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Cutting-edge macro-economics analysis of the crisis

November 18th, 2010 · 8 Comments

Yes, that guy again. Not only a columnist. Combining original work from Koo (on balance sheet recessions), Irving Fisher (debt-deflation) and Minsky..
From Cullen Roche’s website:

18 November 2010 by TPC

The following paper by Paul Krugman is an excellent analysis of the current situation in the United States.  Professor Krugman accepts Richard Koo’s “balance sheet recession” and draws similar conclusions to Koo – primarily that government must maintain large deficits in order to offset the lack of spending by the private sector.  The key component missing in both Krugman and Koo’s argument is the idea that a nation that is sovereign in its own currency cannot default on its “debt”.  Nonetheless, the conclusions we all come to are similar – a temporary deficit is not only necessary, but an economic benefit during a balance sheet recession:

“In this paper we have sought to formalize the notion of a deleveraging crisis, in which there is an abrupt downward revision of views about how much debt it is safe for individual agents to have, and in which this revision of views forces highly indebted agents to reduce their spending sharply. Such a sudden shift to deleveraging can, if it is large enough, create major problems of macroeconomic management. For if a slump is to be avoided, someone must spend more to compensate for the fact that debtors are spending less; yet even a zero nominal interest rate may not be low enough to induce the needed spending.

Formalizing this concept integrates several important strands in economic thought. Fisher’s famous idea of debt deflation emerges naturally, while the deleveraging shock can be seen as our version of the increasingly popular notion of a “Minsky moment.” And the process of recovery, which depends on debtors paying down their liabilities, corresponds quite closely to Koo’s notion of a protracted “balance sheet recession.”

One thing that is especially clear from the analysis is the likelihood that policy discussion in the aftermath of a deleveraging shock will be even more confused than usual, at least viewed through the lens of the model. Why? Because the shock pushes us into a world of topsy-turvy, in which saving is a vice, increased productivity can reduce output, and flexible wages increase unemployment. However, expansionary fiscal policy should be effective, in part because the macroeconomic effects of a deleveraging shock are inherently temporary, so the fiscal response need be only temporary as well. And the model suggests that a temporary rise in government spending not only won’t crowd out private spending, it will lead to increased spending on the part of liquidity-constrained debtors.

The major limitation of this analysis, as we see it, is its reliance on strategically crude dynamics. To simplify the analysis, we think of all the action as taking place within a single, aggregated short run, with debt paid down to sustainable levels and prices returned to full ex ante flexibility by the time the next period begins. This sidesteps the important question of just how fast debtors are required to deleverage; it also rules out any consideration of the effects of changes in inflation expectations during the period when the zero lower bound remains binding, a major theme of recent work by Eggertsson (2010a), Christiano et. al. (2009), and others. In future work we hope to get more realistic about the dynamics.

We do believe, however, that even the present version sheds considerable light on the problems presently faced by major advanced economies. And yes, it does suggest that the current conventional wisdom about what policy makers should be doing now is almost completely wrong.”


Debt, deleveraging, and the liquidity trap

Paul Krugman
18 November 2010

Debt is the crux of advanced economies’ current policy debates. Some argue for fiscal expansion to avoid recession and deflation. Others claim that you can’t solve a debt-created problem with more debt. This column explains the core logic of a new model by Eggertsson and Krugman in which debt shocks and policy reactions can be examined. Relying on heterogeneous agents, the model naturally produces the paradox of thrift but also finds new supply-side paradoxes, those of toil and flexibility. The model suggests that most economists have been misthinking the issues and that actual policy in the US and EU is misguided.

If there is a single word that appears most frequently in discussions of the economic problems now afflicting both the US and Europe, that word is surely “debt.” Between 2000 and 2008, household debt rose from 96% of US personal income to 128%; meanwhile, in Britain it rose from 105% to 160%, and in Spain from 69% to 130%. Sharply rising debt, it’s widely argued, set the stage for the crisis, and the overhang of debt continues to act as a drag on recovery.

The lack of formal theory

The current preoccupation with debt harks back to a long tradition in economic analysis, from Fisher’s (1933) theory of debt deflation, to Minsky’s (1986) back-in-vogue work on financial instability, to Koo’s (2008) concept of balance-sheet recessions. Yet despite the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, there is a surprising lack of models – especially models of monetary and fiscal policy – of economic policy that correspond at all closely to the concerns about debt that dominate practical discourse. Even now, much analysis (including my own) is done in terms of representative-agent models, which by definition can’t deal with the consequences of the fact that some people are debtors while others are creditors.

New work that I’ve done with Gauti Eggertsson (Eggertsson and Krugman 2010) seeks to provide a simple framework that remedies this failing. Minimal as the framework is, I believe that it yields important insights into the problems the world economy faces right now – and it suggests that much of the conventional wisdom governing actual policy is wrong-headed under current conditions.

The model’s economic logic

We envision an economy very much along the lines of standard New Keynesian models – but instead of thinking in terms of a representative agent, we imagine that there are two kinds of people, “patient” and “impatient”; the impatient borrow from the patient. There is, however, a limit on any individual’s debt, implicitly set by views about how much leverage is safe.

We can then model a crisis like the one we now face as the result of a “deleveraging shock.” For whatever reason, there is a sudden downward revision of acceptable debt levels – a “Minsky moment.” This forces debtors to sharply reduce their spending. If the economy is to avoid a slump, other agents must be induced to spend more, say by a fall in interest rates. But if the deleveraging shock is severe enough, even a zero interest rate may not be low enough. So a large deleveraging shock can easily push the economy into a liquidity trap.

Fisher’s (1933) notion of debt deflation emerges immediately and naturally from this analysis. If debts are specified in nominal terms, and a deleveraging shock leads to falling prices, the real burden of debt rises – and so does the forced decline in debtors’ spending, reinforcing the original shock. One implication of the Fisher debt effect is that in the aftermath of a deleveraging shock the aggregate demand curve is likely to be upward, not downward-sloping. That is, a lower price level will actually reduce demand for goods and services.

More broadly, large deleveraging shocks land the economy in a world of topsy-turvy, where many of the usual rules no longer apply. The traditional but long-neglected paradox of thrift – in which attempts to save more end up reducing aggregate savings – is joined by the “paradox of toil” – in which increased potential output reduces actual output, and the “paradox of flexibility” – in which a greater willingness of workers to accept wage cuts actually increases unemployment.

Where our approach really seems to offer clarification, however, is in the analysis of fiscal policy.

Implications for fiscal policy

In the current policy debate, debt is often invoked as a reason to dismiss calls for expansionary fiscal policy as a response to unemployment; you can’t solve a problem created by debt by running up even more debt, say the critics. Households borrowed too much, say many people; now you want the government to borrow even more?

What’s wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, debt wouldn’t be a problem in the first place. After all, to a first approximation debt is money we owe to ourselves – yes, the US has debt to China etc., but that’s not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.

It follows that the level of debt matters only because the distribution of that debt matters, because highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past. This becomes very clear in our analysis. In the model, deficit-financed government spending can, at least in principle, allow the economy to avoid unemployment and deflation while highly indebted private-sector agents repair their balance sheets, and the government can pay down its debts once the deleveraging crisis is past.

In short, one gains a much clearer view of the problems now facing the world, and their potential solutions, if one takes the role of debt and the constraints faced by debtors seriously. And yes, this analysis does suggest that the current conventional wisdom about what policymakers should be doing is almost completely wrong.


Eggertsson, Gauti and Krugman, Paul (2010), “Debt, Deleveraging, and the Liquidity Trap”, mimeo

Fisher, Irving, (1933), “The Debt-Deflation Theory of Great Depressions,” Econometrica, Vol. 1, no. 4.

Koo, Richard (2008), The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, Wiley.

Minsky, Hyman (1986), Stabilizing an Unstable Economy, New Haven: Yale University Press.

——[End of article]———

And if you must, here is the original paper

Tags: Credit Crisis

8 responses so far ↓

  • 1 ron // Nov 23, 2010 at 2:25 am

    Sorry, no faith in Mr. Krugman although the NY Times certainly does.

  • 2 Greg // Nov 29, 2010 at 9:07 pm

    “There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved.”

    – Ludwig von Mises

    FYI, Krugman has been widely discredited by dozens of economists.

  • 3 admin // Nov 29, 2010 at 10:45 pm

    Faith doesn’t come into it, Ron.

    Yes, Greg. By all means. When people and institutions that overleveraged and are deeply in debt cut back spending, nobody should replace that spending. We should just all spiral down into the deflationary debt (death) spiral until we’re rescued by one of your ” anonymous economists”

    Fiscal stimulus worked in the 1930s. It worked in China. It worked even in the US although it was way too small, but it stopped the rot (production and trade fell as fast or even faster than in the early 1930s, until that freefall was arrested by…)

  • 4 admin // Dec 1, 2010 at 10:05 pm

    You might wanna look at this, Greg:

  • 5 Greg // Dec 3, 2010 at 2:20 am

    Pure delusional thoughts. Inflation is here in the US and will ultimately destroy the USD and US economy. The feds exclude most of the real inflationary components.

    Debunking Krugman is a popular sport, here is just one such example.

  • 6 admin // Dec 3, 2010 at 4:22 pm

    Delusional? Where is that inflation you guys are predicting for years?? And beware of zerohedge. These are the guys that day-in, day-out hammered on a decreasin Baltic Dry Index as sign of imminent doom. Until one realized that there were so many new ships coming on-line causing the fall in the BDI.

    We’ve debunked zerohedge on another occasion:

    They don’t even know what ‘Keynesianism’ is. It’s certainly not “debt is good”

    And which country has fared better in the crisis, Ireland, Iceland, or Greece? Krugman’s argument is not a blind favour of debt here anyway, but pointing out the advantages of having one’s own currency..

  • 7 admin // Dec 5, 2010 at 5:01 pm

    You might also want to read this:

  • 8 admin // Dec 8, 2010 at 5:14 pm

    And this. Not only does it show that Iceland has been way better than Ireland, it also shows Krugman was right all along: