Thursday, November 8, 2012

Koo–Krugman Paradox? - Jonathan Finegold

I’d like to share one thing in particular from Koo’s book, (The Holy Grail of Macroeconomics)
[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.
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.
Read the rest at Economic Thought
Koo–Krugman Paradox?
By Jonathan Finegold

I haven't read Koo's book yet, but have been equally fascinated by his ideas through various other works. Regarding the difference between Koo and Krugman on the creditor-borrower dichotomy, I think it boils down to whether one accepts the loanable funds paradigm or not. Krugman, seemingly accepting the premise, believes that creditors (banks) are limited in credit creation by funds from savers and to some degree central bank reserves. In that case it would be true that a relatively large portion of the population would not become debt-constrained at a given time.

Now consider the opposing view, that banks create deposits and are only constrained by capital requirements (to a degree) and the willingness of borrowers to accept the bank's liabilities (which is supported by an implicit/explicit federal guarantee). Banks can therefore lend well in excess of current income and savings. In this scenario, a very significant portion of the population could become debt-constrained. If this is true, debt-constraints can become far more powerful (as Koo suggests) and may render monetary policy ineffective even with higher inflation expectations.

Personally I find the second example far more convincing given my readings and experience. I should also note that In Koo’s scenario, while demand for credit is weak, banks may also tighten credit restrictions since there is some level of debt-to-income (or assets) where the expected return of lending to a potential borrower becomes negative.


  1. I am reading this as saying that the demand for new lines of credit can bottom out sharply, such that no matter how low the cost of new borrowing there is simply no desire for it. People are simply interested in paying off old debts because they are not certain of their ability to make a profit off new debt.
    That makes sense to me, while Krugman's answer does not. Simply having debt does not imply that new prices are relevant, particularly when people are trying to get rid of debt. I wonder why no one is trying to restructure loans at the new, tiny rates, but it doesn't surprise me that a lack of interest in new debt allows prices to bottom out with no appreciable effect on demand. I have been offering sharp pokes in the eye at rock bottom prices for a while now, but never seem to have much of a customer base.

    1. The main idea of your interpretation is correct, although obviously reality is far more nuanced. A household/business with significant debt (and interest costs) may determine that it will take so long to repay current debt (reducing consumption) that it's not worth taking on greater amounts at the price offered (even if very low). There is obviously the question of whether banks will lend to over-leveraged borrowers at the lowest rates, which is where the inability to profit can really come into play.

      Why more borrowers are not taking advantage of current low rates by refinancing may be significant influenced by accounting practices (give me a moment to explain). Banks are able to hold loans on their books at cost, regardless of market prices or the borrowers' perceived ability to repay. Modifying loans would either require taking a present loss on the principal or voluntarily decreasing net interest, hurting profits. There are likely many other reasons why banks only permit the most credit-worthy borrowers to refinance, but my guess is it comes down to profits and compensation schemes.

    2. So why is it that other banks don't refinance? Basically pay off one loan earlier to avoid the higher interest, and take advantage of the really low rates to offer the business a better option?

    3. Assuming bank's loans being corporate debt (or short-term financing measures), the presumption would be that market prices have adjusted so that bonds with higher coupons trade at a premium that aligns current available yields, for a given maturity. Banks could buy back their higher-yielding debt, however they would incur an accounting loss based on the market price being above cost.

      Fun fact: When rates on bank debt rise, the banks are permitted to book an accounting profit (since the bonds could in theory be bought back at cheaper prices). Hence, a bank facing concerns over solvency that result in higher yields on its debt will actually report higher profits, ceteris paribus.