Balance Sheet Recessions And Fiscal Policy

This article is not for everyone. It may be too technical for many readers. On the other hand, it is well written and it sheds a lot of light on our current economic problems. In particular, it describes the problems in the eurozone very well and it even offers some suggestions for solving the problems of fiscal management in different countries with a common currency.

We have two related economic problems to deal with. We had a financial crisis that central banks were able deal with but we have had a balance sheet recession that central banks are less able to fix and it takes a long time to end balance sheet recessions. We have a balance sheet recession after asset bubbles collapse and the private sector begins to deleverage. Even very low interest rates are unable to encourage the private sector to borrow and spend. The public sector must absorb the private savings or we get into a deflationary spiral. We have little experience with balance sheet recessions, however, so we are making things worse by focusing on deficit reduction.

One of the problems in the eurozone is that the flow of funds between countries is procyclical. For example, when Spain was booming, money flowed into Spain from investors looking for higher yields. That accelerated the real estate bubble. After the bubble burst, the flow of funds reversed. Investors in Spain sent their money to core countries seeking a safe return. This has caused interest rates to rise for Spanish debt. It would be better if domestic investors were not permitted to invest in the pubic debt of other eurozone countries. The common currency encourages the procyclical flow of funds,

The other problem with balance sheet recessions is that we fall into the liquidity trap. Interest rates fall to the zero lower bound and monetary policy becomes less effective. Unfortunately, tax revenues fall during recession and governments become fixated on deficit reduction. It becomes very difficult politically to use fiscal policy to absorb the excess private savings that result from deleveraging. Politicians fight over what to spend federal funds on and the deficit hawks use rising budget deficits to political advantage. Historically, spending on wars has been the only way for the necessary level of government spending to be politically tenable.