by From Richard Koo Until 2008, the economics profession considered this kind of contractionary equilibrium (the world of 0) brought about by a lack of borrowers to be an exceptionally rare occurrence—the only recent example was the Great Depression, which was triggered by the stock market crash in October 1929 and during which the US lost 46 percent of nominal GNP in the process described above. Although Japan fell into a similar predicament when its real estate bubble burst in 1990, its lessons were almost completely ignored by the economics profession until the Lehman shock of 2008.[1] Economists failed to consider the case of insufficient borrowers because when macroeconomics was developing as a separate academic discipline starting in the 1940s, investment opportunities for
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from Richard Koo
Until 2008, the economics profession considered this kind of contractionary equilibrium (the world of $500) brought about by a lack of borrowers to be an exceptionally rare occurrence—the only recent example was the Great Depression, which was triggered by the stock market crash in October 1929 and during which the US lost 46 percent of nominal GNP in the process described above. Although Japan fell into a similar predicament when its real estate bubble burst in 1990, its lessons were almost completely ignored by the economics profession until the Lehman shock of 2008.[1]
Economists failed to consider the case of insufficient borrowers because when macroeconomics was developing as a separate academic discipline starting in the 1940s, investment opportunities for businesses were plentiful as new “must-have” household appliances ranging from washing machines to televisions were invented one after another. With businesses trying to start or expand production of these new products, there were plenty of borrowers in the private sector and interest rates were quite high, at least in comparison with the post-2008 world.
With borrowers never in short supply, economists’ emphasis was very much on the availability of savings and the use of monetary policy to ensure that businesses got the funds they needed at interest rates low enough to enable them to continue investing. Economists also disparaged fiscal policy—i.e., government borrowing and spending—when inflation became a problem in the 70s because they were worried the public sector would squander the private sector’s precious savings on largely inefficient pork-barrel projects.
During this period, economists also assumed the financial sector would make sure that all saved funds are borrowed and spent, with interest rates moving higher when there are too many borrowers relative to savers and adjusting lower when there are too few. This assumed automaticity is the reason why most macroeconomic theories and models developed prior to 2008 contained no financial sector.
The advent of the Great Recession starting in 1990 for Japan and in 2008 for the West, demonstrated, however, that private-sector borrowers can disappear altogether in spite of zero or negative interest rates when faced with daunting financial problems following the bursting of a debt-financed bubble. In post-1990 Japan and the post-2008 Western economies borrowers disappeared completely due to the following sequence of events described below.
To begin with, people tend to leverage themselves up in an asset price bubble in the hope of getting rich quickly. But when the bubble bursts and asset prices collapse, these people are left with huge debts and no assets to show for them. With their balance sheets underwater, these people have no choice but to pay down debt or rebuild savings to restore their financial health.
For businesses, negative equity or insolvency implies the potential loss of access to all forms of financing, including trade credit. In the worst case, all transactions must be settled in cash, since no supplier or creditor wants to extend credit to an entity that may seek bankruptcy protection at any time. In order to safeguard depositors’ money, many depository institutions such as banks are also prohibited by government regulations from extending or rolling over loans to insolvent borrowers. For households, negative equity means savings they thought they had for retirement or a rainy day are no longer there.
Since these conditions are very dangerous, both businesses and households will focus on restoring their financial health regardless of the level of interest rates until they feel safe again. With survival at stake, businesses and households are in no position to borrow even if interest rates are brought down to zero. There will not be many lenders either, especially when the lenders themselves have balance sheet problems. That means these households, businesses and financial institutions are effectively in debt minimization mode instead of the usual profit maximization mode.
[1] One exception is the National Association of Business Economists in Washington, D.C., which awarded its Abramson Award to the author’s paper, titled “The Japanese Economy in Balance Sheet Recession,” which was published in its journal Business Economics in April 2001.