What’s so disturbing about the deficit reduction fiasco is that it fails to address the problem that’s in front of our face. Yes, of course, the deficit is a problem and has been since President Bush’s two tax cuts were enacted, but it’s a long term problem that can’t be fixed until the economy is on better ground. The current problem is aggregate demand, which clearly won’t improve with austerity programs.
While I’m no economist – my degree is in Finance - I’ve read quite a bit of about the subject - Smith, Hayek, Fischer, Keynes, Freidman, Minsky, etc. – and feel comfortable enough to conclude that the theory that best explains the current situation is that of Richard Koo, Chief Economist for Nomura Securities in Japan. I’ve read his book The Holy Grail of Macro Economics: Lesson’s From Japan’s Greatest Crisis and have seen a couple of talks he has given that are available on ITunes. (There is a podcast of a talk he gave at the Lowy Institute in February 2011 entitled The Long Haul Towards Economic Recovery and an ITunesU talk he gave at the Center for Strategic and International Studies in 2009.) I can’t recommend the book or the talks enough.
Koo argues that America is suffering from a balance sheet recession similar to what occurred during the Great Depression of the 1930’s and Japan in the 1990’s. In both instances, the downturn was set off by the implosion of an asset bubble. After the asset bubble burst people and businesses realized that their balance sheets showed reduced net worth, if not insolvency. However, rather than simply liquidate their holdings businesses continued to operate and began to pay off debt with the profits from their on-going businesses. The effect of paying off debt and increasing savings was that it reduced current aggregate demand that resulted in a contraction of the economy, which if not propped up by the government with fiscal stimulus resulted in a continuing deterioration of the economy. He further argues that neither monetary policy nor quantitative easing will remedy the recession because the problem isn’t lack of money, the problem is the lack of demand for funds, i.e. people and businesses are paying off debt and saving money rather than borrowing to expand their businesses.
So, what does Koo recommend? He opines the only way to keep the economy from further deteriorating is for the federal fiscal stimulus to make up for the deflationary gap for as long as it takes people and businesses to fix their balance sheets. Moreover, the fiscal stimulus should be in the form of spending rather than tax cuts, because a percentage of tax cuts will be used to further reduce debt and accumulate savings rather than prop up aggregate demand.
I find Koo’s ideas convincing for two reasons. First, it conforms to what I see. Friends, family members, and co-workers all tell me the same thing. The value of their house has dropped and they don’t feel comfortable with their financial situation and are paying off their credit cards and saving money. Second, it answers the question I’ve always had: If Keynes is right, how long does fiscal stimulus need to continue? Koo’s answer would be fiscal stimulus has to continue until people and business have fixed their balance sheets and overcome their fear of debt. Intuitively, this makes a lot of sense and suggests to me that unless we consider multiple years of fiscal stimulus we are looking at a double dip recession that will end up costing even more than multiple year fiscal stimulus packages.
From Koo’s theory, three things jump out at me. First, between President Bush’s tax cut and unfunded wars, the Tea Party, and Republicans fear of being in a competitive primary with a Tea Party candidate, President Obama has no room to maneuver and he ought to point this out so this situation doesn’t happen again. Second, what does Koo’s theory imply when the talk is about cutting/eliminating/revamping Medicare and Social Security? It seems to me that if Medicare and Social Security are at risk, it will take people even longer to fix their respective balance sheets given they can’t be assured that they will have affordable health care or a minimum income upon retirement. Third, we have little choice but to implement fiscal stimulus. If we don’t the economy will continue to deteriorate and while fiscal stimulus will be expensive, it will be cheaper than the alternative of reduced demand, reduced GNP, reduced tax revenues and increased deficits. Obviously, fiscal stimulus doesn’t sound like a winning argument right now, but after a couple of quarters of recession it will be all the rage and Mr. Koo’s book and talks give me a decent framework to understand the issues and the debate.