Streetwise Professor

August 16, 2010

Doing Donuts

Filed under: Economics,Financial crisis,Politics — The Professor @ 7:28 pm

In today’s WSJ Jerry O’Driscoll summarizes quite well something I was saying at the depths of the crisis in late-’08 and early-’09, and during the debate on the stimulus:

The financial panic and ensuing great recession was a classic balance-sheet recession. As balance sheets shrank in value, demand collapsed. There was a liquidity crisis as well, centered around Lehman’s collapse, but the driving force was collapsing balance sheets, impaired capital values and, for many, insolvencies.

The declines in home values, investor portfolios and 401(k) plans, and the uncertainties surrounding retirement plans, have all had a big impact. The solution lies in restoring balance sheets. For financial firms, that means raising capital. For consumers and businesses alike, that means saving more of their reduced incomes.  [Note the symbiosis between raising capital and household saving.]

Yet public policy has focused almost exclusively on stimulating spending without much regard to why spending, especially consumption, has flagged. Until balance sheets (corporate and household) are restored, increased spending cannot be sustained.  [This failure to ask “why” is endemic in current policymaking.  It’s been my pet peeve in the whole debate over changing financial regulation.]

Temporary spending and tax breaks are always dubious, and especially so now when the rational motivation is to save more and consume less.

Amen to that.

The way I put it during the stimulus debate is that while people clearly wanted to rebuild their balance sheets and delever in the aftermath of a huge wealth shock that occurred at a time they were highly leveraged, the government decided that it had to re-lever on their behalf.   For their own good, dontcha know.

Under this interpretation, it is not at all surprising that the stimulus, and government spending in the US generally, has been anything but stimulating, and has indeed been highly counterproductive.  People, seeing the splurge of spending and associated debt, add that to their consolidated mental balance sheet–what they see in their bank account and loan statements plus the future liabilities they are being forced to assume.  The greater the liabilities forced onto them, the more they have to save to get their balance sheets in some semblance of order.  (That’s doubly true when what the assumed liabilities are spent on doesn’t provide that much–if anything–of value to households.)  (The argument is analogous to the one in classical finance whereby investors can undo firm capital structure choices.)

Uncle Sam stomps on the gas, we stomp on the brakes.  All that is produced is a lot of burning rubber and the car doing donuts.

What should raise questions is that Europe, especially in Germany and the UK, are making appreciable progress despite their having banking systems that are in as bad or worse shape than ours.  But, crucially, they have sworn off the stimulants and are making efforts to restore some fiscal sanity.  This isn’t dispositive, but it is suggestive.

Merkel and the Germans are openly contemptuous of US policy.  With good reason.  But Team Obama seems committed on personifying the definition of insanity as doing the same thing repeatedly in the expectation of getting a different result.

Don’t hold your breath.

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  1. […] This post was mentioned on Twitter by Craig pirrong and Craig pirrong, Craig pirrong. Craig pirrong said: Updated my SWP blog post: ( ) […]

    Pingback by Tweets that mention Streetwise Professor » Doing Donuts -- — August 16, 2010 @ 7:41 pm

  2. Rebuilding balance sheets = increasing % of safe assets.

    That’s why tax cut based stimulus clearly helps.

    Comment by The Money Demand Blog — August 17, 2010 @ 5:05 am

  3. […] The stimulus isn't working because it isn't addressing the Balance Sheet Recession.  (StreetwiseProf) […]

    Pingback by Hot Links: Momentum and the Job-pocalypse The Reformed Broker — August 17, 2010 @ 6:18 am

  4. I read over at PragCap or someplace that complacency for monetary stimulus but fervor against fiscal stimulus is counterintuitive, at least for main street. Rates are low as ever, but what’s the point in getting into more debt? Fiscal stimulus on the other hand at least gets us better roads or something.

    Comment by d — August 17, 2010 @ 8:21 am

  5. Saw this from Business Insider. I figure if Richard Koo was prescient in prescribing the problem, surely his advice is good as well.

    Comment by d — August 17, 2010 @ 8:26 am

  6. Nov 2010 – Time for a change? You betcha!!

    Comment by Surya — August 17, 2010 @ 8:26 am

  7. Sitting here in Berlin right now but can only give you a finger-in-the-wind observation… things look like they’re hopping. Something must be going right.

    Comment by Howard Roark — August 17, 2010 @ 8:32 am

  8. @d. Or something. In fact, a good chunk of the stimulus has been spent on various types of transfer payments and aid to state governments. There was an article in the WSJ about the pathetic lack of progress on infrastructure projects allegedly funded by stimulus funds. The empirical evidence on stimulus is underwhelming, to say the least.

    The ProfessorComment by The Professor — August 17, 2010 @ 9:29 am

  9. I don’t follow you professor. I was just highlighting a view from someone with the same prognosis but a seemingly different prescription. I’ve actually read the WSJ article now, and the main point is that massive amounts of monetary stimulus yields little. Gerald specifically states that we should move from “stimulating consumption to encouraging productive investment”. So Gerald isn’t totally opposite of Richard Koo.

    The recent stimulus was hardly stimulative of consumption, what an extra dollar a day tax cut. It in fact seems to fit the definition in general of “productive investment”, in theory at least. Obviously execution is another matter. Both Richard and Gerald remind me of an article by Pimco, where as part of their new normal thesis, they suggest government cushion the collapse in private demand with targeted investments. In effect, stimulus 2 (or stimulus 1 done right).

    Comment by d — August 17, 2010 @ 11:53 am

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