Richard Koo: Meet Secular Stagnation

Richard Koo’s latest book, The Escape from the Balance Sheet Recession and the QE Trap, hit book stores in November. In this book, Koo returns to the same theory he explored in his previous work, namely that Japan, and possibly much of the developed world, is suffering from a balance sheet recession. I’m particularly interested in this theory because of how it relates to secular stagnation.

What exactly is a balance sheet recession? According to Koo, a balance sheet recession occurs when private debt levels are so high that corporations (as well as individuals) feel that the only sensible use of income is to repay debt. Despite rock-bottom interest rates, these corporations feel so existentially threatened by high debt that they use profits for deleveraging. Put another way, excessive debt increases the propensity to save, driving the ideal interest rate into negative territory. The only way to avoid a severe recession is for the government to deficit spend, which keeps the economy at full employment. The following graph uses the ideal interest rate framework to illustrate what happens (the intersection of savings supply and borrowing demand determines the ideal interest rate).

Secular stagnation caused by balance sheet recession

Although the Economist says that Koo unfairly dismisses secular stagnation, I’d argue that his balance sheet recession is just another form of it, one that has a different cause from the version I discussed in my article on Japan. In Koo’s theory, ungodly levels of private debt drive the propensity to save higher, which pushes the ideal rate into negative territory. In my blog post, on the other hand, the culprit is a structural decline in workforce growth. When the growth of the workforce declines, so do the number of profitable investment opportunities, which in turn lowers borrowing demand and pushes the ideal rate negative. The following graph depicts the workforce-driven version of secular stagnation:

Secular stagnation caused by workforce growth

So which is responsible for Japan’s Lost Decades? Is it high private debt or a structural decline in workforce growth? In some sense, the argument is chiefly academic. The result of secular stagnation is essentially the same in both cases, and so are the cures. Sure, mass debt forgiveness would be less effective if the cause is chiefly workforce growth. But apart from this, any policy to reduce savings and increase profitable investment opportunities would help in both scenarios. And when these avenues are exhausted, good old-fashioned government deficit spending will once again provide the only path to full employment.

Where the two scenarios differ, however, is in their duration. Under Koo’s balance sheet recession theory, as long as the private sector is deleveraging, it is slowly approaching the point where the desire to repay debt must dissipate. The more debt is repaid, the closer we get to a private-sector resurgence. In other words, although the affliction could last for decades, it must, mathematically, bring about its own end. But when the culprit is declining workforce growth, which I believe to be the case, secular stagnation has no clear-cut end. Higher birth rates do not become more likely as secular stagnation drags on. So for everyone’s sake, we should hope that Koo is right. But with the ratio of private debt to GDP far below levels seen in Japan’s boom years (see chart below), and still no sign of a private sector recovery, his theory becomes ever more tenuous.

McKinseyJapanDebt

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