Posted by: Dirk | September 6, 2010

Balance sheet recessions and income inequality

Almost two years ago, I asked: “Does high income inequality lead to (Great) depressions via stock market bubbles?”. I followed up on this in May this year, thinking about money as a means of payment versus money as a store of value.

Now Paul Krugman reminds me of another twist. Think of a balance sheet recession as the normal recession that comes around and goes around every 8 years on average. As long as you have a large middle class, there is no problem with falling wealth. Some people are not as rich as they tought, but hey, they are still lower middle class, own a house and have a decent job. No need to worry – these people will continue to consume. And if the central bank lowers the interest rate just a bit towards zero, then there will be no liquidity constraint either.

Some decades later the middle class has eroded, and there are more rich and more poor people. The same kind of balance sheet recession will again leave some people poorer. However, the relatively poor people lose their house and don’t own much besides. They will not get credit from the banking system, and they are out of a job. They would like to consume, but since nobody is willing to lend to them, these people will not make their demand effective. We are in an under-employment equilibrium where some people would like to buy stuff, but can’t.

The strange thing is: if they would be able to borrow the money, they would demand goods and services which would create jobs – and if these jobs are filled by the relatively poor people than they are able to repay the loans that created the demand which created the jobs. It would probably also inflate the economy a bit, which is good: the threat of (debt-)deflation is real, and some inflationary impulse should not spiral out of control since there are lots of production factors which are idle right now. Among them, millions of workers.

An increase in demand is more likely to lead to an increase in supply than in a rise in prices. However, if firms are rebuilding their balance sheet by maximizing cash flow and not profits, this might not be the case. Which, ultimately, would be an argument for intervention and an increase in government spending, which would, by the way, create growth and no insolvable long-run debt burden.

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