:
[The balance sheet recession view] fails to recognize that for every debtor there must be a creditor. Thus, for every debtor who is cutting back on spending in order to pay off his debts, there is a creditor receiving money payments. In principle, these creditors should be increasing their money spending to offset the decline in money spending by the debtors — but if that were happening, there would have been no decline in overall total current-dollar spending. Instead, creditors are sitting on their money because they see an uncertain economic future. Creditor households are reluctant to buy new cars or get their kitchens remodeled lest they lose their jobs in the future. Creditor firms, meanwhile, are reluctant to build new plants since they cannot see how they would be able to sell all the new production coming from those plants. Similarly, creditor banks are not increasing lending as there is little demand for funds and few creditworthy borrowers.

If these creditor households, firms, and banks all simultaneously started spending their excess money balances, this would increase total current-dollar spending and in turn spur a real economic recovery. Moreover, knowing that the real economy would improve would feed back and reinforce current spending decisions by the creditors — creditor households would buy new cars and remodel their kitchens, creditor firms would build new plants, and creditor banks would increase lending. A virtuous cycle would take hold and push the economy back toward full employment. But this virtuous cycle is not taking off because creditors are still hanging on to their money balances. What is needed to kickstart this cycle is an entity powerful enough to incentivize all the creditor households and firms to start spending their money simultaneously.

Enter the Federal Reserve. It alone has the ability to provide these incentives through its control of monetary policy. The fact that total current-dollar spending has remained depressed for so long means that the Federal Reserve has failed to do its job and effectively has kept monetary policy too tight.
The solution, then, is for the Fed to use monetary policy to change nominal expectations in a way that solves the excess money demand problem.  Here is how I would have the Fed do it.


  1. On the aggregate level, however, the creditors are foreigners and they are simply not spending their money in the USA. On a micro level, your hypothesis may work, however, on a big macro level - the level that would have an effect on nominal GDP growth, it stands no chance. As an aside point, the other creditor in the US economy are corporates, but for one reason or another they still are deciding to keep their record cash levels and not spend on capes, r&d, or m&a (even though there is a small pickup in all three).

  2. Anton:

    The excess money demand story still holds at the macro level even if some of the creditors are foreigners. If foreign creditors get the dollar payment they either (1) hold the dollars or (2) they swap them for another asset. If they swap them for their own currency then there are more dollars on the foreign exchange market and the dollar depreciates. If they swap it for an asset other than another currency, say like treasuries, then the seller of the treasury now has more dollars. The seller of the treasury will either (1) hold the dollars or (2) swap it for another asset like currency or equity. This cycle continues until either (1) the dollars are all held or are (2) work their way back to the U.S. economy, the place where they can ultimately be spent on goods and services (i.e. net exports increase). Of course, part of the dollars working their way back to the U.S. economy is through the incentive of dollar depreciation.

    Now if (1) is a problem, then QE2, in principle, should satiate this global excess money demand for dollars and lead to more dollars working their way back to the U.S. economy. Thus, via the forex market and net exports the dollars should ultimately be spent on the U.S. economy.

    The creditor part is addressed in the post.

  3. Very nice post. I've always been skeptical of balance sheet recession models, but you explain why better than I could.

  4. "why aren't the creditors who are receiving the increased payments spending the money?"

    There's no reason to expect them to spend it, because it's not income; it's just a return of captial. The question would be, "Why aren't they re-lending it?" The reason they aren't re-lending it is that, with debtors trying to pay down their loans, the demand for loans is too low to produce high enough interest rates to justify the risk. You can call it an excess money demand problem, but the excess money demand is a result of the balance sheet problem, because money happens to be an asset that becomes attractive when loan demand is weak.

  5. Great post, David.

    Anton, David's response was correct, but I would like to try a different approach. If foreigners are creditors and are obtaining a net repayments, then they create a net capital outflow for the U.S. This must be matched by a trade surplus. Either the foreigners spend more on U.S. goods, and so exports create greater demand for U.S. output, or else, they sell less to the U.S., leaving Americans no choise but to purchase U.S. import competing productions, also raising the demand for U.S. output.

    I would expect the trade surplus to be generated by a depreciation of the foriegn exchange value of the dollar, but not necessarily. The foreigners receiving debt repayments can spend the receipts on U.S. goods.

    If some foreign government tries to block an exchange rate appreciation by accumulating U.S. assets, then there is no net foreign collection of debts after all. Maybe some foreigners collect on debts, but others (like some foreign central bank are lending in place of them.

    Again, if the foreigners accumulate U.S. money balances, this is an increase in the demand for money, which is exactly what an expansion in the quantity of money is supposed to accomodate so that spending is maintained.

  6. The reason folks are not lending when someone de-leverages is simple math. Overall the country must de-leverage. The amount of money in circulation is multiplied by the leverage overall. That is:

    Total dollars = T$ = Initial dollars*(1 + r + r^2 + …) = Initial dollars/(1-r)

    where r is the ratio of dollars re-lent by each successive “shadow banker.”

    If r = .95, T$=Initial dollars*20.

    If r=.90, T$=Initial dollars*10 (after de-leveraging).

  7. Interest rates coordinate the plans of savers and borrowers, investment and consumption. If falling investment demand reduces interest rates, then savers will provide fewer loanable funds. The purpose of production is consumption, either sooner or later. Falling interest rates encourage people to consume sooner than otherwise -- creditors become consumers.

    The problem with an excess demand for money is that it creates a intermediary category between "saver" and "consumer" where scarce resources are sucked into a black hole never to be seen again.

    Eventually the supply of money must increase, in either real or nominal terms.

  8. David and Bill - appreciate that in theory ( and for a small economy) that's how the money should find its way back to the home country. But in practice, it is a fact that 60 percent of all USD are more or less "permanently" held outside of the USA, Because the USD is the global reserve currency, it is used by simply everyone globally as a means of exchange and by a lot of people in developing countries as a store of value as well. In addition a lot of foreign corporates are constantly "short" USD because most of their borrowings is in USD (for the simple reason that it cheaper courtesy of the constantly low US rates for now 25 years - since Volcker really). Reality is that there is a constant shortage of USD globally - US money supply alone is not sufficient to satisfy that shortage.

  9. This is a very interesting post and discussion.

    Anton: A thought-experiment:

    Let's take the extreme case. Suppose the USD is the only currency used anywhere in the world. And assume the US is very small relative to the world. So the Fed is the only central bank in the world, but only cares about the US economy.

    So it would be like assuming the US is a closed economy, but the Fed only cares about the economy in (say) Washington DC.

    What's the problem the Fed faces? If there's a global excess demand for USD, that results in an excess supply for US goods, the Fed just satisfies it.

  10. An explicit policy of US dollar depreciation will certainly achieve the objective of directing some US dollars back to USA, but such a policy is extremely unlikely. On the other hand, it is not possible to expect an easy switch for consumers (either domestic or foreign) towards US produced goods for the simple fact that either 1. The US economy is not geared (and certainly not competitive anymore) for producing manufactured consumer goods; 2. In the post industrialist economy a lot of "Consumption" is happening now of intangible goods without an exchange of money taking place.

  11. Anton,

    You said:

    An explicit policy of US dollar depreciation will certainly achieve the objective of directing some US dollars back to USA, but such a policy is extremely unlikely.

    So you agree there is an excess money demand problem (globally), but you just don't think the Fed will actually do it? Fair enough, but the whole point quasi-monetarist have been making is that the Fed should be doing more (systematic, rule based) monetary stimulus. Note, that such policy doesn't have to be an explicit depreciation policy... it will come automatically with the appropriate monetary stimulus.

  12. David:
    Yes, that's right. There is excess demand of money globally and, even though the Fed under Bernanke, is possibly doing more than it is given credit for, still will not go the length of properly increasing the money supply to satisfy that demand. I wish it is another topic whether the Fed can increase the money supply without a corresponding increase of the overall debt in the economy. And thus I wonder if the USD can weaken to the point when it will have a positive effect on addressing the problems of "the balance sheet" recession.

  13. David,

    What percentage of creditor households provide 80% of savings? My sense is the number is below 5% given record income inequality. If this is correct, the propensity to consume of these households is exceedingly low.

    Middle-income seniors are, as a group, also net creditors. Their rate of dis-saving is sensitive to short term rates. Under ZIRP, they are being forced to dis-save less, not more. This seems to be rarely mentioned.

    Finally, the group of middle aged, middle income households may be net creditors. However, their retirement fund return expectations have fallen since the crisis; therefore, they have to save more, not less, to achieve the same level of spending in retirement. BTW, most pension funds have retained unrealistic return expecations (8%+) post-crisis. Eventually, they will have to lower these and raise required contributions.

    It would be interesting to hear how the savings behavior of each of the above groups of creditors might be influenced by Fed policy.

  14. Thank you for this post-I have been asking myself the same thing--should not financial intermediaries take the savings and spend or invest them?

    Thank goodness Bernanke is going ahead with QE--this is the important thing,

  15. BTW, I had an idea lately, and I would like a real economist somewhere to respond.

    Okay goes like this; The US has open borders. Labor, goods, services, capital come here easily. Okay, so the fed cranks up the money supply, and dmand kicks in.

    Until we reach capacity, there should not be much inflation--and that is the secret: Our capacity expands easily in the face of demand, thanks to open borders. Does anyone doubt that 12 million hard-working Latins did not tamp down wages? That when cars come in by the millions, that suppresses car prices? That when capital pours in, it suppresses interest rates while boosting capacity?
    More services can be offshored too, through the internet.

    To me, this suggest the Fed can just about blow the doors open. It may also explain why despite strong growth in the 1990s, we really never ran into inflation.

    I think Bernanke has a lot of room to run.

  16. David Pearson:

    Even for these high savers there is still the issue of how much of their portfolio is weighted to highly liquid assets versus higher-yielding less liquid assets. Presumably, they are overweighted on highly liquid assets. To the extent they are the scenario I laid out above--the Fed starts a virtuous cycle by changing expectations--these folks would reallocate to the higher yielding, less liquid assets like stocks and commodities. In so doing it would increase these other asset prices. This would, then, improve balance sheets, increase wealth, and further improve economic expectations. Such developments would spur spending, even if not by the high savers themselves.

  17. David,

    Your view makes sense, but I think there is more nuance at work. If rich savers decide to inflation hedge, this forces up prices of necessities for middle income spenders (and seniors). Theory has it that demand goes up as well, but not if consumer confidence takes a bit hit. The latter is an "intangible", as is the behavior of corporate investment as margins are squeezed. You might end up with a situation in which savers' inflation hedging produces more inflation than it does real growth.

    China import price inflation is running around .3% a month, way outstripping core cpi. This is an example of how commodity inflation pass-through is impacting middle income spenders at Walmart.

  18. Your discussion is strictly closed economy. The real offset to increased household sector savings should come from net exports, not expecting lenders (i.e. wealth accumulators) to suddenly change their spots and become spendthrifts.

  19. Reason:

    Read the comment thread above. We have been discussion the open economy implications.

  20. Debts are not being reduced by higher savings out of income leading to repayment of consumer debt to financial insitutions.

    Consumers are defaulting to financial insitutions. At record rates, 3% of the loan book written off per year. These rates are 20 times the average over the previous 20 years.

    The symmetry the article expects assumes that loans are actually repaid. Default has a symmetry to it as well, of course - it is a windfall to the defaulter at the creditor's expense. However, the defaulter is not in any position to increase consumption or make new loans with the disappearance of his past debts - and the creditor can't make new loans with his non existing repayment.

    There is no getting around the fact that default destroys asset values, assymmetrically. A world in which all actors are meeting their commitments as forecast has higher total value than one in which they routinely do not.

    Financial institutions are responding by reducing *their* total balance sheet size. Specifically, the total debt outstanding of the US financial sector has fallen by over $2.5 trillion since the cycle peak.

    The average behavior of that item since the end of the Korean war is to increase by 14% per year. The shrinkage seen recently instead is 5 standard deviations below that mean behavior. You have to go back to the 1930s to find similar behavior in total financial sector debts.

    In short, there is indeed a balance sheet recession. But it is not consumer balance sheets that are driving it.

    Nor is the effective money supply up to the Fed. It is leaning against the gale force deflation coming from deleveraging in the private financial sector. That deleveraging is driven by actual credit market behaviors - defaults - 20 times worse than past average rates.

    The banks are not expanding their loans because the people are flat not paying them back, and because they were slaughtered for the level of risk they were already running at 2007 asset sizes. They need a prolonged period of steep yield curve and falling default rates to repair *their* balance sheets.

    Until then, the banks being capital constrained not reserve constrained, the Fed adding reserves does increase effective money supply, but without the usual multiplier.

    The best thing the policy mix can do to speed this along is to encourage the rights of creditors and straighten out the lawyer and populist created mess in the resolution system for real estate collateral, work to get default rates down generally, and do as little as possible that strains the banking system for the benefit of everyone else.

    Needless to say, besides the Fed, nobody is doing any of that. Instead every pol wants bankers scalped.

    It is necessary to point out that a thriving capitalist economy without thriving capitalist financiers is a round square and a misunderstanding.

    People need to make up their minds whether they want one; if they do, then bankers getting rich is the entry fee, and beating them up at every turn will not work.

  21. I apologize for the late comment.
    I had a sophomore in Principles of Macro ask this question this week:
    If an increase in savings is good for investment, kapital accumulation, and productivity, doesn't a balance sheet correction-- both households and government saving more-- also reduce the incentives that firms have to Invest? Why would firms accumulate physical capital that will help increase future production if households and governments are no longer going to be buying as much?
    I understand the exchange rate and net exports channel. But without it, there doesn't appear to be a good answer to his question.

    I answered by discussing how our government was dissaving and households also in recent years, making us a net borrower (and importer, though in the course we are weeks away from how that works).

    He was simply asking from a micro standpoint. If Consumption falls, what incentives do firms have to Invest?
    I think the classical view would be that prices would fall, enticing households to spend more again. But doesn't that get us right back where we started?

    In the above post the answer seems to be simply "let the Fed target NGDP expectations so that firms continue to have that expectation of future sales and continue to Invest." But to a sophomore that sounds like "The Fed should trick firms into thinking households and government aren't consuming less." Does my problem make sense?

  22. To summarize my previous question, if the Fed targets nominal spending and wants it to increase from current level, that necessarily means that it wants saving by households to decrease (or net exports to increase). But how do we reconcile the idea that saving is good because it leads to capital accumulation with the idea that saving is bad (increased nominal spending is good) because it causes firms to Invest less at any price? That's the apparent paradox I'm trying to answer.

    Is the problem not that households are saving too much but rather that they're saving the wrong way-- liquid assets like cash instead of less-liquid assets like stocks/bonds? And that's how I should answer the student's question?

  23. Andy Harless's account seems to me to be the closest to my own personal experience of what is going on. Neither households nor businesses want to borrow money - households, because they are too poor and are paying down debt, and businesses because they don't see any return on investment for borrowed money spent on capital goods and hiring, since their customers are so poor.