Friday, November 19, 2010


The following paper by Paul Krugman is an excellent analysis of the current situation in the United States.? Professor Krugman accepts Richard Koo’s “balance sheet recession” and draws similar conclusions to Koo – primarily that government must maintain large deficits in order to offset the lack of spending by the private sector.? The key component missing in both Krugman and Koo’s argument is the idea that a nation that is sovereign in its own currency cannot default on its “debt”.? Nonetheless, the conclusions we all come to are similar – a temporary deficit is not only necessary, but an economic benefit during a balance sheet recession:

“In this paper we have sought to formalize the notion of a deleveraging crisis, in which there is an abrupt downward revision of views about how much debt it is safe for individual agents to have, and in which this revision of views forces highly indebted agents to reduce their spending sharply. Such a sudden shift to deleveraging can, if it is large enough, create major problems of macroeconomic management. For if a slump is to be avoided, someone must spend more to compensate for the fact that debtors are spending less; yet even a zero nominal interest rate may not be low enough to induce the needed spending.

Formalizing this concept integrates several important strands in economic thought. Fisher’s famous idea of debt deflation emerges naturally, while the deleveraging shock can be seen as our version of the increasingly popular notion of a “Minsky moment.” And the process of recovery, which depends on debtors paying down their liabilities, corresponds quite closely to Koo’s notion of a protracted “balance sheet recession.”

One thing that is especially clear from the analysis is the likelihood that policy discussion in the aftermath of a deleveraging shock will be even more confused than usual, at least viewed through the lens of the model. Why? Because the shock pushes us into a world of topsy-turvy, in which saving is a vice, increased productivity can reduce output, and flexible wages increase unemployment. However, expansionary fiscal policy should be effective, in part because the macroeconomic effects of a deleveraging shock are inherently temporary, so the fiscal response need be only temporary as well. And the model suggests that a temporary rise in government spending not only won’t crowd out private spending, it will lead to increased spending on the part of liquidity-constrained debtors.

The major limitation of this analysis, as we see it, is its reliance on strategically crude dynamics. To simplify the analysis, we think of all the action as taking place within a single, aggregated short run, with debt paid down to sustainable levels and prices returned to full ex ante flexibility by the time the next period begins. This sidesteps the important question of just how fast debtors are required to deleverage; it also rules out any consideration of the effects of changes in inflation expectations during the period when the zero lower bound remains binding, a major theme of recent work by Eggertsson (2010a), Christiano et. al. (2009), and others. In future work we hope to get more realistic about the dynamics.

We do believe, however, that even the present version sheds considerable light on the problems presently faced by major advanced economies. And yes, it does suggest that the current conventional wisdom about what policy makers should be doing now is almost completely wrong.”



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