I’m currently reading through Richard Koo’s The Holy Grail of Macroeconomics, which is turning out to be incredibly interesting. So far, I do have some disagreements, but they’re the kind that make you think, “This is something that I need to look into” — i.e. they’re the disagreements that make you doubt yourself. For those of you who haven’t read Koo’s book, based on what I’ve read so far I do recommend it.

I’d like to share one thing in particular from Koo’s book,

[A]fter the bubble collapsed in Japan, not only were there no willing borrowers, but existing borrowers were paying down debt — and they were doing so when interest rates were at zero. Technically insolvent companies, struggling to pay down debt and repair balance sheets hit by the nationwide plunge in asset prices, were not interested in borrowing money, regardless how far the central bank lowered rates. In this environment, monetary policy by itself no longer has any effect.

— p. 29.

If we think about it in terms of supply and demand for money, Koo is saying that there is insufficient demand for money. He still advocates price stabilization, but his solution is an increase in government spending to make up the gap between demand for and supply of money.

While Koo does mention Krugman’s Japan paper, he only mentions that it credits deflation as the main culprit for Japan’s recessionary woes. He doesn’t, at least so far, comment on Krugman’s solution: targeting inflation to increase inflation expectations. Yet, there may be an important incongruity between the theories of a balance sheet recession and of forward-looking monetary policies. (Note: Koo does spend time criticizing monetary policy, but considers only conventional monetary policy, with his argument boiling down to explaining why there’s a liquidity trap.) None of this is new, or something that economists are privy to, but I’d thought it’d interest those who haven’t read Koo or followed critics of this particular facet of the balance sheet recession argument.

During the recessionary, or what the book refers to as the “yin,” phase, businesses should be fixing their balance sheets. This requires what amounts to “saving,” as firms draw from revenue flows to pay down their liabilities. (In this case, to clarify, the creditor doesn’t add to spending, because banks — the creditors — can’t find borrowers.) Krugman’s theory, in turn, seeks to increase inflation expectations, pushing the private sector to spend cash; if we see inflation as a tax on non-interest bearing liquidity, those expecting higher inflation will swap these types of assets for those with higher returns. But, this still doesn’t address the fact that what’s holding back spending is private sector deleveraging.

Some time ago Krugman suggested that Koo isn’t entirely right,

Koo’s argument is that interest rates and monetary policy don’t matter because everyone is debt-constrained. That can’t be right; if there are debtors, there must also be creditors, and the creditors must be influenced at the margin by interest rates, expected inflation, and all that.

In the very next sentence, he gets to the heart of the issue, “That said, widespread credit constraints presumably reduce the number of players who can take advantage of lower rates.” Koo argues that the creditors are banks, and these are firms that aren’t sensitive to falling interest rates and increased inflation expectations (if nobody wants to borrow, there aren’t assets banks can buy).

I wonder if it’s Koo, in any case, who pushed Krugman towards advocating fiscal policy, rather than focusing on monetary policy.