Balance Sheet Dynamics

Paul Krugman recently posted his preliminary thoughts on the 'Balance Sheet Recession,' a meme started by Richard Koo, who wrote a book by the same name about Japan's bust. Krugman writes:

"As I see it, the balance sheet recession approach to the business cycle is a close cousin to a once-influential but largely forgotten literature: the “non-linear” theory of the business cycle. The original version, by John Hicks (”A contribution to the theory of the trade cycle”), set up the basics. The idea was that in the short run the economy is unstable: an economic boom causes rising investment spending, which further feeds the boom, and so on, while a slump depresses investment spending, deepening the slump, etc.. Hicks’s big contribution was to add limits to the boom and slump: a “ceiling” set by the economy’s capacity, a “floor” set by the fact that investment can’t go negative.

....What Koo is arguing for is something similar, but with debt playing the role played by capacity in the old trade cycle. When the economy is growing, taking on more debt seems OK, and rising debt feeds rising spending, which feeds the boom. Eventually growth has to slow, however, and the debt starts to drag down spending, which reduces income, forcing more deleveraging, and so on to the floor. Then debt slowly gets paid down, until the cycle is ready to start again."

I think this is an incomplete picture of balance sheet dynamics. It ignores the asset side altogether and the positive feedback loops between assets, debt, and demand. Here is my simple schematic representation (I have a more complex representation that takes into account physical capacity and investment, but I leave it for later):
I have represented here the cycle when it is virtuous--asset prices, debt, and demand are all rising and reinforcing each other. Rising leverage allows asset prices to be bid up and fuels demand as well. Rising asset prices in turn fuel demand through wealth effects and also by facilitating borrowing against collateral (think of mortgage refinancing). Rising demand rationalizes rising asset valuations and generates the cash flow needed to justify rising leverage. However, well before the last stages of the virtuous cycle (bubble mania), demand, income, and cash flows have started to fall behind asset prices and debt. In other words, balance sheets have started to outpace the real side of the economy. In the last stage, that is the bubble stage, debt is increasingly fueled toward asset speculation, incomes have started to stagnate and demand is propped up by leverage. When this increasingly unstable arrangement starts to unravel, the big balance sheet dynamics start to go into reverse. What was a virtuous cycle now becomes a vicious downward spiral--falling demand and incomes causing debt service problems, which in turn leads to falling credit, leading to falling asset prices and so on. We are in the vicious cycle right now. Balance sheets are still too big in relation to the real economy.

I have developed my framework and ideas by building on Minsky's financial Keynesianism (more on that later) and marrying it with John Sterman's systems dynamics models. I will explain my framework in more detail in future posts.

The Myth About Foreigners Financing America

Like the proverbial sky falling on the head fear, the financial community is perennially worried that foreigners will stop financing America's current account deficit--specifically, that they will stop buying Treasury debt and start selling it. The events of the past ten months should have put such thoughts to rest, but alas. Amid America's gravest financial crisis since the Depression, investors globally have actually flocked to the dollar and Treasuries with great gusto.


People think of 'our dependence on foreigner investors' as if America were perched on a high tree trunk and foreign investors were armed with saws, ready to cutoff the limb. The analogy is not bad, except that it has the actors switched. The question is not, "What will happen to us if foreigners stop buying our debt?" but, "What will happen to other countries if they can no longer sell us their goods?"


Two fallacies underlie the worry that we will be abandoned by foreign investors. The first is that foreigners somehow bring money to our markets that otherwise would not be there, and the second is that they can make money disappear from our economy. Last time I checked, Treasury debt was denominated in dollars, and the United States was obligated to make interest and principal payments in dollars. I also note that the Federal Reserve, not international investors, determines the US money supply. Only if foreigners actions made the Fed compelled to support the dollar through higher interest rates would domestic credit conditions tighten.


Foreign investors can affect currency markets, but they can only frighten or briefly disrupt the Treasury market. Suppose a foreign investor becomes fed up with financing America's debts, so he sells all his US government bonds and converts the proceeds to euro, yen, or gold. Unless he does business with Houdini, the dollars do not disappear or magically turn into gold, yen , or euro. Now someone else owns the dollars and what will they do with them? Dollars pulled out of the US asset markets by foreigners wishing to repatriate do no vanish but instead keep flowing back to the same markets.


Widespread selling of dollar denominated assets could put great pressure on the dollar's exchange rate. Although the supply of dollars is not changed, the bond market could sell off because it believes that the weak dollar will cause inflation, forcing the Fed to tighten. But these are effects on perception. To be sure, such misplaced perceptions could cause momentary turmoil in the bond market, but economic reality would soon bring it back to balance.

A drop in the US dollar would have little effect on US inflation (certainly not in the current environment of massive slack in global capacity). The influence of exchange rates on import prices has waned in recent times. US consumers pricing power has become increasingly dominant and overcapacity has created chronic buyers' markets, which was not the case in the 1970s.

Which brings us to the bigger question. Who is dependent on whom? The precipitous decline in global economic activity in the past six months, especially in China, and the rally in Treasury bonds reveal how much the global economy is dependent on US demand rather than how much US is dependent on foreigners for financing. China (or for that matter anyone else) is not buying Treasury securities out of munificence. Nor is their buying of Treasury securities 'financing' anything. Rather China acquires dollars when it agrees to accept dollars are payment for goods it sells in the US. How it allocated the thus acquired dollars to various dollar-denominated assets is a portfolio choice not a financing decision. Of course, China could decide not to accept dollars as payment for goods. But then where are they going to sell their goods to keep their factories running and, more importantly, keep their vast population gainfully employed? As long as the rest of the world has not figured out a way to generate domestic demand sufficient to keep its domestic supply gainfully employed, the world will remain dependent on the US consumer as the buyer of last resort.