The Other Half of Macroeconomics and the Fate of Globalization

Richard C. Koo

• Publisher: Wiley
• Year: 2018
• ISBN:
  9781119482161
• Edition: 1
• Topic: Économie
• Subtopic: Macroéconomie

Get a new perspective from the 'other half' of macroeconomics

The failure of the vast majority of economists in government, academia and the private sector to predict either the post-2008 Great Recession or the degree of its severity has raised serious credibility issues for the profession. The repeated failures of central banks and other policymakers in all advanced countries to meet their inflation or growth targets in spite of astronomical monetary easing, have left the public rightfully suspicious of the establishment and its economists.

The Other Half of Macroeconomics and the Fate of Globalization elucidates what was missing in economics all along and what changes are needed to make the profession relevant to the economic challenges of today. Once the other half of macroeconomics is understood both as a post-bubble phenomenon and as a phase of post-industrial economies, it should be possible for policy makers to devise appropriate measures to overcome difficulties advanced countries are facing today such as stagnation and income inequality.

• Shows how it's possible to devise appropriate policy response to slow wage and productivity growth in these economies

• Demonstrates that the effectiveness of monetary and fiscal policy changes as an economy undergoes different stages of development

• Argues that tax rules, regulations and even educational system must be revised to match the need of pursued (by emerging nations) countries

• Explains the 200-year process of economic development and where that process is taking all of us

Inside, Richard C. Koo offers a completely new way of looking at the economic predicament of advanced countries today.

CHAPTER 1
Introduction to the Other Half of Macroeconomics

The discipline of macroeconomics, which was founded in the late 1940s and was based on the assumption that the private sector always seeks to maximize profits, considered in its short history only one of the two phases an actual economy experiences. The largely overlooked other phase, in which the private sector may instead seek to minimize debt, can help explain why economies undergo extended periods of stagnation and why the much‐touted policies of quantitative easing and zero or even negative interest rates have failed to produce the expected results. With sluggish economic and wage growth becoming a pressing issue in many developed countries, it is time for economists to leave their comfort zones and honestly confront the other half of macroeconomics.

The failure of the vast majority of economists in government, academia, and the private sector to predict either the post‐2008 Great Recession or the degree of its severity has raised serious credibility issues for the profession. The widely varying opinions of these “experts” on how this recession should be addressed, together with the repeated failures of central banks and other policymakers to meet inflation or growth targets in spite of truly astronomical levels of monetary accommodation, have left the public rightfully suspicious of the establishment and its economists.

This book seeks to elucidate what was missing in economics all along and what changes are needed to make the profession relevant to the economic challenges of today. Once the other half of macroeconomics is understood both as a post‐bubble phenomenon and as a phase of post‐industrial economies, it should be possible for policymakers to devise appropriate measures to overcome the difficulties faced by advanced countries today, including stagnation and deflation.

Human progress is said to have started when civilizations sprang up in China, Egypt, and Mesopotamia over 5,000 years ago. The Renaissance, which began in Europe in the 13th century, accelerated the search for both a better understanding of the physical world and better forms of government. But for centuries that progress benefited only the fortunate few who had enough to eat and the leisure to ponder worldly affairs. Life for the masses was little better in the 18th century than it was in the 13th century when the Renaissance began. Thomas Piketty noted in his book Capital in the 21^st Century that economic growth was basically at a standstill during this period, averaging only 0.1 percent per year¹.

Today, on the other hand, economic growth is largely taken for granted, and most economists only talk about “getting back to trend” without asking how the trend was established in the first place. To understand how we got from centuries of economic stagnation to where we are today, with economic growth taken for granted, we need to review certain basic facts about the economy and how it operates.

Basic Macroeconomics: One Person’s Expenditure Is Another Person’s Income

One person’s expenditure is another person’s income. It is this unalterable linkage between the expenditures and incomes of millions of thinking and reacting households and businesses that makes the study of the economy both an interesting and a unique undertaking. It is interesting because the interaction between thinking and reacting households and businesses creates a situation where one plus one does not necessarily equal two. For example, if A decides to buy less from B in order to set aside more savings for an uncertain future, B will have less income to buy things from A. That will lower A’s income, which in turn will reduce the amount A can save.

This interaction between expenditure and income also means that, at the national level, if one group is saving money, another group must be doing the opposite—“dis‐saving”—to keep the economy running. In most cases, this dis‐saving takes the form of borrowing by businesses that seek to expand their operations. If everyone is saving and no one is dis‐saving on borrowing, all of those savings will leak out of the economy’s income stream, resulting in less income for all.

For example, if a person with an income of $1,000 decides to spend $900 and save $100, the $900 that is spent becomes someone else’s income and continues circulating in the economy. The $100 that is saved is typically deposited with a financial institution such as a bank, which then lends it to someone else who can make use of it. When that person borrows and spends the $100, total expenditures in the economy amount to $900 plus $100, which is equal to the original income of $1,000, and the economy moves forward.

In a normal economy, this function of matching savers and borrowers is performed by the financial sector, with interest rates moving higher or lower depending on whether there are too many or too few borrowers. If there are too many, interest rates will rise and some will drop out. If there are too few, interest rates will fall and prompt potential borrowers who stayed on the sidelines to step forward.

The government also has two types of policy, known as monetary and fiscal policy, that it can use to help stabilize the economy by matching private‐sector savings and borrowings. The more frequently used is monetary policy, which involves raising or lowering interest rates to assist the matching process. Since an excess of borrowers is usually associated with a strong economy, a higher policy rate might be appropriate to prevent overheating and inflation. Similarly, a shortage of borrowers is usually associated with a weak economy, in which case a lower policy rate might be needed to avert a recession or deflation.

With fiscal policy, the government itself borrows and spends money on such projects as highways, airports, and other social infrastructure. While monetary policy decisions can be made very quickly by the central bank governor and his or her associates, fiscal policy tends to be very cumbersome in a peacetime democracy because elected representatives must come to an agreement on how much to borrow and where to spend the money. Because of the political nature of these decisions and the time it takes to implement them, most recent economic fluctuations were dealt with by central banks using monetary policy.

Two Reasons for Disappearance of Borrowers

Now that we have covered the basics, consider an economy in which everyone wants to save but no one wants to borrow, even at near‐zero interest rates. There are at least two sets of circumstances where such a situation might arise.

The first is one in which private‐sector businesses cannot find investment opportunities that will pay for themselves. The private sector will only borrow money if it believes it can pay back the debt with interest. And there is no guarantee that such opportunities will always be available. Indeed, the emergence of such opportunities depends very much on scientific discoveries and technological innovations, both of which are highly irregular and difficult to predict.

In open economies, businesses may also find that overseas investment opportunities are more attractive than those available at home. If the return on capital is higher in emerging markets, for example, pressure from shareholders will force businesses to invest more abroad while reducing borrowings and investments at home. In modern globalized economies, this pressure from shareholders to invest where the return on capital is highest may play a greater role than any technological breakthroughs, or lack thereof, in the decision as to whether to borrow and invest at home.

In the second set of circumstances, private‐sector borrowers have sustained huge losses and are forced to rebuild savings or pay down debt to restore their financial health. Such a situation may arise following the collapse of a nationwide asset price bubble in which a substantial part of the private sector participated with borrowed money. The collapse of the bubble leaves borrowers with huge liabilities but no assets to show for the debt. Facing a huge debt overhang, these borrowers have no choice but to pay down debt or increase savings in order to restore their balance sheets, regardless of the level of interest rates.

Even when the economy is doing well, there will always be businesses that experience financial difficulties or go bankrupt because of poor business decisions. But the number of such businesses explodes after a nationwide asset bubble bursts.

For businesses, negative equity or insolvency implies the potential loss of access to all forms of financing, including trade credit. In the worst case, all transactions must be settled in cash, since no supplier or creditor wants to extend credit to an entity that may seek bankruptcy protection at any time. Many banks and other depository institutions are also prohibited by government regulations from extending or rolling over loans to insolvent borrowers in order to safeguard depositors’ money. For households, negative equity means savings they thought they had for retirement or a rainy day are no longer there. Both businesses and households will respond to these life‐threatening conditions by focusing on restoring their financial health—regardless of the level of interest rates—until their survival is no longer at stake.

What happens when borrowers disappear for either or both of the above reasons? If there are no borrowers for the $100 in savings in the above example, even at zero interest rates, total expenditures in the economy will drop to $900, while the saved $100 remains unborrowed in financial institutions or under mattresses. The economy has effectively shrunk by 10 percent, from $1,000 to $900. That $900 now becomes someone else’s income. If that person decides to save 10 percent and there are still no borrowers, only $810 will be spent, causing the economy to contract to $810. This cycle will repeat, and the economy will shrink to $730, if borrowers remain on the sidelines. This process of contraction is called a “deflationary spiral.”

The $100 that remains in the financial sector could still be invested in various asset classes. It could even create mini‐bubbles in certain asset classes from time to time. But without borrowers in the real economy, it will never be able to leave the financial sector and support transactions that add to GDP (changes in ownership of assets do not add to GDP).

The deflationary process described above does not continue forever, since the savings‐driven leakages from the income stream end once people become too poor to save. For example, if a person cannot save any money on an income of $500, the entire $500 will naturally be spent....