This is an invited paper by the Private Debt Project, an
initiative of the philanthropic organization the Governor’s
Woods Foundation to raise awareness
about the economic importance and dangers of private debt.
The era of low growth known as Japan’s “Lost Decade”
commenced in 1990, and persists to this day. While most authors
acknowledge that the seeds for the Lost Decade were sown by excessive credit
growth in the preceding Bubble Economy years, only Richard Koo (Koo, 2009,
Koo, 2011, Koo, 2003, Koo, 2014) and Richard Werner (Voutsinas and Werner, 2011,
Werner, 2002) have systematically argued that insufficient credit growth
during the “Lost Decade” explains Japan’s now quarter-century long slump. Yet
these arguments tell us more about the dilemmas facing today’s world economy
than many more commonly accepted explanations of the current slowdown.
The insufficient credit growth story is rejected out of
hand by most economists, for reasons summed up by Paul Krugman. From the
perspective of mainstream economics, any event that negatively affects
debtors is, to a large degree, offset by the positive effects of that event
for creditors. Krugman therefore sees no possibility of Koo’s argument of “an
entire economy being “balance-sheet constrained”:
Maybe part of the problem is that Koo envisages an
economy in which everyone is balance-sheet constrained, as opposed to one in
which lots of people are balance-sheet constrained. I’d say that his vision
makes no sense: where there are debtors, there must also be creditors, so
there have to be at least some people who can respond to lower real interest
rates even in a balance-sheet recession. (Krugman, 2013)
Koo is, however, correct: it is possible for an
entire economy to be balance-sheet constrained. Understanding why requires an
appreciation of private credit creation that goes beyond the mere accounting
truism that every entity’s liability is another entity’s asset. This paper
will argue that the assumptions made by mainstream economists about the role
of credit and banking in the economy are incorrect. When taking into account
the “money creation” functions of banking, it becomes clear that the USA and
most advanced economies as well as many emerging economies have joined Japan
in being balance-sheet constrained, and face their own “lost decade” as a
consequence of low credit growth.
I will start with the empirical data and its
implications, and then move on to the argument that an entire economy
can be balance-sheet constrained.
Click here to read the rest of this paper.
