Saturday, June 16, 2012

A Balance Sheet Recession in a Nutshell

The Financial Times is occasionally refreshingly good.  Yesterday Martin Wolf put the essential problem of a balance sheet recession very succinctly:

[T]hose who are creditworthy do not wish to borrow; those who want to borrow are not creditworthy...
This is the problem in a balance sheet recession.  Policymakers, who overwhelmingly have banking backgrounds, want to solve these problems through the banking system - by setting interest rates and letting banks create money by lending.

However, banks cannot create net financial assets - every time a bank makes a loan, it creates an equivalent liability for each asset it creates.  So if private sector balance sheets are strained, banks don't lend, no matter what the interest rate is and no matter how much the government might want them to.

The solution to this problem is fairly simple; unfortunately ideological orthodoxy tends to assume it away.  From a different part of the same article:
Mr Osborne repeated the orthodoxies of the government’s approach to fiscal policy (it needs to be tight), monetary policy (it needs to be loose) and debt (it needs to be reduced).
The problem is, in a balance sheet recession, if fiscal policy is tight, balance sheets stay strained because no net financial assets are being transferred to the private sector, and thus no amount of "loosening" of monetary policy (which really just means low interest rates) can actually produce an expansion of private credit.

The most crucial part of the quote, though, is that bit at the end about debt needing to be reduced.  Whose debt?  For private balance sheets to "deleverage" (that is, to pay off debt) government debt must be increased.  There is no other source for the money needed to pay private debt off - that's what it means to be a monopoly issuer of a currency.

The simplest way for the UK and US to jumpstart their economies would be to target the people whose balance sheets are in the worst shape - the unemployed.  The government could hire the unemployed to perform useful work in their communities for $8/hr until such time as the private economy was ready to hire those people again.

It really is quite simple, but orthodoxy has a way of blinding people to obvious solutions that don't fit their prejudices.


  1. Why should not those not creditworthy who want to borrow not be allowed to compete for access to bank credit on the same regulatory terms than those who are creditworthy but do not want to borrow? That is a question you should try one day to answer, as currently the banks are required to hold more capital when lending to the risky than when lending to the not risky.

    This issue of discriminatory bank capital requirements is ignored over and over again, by those who feebly believe, even after all current evidence against such nonsense, that the best thing to do is to make sure that already risk adverse bankers avoid taking any ex ante deemed high risks. It is truly sad to see what a brave society can reduce itself to, when it allows its nannies to reign supremely.

    Instead of a temporary banking funding scheme such as is proposed by Mervyn King and or George Osborne I propose that regulators urgently calculate any individual bank´s capital to total assets ratio, and ask for it to apply a capital requirement that increases ever so slightly on any new asset it acquires… until reaching some basic goal. That way they would be able to put the banks on a stronger footing to lend, with so much less distortion.

  2. I think there's a level at which I agree with you, though I don't think fundamentally that an expansion of private credit is a good idea right now.

    However, as an abstract matter it does seem odd to have a tiered capital system instead of just letting banks make their own judgments about how to allocated their capital.

    It suggests that banks can't make responsible lending decisions on their own, which leads to the question: why have a private banking system at all?