[Modern Heterodox Thoughts] Why Does It Become Insufficient? — 1. The Mechanism of Balance Sheet Recession

Abstract:
The term "balance sheet recession" once garnered attention as a concept to explain the long-term stagnation of the Japanese economy. Richard Koo used this concept to explain a situation where, after the bubble burst, companies prioritized debt minimization over profit maximization, and investment failed to recover even with monetary easing.

In this paper, I reinterpret this argument through the distinctions of macro/micro, stock/flow, and aggregate/distribution. To state the conclusion first, precisely because private entities act defensively by looking at their stocks, the state must look at the flows. The role of the state is not to take over the private sector's balance sheets, but to keep the economic circulation from stopping, to observe where the clogging occurs, and to maintain a state where learning is possible.

Introduction: What the term "balance sheet recession" was looking at

In a normal recession, if interest rates are lowered, companies increase borrowing, make investments, and the economy heads toward recovery. However, in post-bubble Japan, even when interest rates were lowered, companies did not try to borrow. Instead, they repaid debts, accumulated cash, and suppressed investment. Koo called this phenomenon a "balance sheet recession."

The importance of this perspective lies in the fact that it showed that the subject model of "if you lower interest rates, they will borrow" does not hold after a crisis. In a state where asset prices have fallen and only debts remain, a company's top priority becomes survival, not growth.

However, if one only says "companies do not invest because their balance sheets are damaged," it is close to saying "there is no growth because there is no investment." Or, it may appear as if it is merely rephrasing the general theory that "they do not invest because of anxiety about the future" using accounting terminology.

Therefore, in this paper, I will consider what a balance sheet indicates and what the limitations are in viewing the private sector as a single entity.

1. Koo's Argument — From Profit Maximization to Debt Minimization

A normal company is understood as an entity aiming for profit maximization. If profits are expected to be gained through investment, the company will borrow, invest in equipment, and expand production. Therefore, lowering interest rates encourages investment.

However, this premise collapses after the bubble bursts. When asset prices plummet, asset values drop, but debts remain as they are. Consequently, companies prioritize debt repayment over new investment.

Here, the company's behavioral principle changes. A company in normal times is a profit-maximizing entity. However, a company after a crisis becomes a debt-minimizing entity. A balance sheet recession is a state where a company has changed from an "entity that borrows and invests" to an "entity that repays and protects."

As a result, monetary policy becomes less effective. No matter how much funds the central bank supplies, investment will not increase if there are no borrowers. Therefore, Koo thinks that if the private sector does not borrow, the government must borrow. If the private sector reduces spending, the entire economy will shrink unless that hole is filled by government spending.

2. What does it mean to look at a balance sheet?

An income statement shows sales, expenses, and profits over a certain period. This is a flow. In contrast, a balance sheet shows the state of assets, liabilities, and net assets at a certain point in time. This is a stock.

In normal business cycle theory, it is easy to focus on flows such as current-term sales, profits, investment, income, and GDP. However, companies do not live on flows alone. Even if they are currently in the black, if the debts accumulated in the past are heavy, they cannot invest freely.

The significance of Koo's argument lies in emphasizing this point. A balance sheet recession is not just a story of "corporate psychology having deteriorated." It is a story of how debts accumulated in the past and the decline in asset prices constrain current actions.

In other words, a balance sheet is a place where past history is converted into current actions. Up to this point, Koo's argument is valid. The problem starts from here.

3. Is the "private sector balance sheet" really one thing?

In Koo's argument, the "private sector" is often treated as if it were a single entity. The private sector damaged its balance sheet. The private sector stopped borrowing. Therefore, the government needs to take on the deficit.

This aggregation is effective for thinking about the macroeconomy. However, the uneven distribution within the private sector becomes harder to see. The balance sheets of actual companies are not uniform. There are companies with abundant funds, and there are companies struggling with cash flow. There are companies that have funds but cannot find investment opportunities, and there are companies that have room for growth but have difficulty raising funds.

In other words, the problem is not just the total amount. If viewed as the private sector as a whole, there might be funds. However, it is not necessarily the case that the entity holding those funds and the entity holding investment opportunities are the same.

Companies with funds have no investment opportunities. Companies with investment opportunities have no funds. Banks have funds but cannot take risks. Households have deposits but do not spend them.

In this state, it is insufficient to just say "the private sector's balance sheet is damaged." The problem is not the soundness of the private sector as a whole, but the disconnection between funds and investment opportunities. Therefore, a balance sheet recession should be reinterpreted as a state where funds, debts, risks, and investment opportunities are unevenly distributed within the private sector and are no longer connected well.

4. Is the problem "insufficient aggregate" or "clogging"?

Considering Japan's long-term stagnation, companies are accumulating internal reserves, households are holding deposits, banks have funds, and interest rates are low. Yet, the question arises: is there any point in supplying even more money?

This is the so-called "pushing on a string" problem. Even if the central bank supplies funds and lowers interest rates, investment will not increase if borrowers do not try to borrow.

However, is the problem really an insufficient aggregate? Or is it a clogging of the flow?

An insufficient aggregate is a state where funds and demand are lacking in the entire economy. In this case, it makes sense to increase the aggregate through government spending or monetary easing. But clogging is a state where things that exist as an aggregate are not flowing to the necessary places. In this case, simply increasing the aggregate is not enough.

Even with the same one trillion yen in spending, the meaning differs depending on whether it is used for the life-extension of existing companies, leads to investment in new industries, supports household income, or encourages research and development. What is important is not just how much is flowing, but where it is flowing.

5. The reason why aggregate policy is still necessary

However, one should not conclude that "aggregate policy is meaningless because clogging is the problem."

Aggregate policy has the meaning of making it possible to observe where the clogging is by causing circulation. In a state where the economy is stagnant, it is difficult to see where investment opportunities are, which industries will react, and which systems are bottlenecks.

You cannot know which pipe is clogged unless you try running water through it.

In this sense, the government increasing the aggregate is not just filling a demand hole. It is also about putting pressure on the economic circuit to create conditions for observing where things move and where they do not.

Of course, if the way of spending is mistaken, there is a possibility of strengthening the existing stagnant structure. Even so, if the circulation itself stops, learning cannot happen either. Economic policy is less a problem of "choosing the right policy" and more a process of executing, observing reactions, correcting, and trying again.

The meaning of aggregate policy lies in maintaining this movement. If Koo's argument is reinterpreted in this way, it can be positioned as a policy to prevent the collapse of flows and leave behind the possibility of future learning when the private sector enters stock defense.

6. Why are policy effects hard to see?

Even if the government increases the aggregate and creates a flow in the economy, it is difficult to identify what that policy really brought about.

If the economy has recovered, is it the effect of fiscal spending? The effect of monetary easing? An increase in overseas demand? The influence of exchange rates? Technological innovation? A change in the labor share? Or is it just a business cycle?

In the real economy, these factors move simultaneously. Moreover, while executing policies, technology, international situations, resource prices, and population structures also change. In other words, economic policy is not an intervention into a fixed object, but an intervention into an object that keeps changing.

Because of this indistinguishability, economic debates are hard to end. Even for the same phenomenon, the interpretation changes depending on the position. Success is misidentified, and failure is also misidentified.

That is precisely why policy needs to be grasped as continuous exploration and learning, not as a one-time implementation of the correct answer. The state is not an entity that knows the correct answer. It is an entity that prepares the conditions for continuing trial and error.

7. The private sector looks at stocks. Therefore, the state looks at flows

A balance sheet recession is a state where private entities have come to look at stocks and act defensively. Companies look at assets, liabilities, cash on hand, and repayment capacity. Households accumulate deposits amidst income anxiety. Financial institutions avoid risks.

This is rational as an individual entity. If a company goes bankrupt, it is over. If a household's life collapses, it is over. If a financial institution holds non-performing loans, it falls into crisis. Therefore, it is natural for each to look at their own balance sheet and act defensively.

The problem is that it creates a cessation of circulation as a whole. If all companies refrain from investment, all households refrain from consumption, and all financial institutions avoid risks, someone's spending decreases, someone's income decreases, and the entire economy shrinks.

Here, the role of the state arises. However, that role is not simply to take over the private sector's balance sheet. What the state should look at is not the average balance sheet of the entire private sector, but where the economic flow is stopping. There is a paradox here.

The private sector has the rationality to look at the balance sheet.
That is precisely why the state must not look only at the balance sheet.

The flow that the state should look at is not just GDP. Is income flowing? Is investment happening? Are funds reaching growth areas? Is human talent moving? Are companies challenging, failing, and being reallocated? Is capital not stagnating and reaching the necessary places?

Of course, the state also has stock constraints such as fiscal deficits, government debt, currency credibility, inflation, balance of payments, and political support. However, the state is an institution that has the power of taxation, a currency system, and continues across generations. That is precisely why it bears the role of maintaining flows on a longer time axis than the private sector.

The state cannot perfectly grasp everything at the micro level. That is precisely why it must not stop the flow. If there is no flow, it cannot be observed. If it cannot be observed, it cannot be learned. If it cannot be learned, it cannot be corrected. The state is not an "entity that implements the correct answer," but an "entity that keeps learning going."

Conclusion: From balance sheet recession to "economics of circulation"

The concept of a balance sheet recession held great significance in explaining the Japanese economy after the bubble burst. Companies shift from profit maximization to debt minimization. Even with monetary easing, there are no borrowers. If the private sector attempts to achieve a surplus, the government must take on the deficit, or the entire economy will shrink.

However, that alone is not enough.
When we speak of the "private sector balance sheet," it includes countless companies, households, and financial institutions. What appears healthy at the macro level may be unevenly distributed at the micro level. Even if it seems sufficient in total volume, it may not be reaching the places where it is needed.

Therefore, the problem must be understood not merely as a shortage of total volume, but as a clogging of circulation. While it is meaningful for the government to increase the total volume, it is not simply about piling up money. It is about creating the conditions to maintain the flow of the economy and to observe where things are moving, where they have stopped, and where funds are failing to reach.

The private sector looks at stocks.
The state looks at flows.

This division of roles is the conclusion that emerges once we reinterpret the balance sheet recession.

And this perspective is not limited to finance. Something may exist in total volume, yet fail to reach the places where it is needed. Even if it appears sufficient as a whole, shortages occur locally. Such structures also appear in issues of logistics and resource supply.