Tuesday, April 7, 2009

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.

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