Accounting Identities

from Paul Krugman's blog
http://krugman.blogs.nytimes.com/
October 30, 2010, 11:29 am

sThe background to the world economic crisis is that we went through an
extended period of rising debt. Now, one person's liability is another
person's asset, so rising debt made the world as a whole neither richer nor
poorer. It did, however, leave the borrowers increasingly leveraged. And
then came the Minsky moment; suddenly, investors were no longer willing to
roll over, let alone increase, the debts of highly leveraged players. So
these players are being forced to pay down debt.

The process of paying down debt, however, must obey two rules:

1. Those who pay down debt must do so by spending less than their income.
2. For the world as a whole, spending equals income.

It follows that

3. Those who are not being forced to pay down debt must spend more than
their income.

But here's the problem: there's no good mechanism in place to induce those
who can spend more to do so. Low interest rates do encourage spending; but
given the size of the debt shock, even zero rates are nowhere near low
enough.

So since the world economy can't raise the bridge, it is lowering the water:
without sufficient spending from those who can, the only way to make the
accounting identities hold is for incomes to decline - specifically, the
incomes of those not constrained by debt must decline so as to create a
sufficiently large gap between their (unchanged) spending and their incomes
to offset the forced saving of debtors. Of course, the mechanism here is an
overall global slump, so the debtors are squeezed as well, forced into even
more painful cuts.

To avoid all this, we'd need policies to encourage more spending. Fiscal
stimulus on the part of financially strong governments would do it;
quantitative easing can help, but only to the extent that it encourages
spending by the financially sound, and it's a little unclear what the
process there is supposed to be.

Oh, and widespread debt forgiveness (or inflating away some of the debt)
would solve the problem.

But what we actually have is a climate in which it's considered sensible to
demand fiscal austerity from everyone; to reject unconventional monetary
policy as unsound; and of course to denounce any help for debtors as morally
reprehensible. So we're in a world in which Very Serious People demand that
debtors spend less than their income, but that nobody else spend more than
their income.

And the slump goes on.