How do we rebuild balance sheets?
Suppose your family’s balance sheet has shrunk. How do you rebuild it? I suppose you could consume less and/or work more. Now suppose you are a country and your balance sheet has shrunk, how do you rebuild it? Wouldn’t the answer be the same?
If I faced a depleted balance sheet the last thing I would do is go on vacation, or switch from a full time job to a part time job. If anything, I’d want to start working overtime. But maybe this commonsense view is wrong. Consider the following observation from The Economist:
And as investors’ panic recedes, so credit markets are beginning to function. This will not be enough to spur a vibrant recovery in America, where households must painfully rebuild their balance-sheets.
I can’t quite tell what The Economist is saying here. Are they saying a vibrant economy (which I assume means full employment) would make it harder to rebuild balance sheets, or are they saying that one can’t have a vibrant economy at the same time as one tries to rebuild balance sheets?
I do see how attempts to rebuild balance sheets could depress velocity, and if the central bank was foolish enough to leave the money supply unchanged then this could depress economic activity. But is that really all they are saying?
If, on the other hand, they are claiming that to rebuild balance sheets a country must consume less, and to consume less one must produce less, then the statement seems not just wrong, but dangerously wrong. If we want to rebuild balance sheets we need to stimulate output. Over the past year we have done the opposite, we have adopted contractionary policies which have reduced output and thus national income, and made our balance sheets much worse. (Mine is much worse despite a steady job, I can only imagine what the balance sheets look like of those who have lost jobs.)
I’ve probably misinterpreted the quotation, but I’d like to see what others think.
PS. Speaking of The Economist, an interesting coincidence here and here.
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9. June 2009 at 15:15
Rebuilding balance sheets means increasing personal savings rates. This means less consumption, which means ‘less vibrant’ in this context. Paradox of thrift, plus paradox of deleveraging. Monetary policy will have trouble changing the behavior of people who are absolutely intent on saving more and spending less, so they can retire.
But presumably this contraction gets offset at least partly by reducing the public sector saving rate (i.e. making it more negative) and increasing public sector expenditure.
Although there is little question that increased personal saving rates is the way the US current account balance will be brought back to a more sustainable level, consistent with less consumption via imports.
9. June 2009 at 15:34
They’re saying that credit markets recovering is not enough on its own to lead to a recovery. Households need to start working more, saving more and consuming less.
Common sense, really, as you describe in your opening ‘graph.
But this common sense observation shows the problem with Keynesian prescriptions. Keynesians would say that you would first need households to sabotage their balance sheets further in order to raise aggregate demand, and the government needs to sabotage its balance sheet by providing fiscal stimulus and cheap credit.
The obvious problem with this is that the only reason this mess arrived in the first place was the government and households sabotaging their balance sheet.
9. June 2009 at 15:34
Depends what they mean by “rebuilding balance sheets”.
If they mean “reduce net foreign debt”, then the increase in AD must come from net exports rather than domestic absorption. And it is easier to see how improvements in credit markets functioning might increase domestic absorption than increase net exports.
But if they mean “reduce gross debt” or “gross debt/income ratios”, including debts that some Americans owe to other Americans, then that is compatible with domestic absorption rising and net exports staying the same.
9. June 2009 at 15:43
My first thought is that they must mean rebuilding balance sheets will involve a reduction in consumption expenditures and thus living standards, as opposed to a slowdown in GDP. You’re right that this doesn’t mean production should go down. So their “vibrant economy” would mean strong consumption rather than output.
However, there’s an argument that output might not start to grow either until balance sheets have been rebuilt, because a structural change in the level of savings that households desire, leads in turn to declining output via the paradox of thrift. Then again, this doesn’t entirely make sense – because the paradox of thrift implies that the attempt to save more will be unsuccessful, so balance sheets won’t be rebuilt after all.
More simply, I realise that the Economist’s point is that even if you produce more, you have to have someone to sell your output to. If we’re stuck in a low-output equilibrium then a demand recovery is needed to enable higher output. Their contention is presumably that reduced household debt is needed for demand to return.
Krugman also referred to the question of rebuilding balance sheets tonight (in the Japanese context particularly) but in that case he was looking at corporate balance sheets, and it seems plausible that reduced corporate debt would enable a business investment-led recovery.
9. June 2009 at 15:46
Nick makes a good point about including exports. In my comment I was thinking of total world demand and output. But the Economist is specifically talking about the US, which does allow room for an export-led recovery (or, if exports are too much to expect, at least a contribution from reduced net imports).
Which, perhaps not coincidentally, was also Paul Krugman’s conclusion about Japan – for all the corporate balance sheet rebuilding that took place, it was actually exports which stimulated the recovery there from 2003.
9. June 2009 at 17:25
The argument is about the US, or more precisely, about indebted rich-world countries. Since the world is a closed economy, one country’s indebtedness (or group of indebted countries) must be matched by another country’s (or countries) surplus.
In short: we need the surplus countries to ‘expand their balance sheets’ (i.e. take on more debt) and the deficit countries to ‘contract’ their balance sheets. The problem might be that those countries that have run up big surpluses probably feel they need even bigger surpluses to insure against the next crash.
9. June 2009 at 21:20
They’re Keynesians. Of course this is what they are saying.
“or are they saying that one can’t have a vibrant economy at the same time as one tries to rebuild balance sheets?”
Is there an economist besides Roger Garrison who really gets why this is false? Well, name them.
10. June 2009 at 04:06
Alan has it.
Closed economy. Aggregate net debt is zero. Gross debt is non-zero. Some people, firms, governments owe money to other people, firms, governments. “Rebuilding balance sheets” cannot be about reducing net debt, because it is already zero in aggregate, or on average; it must be about changing the distribution of net debt. Those who have positive net debt need to spend less; those who have negative net debt need to spend more. This says nothing about aggregate spending.
If everybody TRIES to increase their net debt they will fail. (They must fail, because net debt is zero). But in the attempt to do so they will increase spending and income, and reduce the ratio of gross debt to income. This, the paradox of debt, is an extension of the paradox of thrift.
10. June 2009 at 04:23
government spending and net export expansion are both hedges against the paradox of thrift as it applies to the household sector
10. June 2009 at 04:25
anon, Less consumption doesn’t mean less output, just different kinds of output (investment and exports.)
You evoke the Keynesian Paradox of Thrift (which I don’t agree with). But even if true, Keynes’s point was that attempts to rebuild balance sheets by saving will fail. So that doesn’t rescue The Economist.
saifedean, I am also skeptical of a one step back and two step forward theory, at least in economics. If you want to go north, don’t start walking south, start walking north right away.
Nick, Your answer is closest to what I was thinking of. I would put it slightly differently. You need more exports or investment. By my answer is the same as yours. Hence The Economist is wrong.
Leigh, Yes, I also thought of the problem with trying to apply the Paradox of Thrift (see above.) I do think, however, that The Economist meant “output” not “consumption.” The economy was vibrant in WWII despite falling consumption.
I would add that one doesn’t have to reduce consumption to rebuild balance sheets, but one does have to increase (investment + exports). If you are in a recession, both C and (I + E) can increase at the same time. Indeed that is probably the most effective way to rebuild balance sheets. It’s like going from a part time to a full time job. You will both save more and consume more.
Leigh, I agree about exports, but again I would think exports make an economy more vibrant. I still think The Economist is saying we must produce less to rebuild our balance sheets. But when we produce less we generally invest less, and our balance sheets get worse.
Alan Rai, Yes, but note that it’s not a zero sum game. All countries can increase their balance sheets at once it they produce more investment goods.
Greg Ransom, I agree that some Keynesians make this error, but Roger Garrison is hardly the only one who understands the fallacy. I’m pretty sure all the profs I had at Chicago would see the flaw in this reasoning, as did many of the commenters here.
10. June 2009 at 04:35
Nick, I don’t interpret “balance sheets” as “net debt”. Doesn’t the term ‘balance sheet’ includes equities. So all countries can improve their balances sheets at once, can’t they? I thought balance sheets measured net wealth.
Anon, Both G and E can expand demand in the Keynesian model. How that affects balance sheets is more complicated. E definitely helps. G helps if it goes toward government investment, not government consumption.
10. June 2009 at 05:36
Government expenditure will improve household balance sheets by allowing households to save. This is independent of the type of government expenditure.
The type of government expenditure determines whether the effect on the government balance sheet itself is neutral (investment) or negative (consumption).
The economist comment focuses on household balance sheets, not national balance sheets.
The case of exports is parallel. Exports allow the domestic balance sheet (in total, but including households) to improve regardless of the type of foreign expenditure – i.e. consumer goods or investment goods. E.g. foreign expenditure on imported consumer goods allows the domestic balance sheet to improve while the foreign balance sheet deteriorates.
10. June 2009 at 07:10
“Greg Ransom, I agree that some Keynesians make this error, but Roger Garrison is hardly the only one who understands the fallacy. I’m pretty sure all the profs I had at Chicago would see the flaw in this reasoning, as did many of the commenters here.”
Do they get this?
http://www.auburn.edu/~garriro/kandh.ppt
It’s rare to find an economist who understands (at the system wide level) the capital microeconomics of how production is increased by reducing consumption and demand. Watch Garrison’s PowerPoint on this, and tell me if you’ve ever seen it in Chicago economics. My wager is that you have not.
Of course, I stand to be corrected, but my understanding is that Chicago economists do not include what Hayek called “capital theory” in their macroeconomics — the legacy of Frank Knight and his failure to understand capital theory. At Chicago the basic capital theoretical (non-aggregated) insights of Wicksell and Bohm-Bawerk were essentially banned by Knight — the oral tradition I’ve heard from Chicago people is that Knight would only approve Stigler’s dissertation on the production theory if it provided a negative assessment of Bohm-Bawerk’s work in capital theory.
10. June 2009 at 07:18
Here’s another Garrison PowerPoint showing how system wide output increases over time with consumption and demand reductions in the near term:
http://www.auburn.edu/~garriro/cbm.ppt
10. June 2009 at 08:47
Scott:
You are correct, but Nick explains it better on the whole.
Perhaps to him and others “net debt is zero” is clear, I always like to emphasize that for every borrower there is a lender.
If the borrowers don’t want to borrow (or can’t find lenders because of they are already too far in debt,) then what do those who would have lent to them do with the money? When those in debt repay their debts, there is someone recieving repayment. What do they do with the money?
If this doesn’t result in a decrease in the quantity of money by banks increasing reserves, or an increase in the demand for money, by people accumulating money balances, then THERE CAN BE NO IMPACT ON NOMINAL EXPENDITURES.
However, when we start this talk of “deleveraging,” then we do need to speak of equity. While one investor or firm “deleveraging” shrinks their portfolio or their scale of operations, in aggregate, it is a call to fund investmnet by equity rather than debt. That people should save by accumulating stocks rather than bonds or bank deposits. Again, for every borrower there is a lender. To say that firms shouldn’t fund their investmnet by selling bonds, is to say that people shouldn’t save by purchasing bonds.
Thinking of the exisisting stock of debt by firms, it is that firms should sell stock and pay off debt. And investors who buy stock with the funds they receive from their repaid debt.
(I think describing households as “overleveraged” is a bad analogy.)
And, of course, if they don’t want to accumulate anything, then they must consume. (Oh.. or accumulate money? See, it is always monetary disequilibrium.)
Personal saving in the U.S. has been positive nearly every quarter for the last decade. (And business savings has been positive too, so that private saving is strongly positive.) On the whole, the households are consuming out of current income. Of course, some households save and others dissave and so household debt is very high.
If those household that were dissaving pay off their debts to those households that were saving, then they can reverse and those repaying debt save (repairing their balance sheets) and those that had saved can now dissave, consuming more than their income. Since private saving is positive, it is possible to increase consumption out of current income with no change in indebtedness by anyone.
I think the problem is a kind of partial Keynesian macro. Aggregate demand is the sum of C+I+G+Xn. C and I are funded by borrowing. More lending, more borrowing, more C, more I, more C+I+G+Xn, and so more spending, more production, and more employment. If there is a problem with credit markets, or worse, the problem is too much debt already, so that it is sensible not to lend to those with nearly unpayable debts and sensible not to borrow for those who can hardly repay what they owe, then less can be funded, and so C+I+G+Xn must be depressed until these debts are paid down. I guess the idea is that those who continue to work and make money need to pay down their debts. And they can then start to spend again and start employing those who aren’t working.
The problem is that it ignores money. What would do the lenders do with the money if they don’t lend it? (They hold it, is the implicit assumption.) What do those receiving debt repayments do with the money they receive (they hold is the implicit assumption.)
It is so wrong!
Or rather, has you say, Scott, maybe there is an increase in the demand for money in the process. But that is the problem that needs to be fixed.
Oh.. and yes.. maybe people in the U.S. should reduce consumption and pay off debts to asians.
10. June 2009 at 10:29
One way to rationalize the Economist quote is to think of the wealth shock as a hit to the capital stock (to me, this is the kernel of truth in the Austrian mal-investment story). Then it make sense that (real) output falls. To get employment to fall with it, I guess you need some complementarity between K and L or low L mobility or some such.
10. June 2009 at 11:05
I’d like to make a distinction between “cash savings” and “capital savings”. Cash savings are savings in the form of bonds or currency. Capital savings are investments in real productive assets, including education and infrastructure. Keynes’ paradox of thrift only applies to an increased demand for cash savings, because people can always increase investment without affecting aggregate demand. A dollar spent on capital goods is just as effective at employing idle workers as a dollar spent on consumption goods. Capital savings can increase without limit (although the return might be limited by decreasing returns to scale). Money savings on the other hand are limited by the amount of money balances. Bonds and loans, as some other commenters have pointed out, always sum to zero, and so the only net “cash savings” people can hold is the value of currency in circulation.
Households can substitute between these two forms of savings and in normal times and financial intermediation transforms one into the other. People have recently seen the value of their capital decline dramatically (bust out those Austrian capital theories!) and so are looking to shift into cash savings. Unfortunately the only way to satisfy cash savings demand would be to either print money, issue debt, or for prices to fall (increasing real balances).
10. June 2009 at 14:38
Scott:
“Nick, I don’t interpret “balance sheets” as “net debt”. Doesn’t the term ‘balance sheet’ includes equities. So all countries can improve their balances sheets at once, can’t they? I thought balance sheets measured net wealth.”
Fair point. But I would say that stocks/shares are just a different form of debt, with a contingent interest rate. But if you want to include real capital in the “balance sheet”, (which is what you probably had in mind) that makes sense.
azmyth: my position is like yours, only more extreme. A supply of “Saving” can mean a demand for investment, antique furniture, financial assets, etc., etc. But the only type of excessive desired “savings” that can result in a general glut of goods and recession is an excess demand for the medium of exchange. If you try to save in any of those other forms, you have to find a willing seller, and if everybody else is trying to save more too, you won’t find a willing seller. So you give up, and decide to try to buy something else instead. But an individual can always get more medium of exchange, simply by buying less of other things. It’s only in aggregate we can’t do this.
The “paradox of thrift” is really the paradox of an excess demand for the medium of exchange.
11. June 2009 at 00:43
Just to further Nick’s point, one also think of the “paradox of thrift” as capturing the fact that savings=investment is an equilibrium condition, not an identity. So, while it seems that all that’s happening at the moment is a simple substitution between the investment and consumption components of “aggregate demand”, the paradox of thrift highlights the fact that we have an excess of desired savings over desired investment. The Fed’s role as “intermediary of last resort” and its “credit easing” program is their attempt to correct this imbalance.
As long as the market remains in this state of disequilibrium, GDP is likely to remain depressed. Perhaps this is what the Economist has in mind….
Btw, as a newcomer to this blog, I must say that this is an excellent blog Scott!
11. June 2009 at 04:45
anon, You said:
“The economist comment focuses on household balance sheets, not national balance sheets.”
I regard national balance sheets as household balance sheets. If households aren’t responsible for servicing government debt, then who is? I realize your approach may be more conventional, but it doesn’t make sense to me. It seems analogous to people who distinguish between household income and corporate income.
Greg, All I see in the slides you presented is that if you move along the PPF in (C, I) space toward more investment you get faster economic growth. Doesn’t every economist know this?
Chicago economists definitely deal in capital theory. People like Lucas study economic growth—how can you do that without studying capital? They may not use Austrian models, but that is another issue.
Greg#2, Again, the second slide set is also standard macro. If you save and invest more, you grow faster. It is what is taught in all the principles texts. The paradox of thrift is now just a footnote. (But may come back.)
Bill, You have some good criticisms of the standard view, but I think you make things too complicated:
In a closed economy:
1. Household balance sheets = capital stock. Period.
If you want to rebuild balance sheets, rebuild the capital stock, which is called net investment (of course at market values, to dismiss the objection that we don’t need more houses.)
2. Money only comes into the picture in one way, because wages and prices are sticky, monetary shocks can affect employment. With more employment you usually get both C and I going up, and vice versa with less employment. So austerity is a horrible way to rebuild balance sheets, it actually reduces investment, and hence reduces balance sheets.
With an open economy:
3. You can also improve balance sheets by improving the trade balance.
Have I left out anything?
Thruth, I’m not going to argue that the Austrian view is theoretically impossible, but I simply don’t buy the argument that we need to reduce employment when there are labor flows between sectors. That did not occur in 2007, despite the flow out of housing. It only happened in 2008, when NGDP started falling. I’d be really surprised if The Economist had a convoluted Austrian argument in mind, that is certainly not their standard approach to macro.
azmyth, Well put. I would just add that “cash savings” aka hoarding, aren’t really saving at all.
Nick, I agree with your response to me, and also to azmyth. As an aside, azmyth hinted that he had the same view as you in his reference to “paradox of thrift.” I think all three of us are on the same page, it’s not saving that is problematic, it’s hoarding of cash, the MEDIUM OF ACCOUNT. (Or did you say medium of exchange?) 🙂
Alan Rai, I actually prefer the identity version of S=I, but I do understand that it is a matter of definitions, and that if you define cash hoarding as saving but not investment then you can get the result you mention. So I won’t quibble over definitions. But I still say that it is important to highlight the role of money in the way that Nick does, because in Keynes’s formulation that role is hidden, and it is not obvious the central bank can do anything about excess saving. In fact the “problem” is easy to solve with an inflation or NGDP targeting regime. That’s why economists stopped worrying about the paradox of thrift in the new Keynesian era, and only started again when rates hit zero and some (not me) doubted the efficacy of monetary policy. So I think we basically agree.
Thanks for the comment on my blog
11. June 2009 at 07:34
Scott — in a one good “capital theory” model you can’t get the choice theoretical trade off that grounds the “exchange” where you trade less consumption now for greater consumption later due to the fact that people will only chose longer production processes if these longer processes produce greater output than shorter processes — only one good, no trade off.
The “deep” key to the fallacy of the paradox of thrift — the key to understanding Keynes’ failure as an economist — is the failure to recognize and incorporate this central fact of production microeconomics within “macroeconomics”.
Modern “growth theory” was invented by taking Hayek’s micro-grounded capital theory and eliminating the micro and modeling the “growth” process in a one goods macro model (see Hick’s discussing how Hayek’s work gave rise to Harrod’s original “growth” model).
A capital “stock” or one good “capital theory” isn’t really capital theory — it leaves out the production increase due to the choice of longer processes that produce greater output.
This is Knight’s original fallacy / oversight / failure of understanding — and adding technological innovation / productivity to the picture doesn’t fix things.
Scott wrote:
“Greg, All I see in the slides you presented is that if you move along the PPF in (C, I) space toward more investment you get faster economic growth. Doesn’t every economist know this?
Chicago economists definitely deal in capital theory. People like Lucas study economic growth””how can you do that without studying capital? They may not use Austrian models, but that is another issue.
Greg#2, Again, the second slide set is also standard macro. If you save and invest more, you grow faster. It is what is taught in all the principles texts. The paradox of thrift is now just a footnote.”
11. June 2009 at 07:58
Scott wrote: “If you save and invest more, you grow faster. It is what is taught in all the principles texts.”
Yes, that is what’s taught but this in no way contradicts the paradox of thrift.
The paradox of thrift occurs when aggregate savings demand exceeds aggregate investment demand, that is the economy is in recession. If you save more but don’t invest more then current income falls while growth does not get faster.
11. June 2009 at 10:10
Here’s a basic fact of the choice situation and of the empirical world.
Some production processes take less time and produce less output.
E.g. taking fishing with your hands.
Some production processes take more time at first — and produce much greater output late, a choice situation.
E.g. taking time to weave a net and then catching fish with a net.
Show many any Chicago economics which deals with this fundamental fact of nature and human choice.
12. June 2009 at 04:57
Greg, You are right that some growth models only assume one type of capital, but I don’t see that as a big problem. Certainly one doesn’t need a sophisticated capital model to dispose of the paradox of thrift, all you need is a central bank that targets inflation or NGDP.
Adam P, Yes, I agree. I was thinking of Greg’s objection that we don’t cover the PPF approach to C and I in mainstream growth models. We certainly do (although I apparently misunderstood the specific point Greg was making.) Obviously the paradox of thrift is about cases where you go inside the PPF, and the classical assumption doesn’t hold, as you say. Unlike Keynes I see that as a failure of monetary policy, and the imbalance between planned saving and investment seems a trivial issue. It only becomes important if monetary policy is inept (as under a gold standard.) Then an attempt to save more can reduce velocity, and hence NGDP.
12. June 2009 at 05:08
Scott, yes I know. I was trying to agree with you and re-phrase with a bit of extra detail, that’s all.
On re-reading though it does almost sound like a critique, habit I guess 🙂
12. June 2009 at 06:57
I find it remarkable that Ransom doesn’t understand that the simple things he is saying about saving, investment, and future production aren’t standard.
Less consumption now, more investment now, more capital in the future, more output in the future.
The “problem” with single good capital theory is that if something “shocks” the production of capital goods, then there is a permanent increase in wealth. This makes the Austrian Business Cycle Theory nonsense. But, if there are heterogeneous capital goods, then it is possible that the wrong capital goods are produced and so that the capital goods are “malinvestments” if there is a switch back an allocation of resources with more consumption and less capital.
This possibility makes the idea of heterogeneous capital goods important. But, it isn’t important for every possible scenario.. in particular the ones of concern by simple growth theory.
Anyway, even if one doesn’t focus on the time element of this (which most everyone does these days,) then it is always implicit. Growth is more output in the future. Saving reduces consumption now and raises the ability to consume in the future. The notion that additional capital goods allow additional output is common place. And you use resources now to produce capital goods now to get more production in the future.
There is not some kind of huge divergence between orthodox and Austrian theory here.
And, orthodox theory deals with capital goods heterogenity in many contexts.
13. June 2009 at 05:47
Adam P, I should apply the ‘theory of relativity’ If by comparison with your other comments it sounds positive, then it is positive. 🙂
Bill, I think we all agree that some of the basic ideas in ABCT about C, S, I, and the PPF are also in other mainstream theories. I think we all agree that the ABCT does more with capital heterogeneity than other theories. And I think that you and I disagree with Greg about how important that omission is.
17. March 2010 at 05:34
[…] balance sheet is a factor that I find Professor Sumner dismisses too easily; he seems not to see how if one part of the economy determinedly pursues savings, then output may […]
17. March 2010 at 08:18
freethinking economist asks:
“The balance sheet is a factor that I find Professor Sumner dismisses too easily; he seems not to see how if one part of the economy determinedly pursues savings, then output may fall. His comment says it all: “Less consumption doesn’t mean less output, just different kinds of output (investment and exports.)” That seems extraordinarily complacent. If households save suddenly, why would businesses invest? If every Western household wants to save, why do exports rise?”
I think this confuses two issues. Often when it looks like you have households sitting on their hands, and not spending, what is really going on is NGDP is falling, i.e. money is much too tight. It doesn’t look that way because nominal rates are low, but monetary is failing to maintain expectations of adequate NGDP growth. In that case falling consumption might well not be offset by business investment. But that is bad monetary policy, not an unstable economy.
It is wrong to apply this sort of demand-side model in a world were the central bank targets NGDP growth. That is the world described by Say’s Law, unless there is some weird supply-side problem like sharply higher minimum wage rates. But as long as NGDP is high enough to provide close to full employment at current nominal wage settings, then you can let the sectoral issues sort themselves out.
One criticism of this argument is that if consumption falls, and business investment is weak, housing is all that is left to pick up the slack. And we know what happened in 2006. But housing malinvestment must be addressed through better regulation. It is essential that monetary policy keep the focus on NGDP. As a practical matter, because C is 70% of the economy, consumption won’t fall much if the Fed keeps NGDP on target. Rather any slight fall in C will trigger much lower interest rates, which will encourage increased investment and also discourage consumers from reducing C even more. Remember that with price level targeting real rates can go negative, if needed.
Here’s his link:
http://freethinkingeconomist.com/2010/03/17/we-can-do-this-the-nice-way-or-the-nasty-way/