Tuesday, December 13, 2011

Balance Sheet Recessions

A balance sheet recession occurs when some major asset class valuations collapse. The US experienced a balance sheet recession beginning in 1929 when the stock market tanked. Japan experienced one in 1990 when its real estate market collapsed. The US, and then most of the world, experienced one in 2008 when the US housing bubble burst. Recessions centered around the collapse in personal and corporate wealth are very different from a "normal" inventory/business cycle recession. In the one, both the consumer and business have been badly burned, and they are not willing to borrow for new spending or investments. In the other, borrowing and spending pick up soon after businesses begin rebuilding inventories, and money is moving back into the economy.

Why does this matter? A balance sheet recession requires a very different policy response than a normal business cycle downturn. Specifically, government spending must replace private spending, until both households and companies have repaired their balance sheets and are willing to invest/borrow/spend again. During the Depression, it took 12 years and a World War to pull the US out. In Japan, the deleveraging took 16 years. There is no reason to think the US will get by with a fast turnaround, especially when the fiscal hawks are committed to austerity and budget cutting. The lesson, as outlined by Richard Koo in The Holy Grail of Maroeconomics: Lessons from Japan's Great Recession, is that the government must be willing to step into the private sector's place, while households and companies deleverage, and deficit spend to support employment and economic growth. Let's take a look:

First let's look at a comparison between our housing price collapse and Japan's:

From Richard Koo's recent paper

Obviously very similar patterns of asset collapse. And here is what followed:

From Richard Koo

Sixteen years of deleveraging. But because the government was most of the time willing to deficit spend, to replace the missing private demand, GDP still grew. Two times, in 1996 and 2001, the fiscal hawks won the day: spending was cut back, recessions ensued, and deficits actually increased.

From Richard Koo

You can see that the two times the GDP line turned down (before 2008) were in 1996 and 2001, when government spending was cut. But why isn't all this deficit spending inflationary? Take a look at this chart:

From Richard Koo

Although there were huge injections of liquidity in the form of monetary reserves injected into the system, banks didn't lend because no one wanted to borrow - the same problem we are facing now in the US. The slow upward movement in M2 (Monetary base plus demand deposits and some time deposits) was based on government borrowing and deficit spending. And inflation was consistently nil. Although not shown, interest rates on long governments remained well under 2% for the duration.

To summarize:

     1. Balance sheet recessions - those that occur when an entire asset class blows up - are different animals, and we do not have much experience with them: the Depression, Japan from 1990 to 2007, and the US now.

     2. When personal wealth is destroyed in a tsunami-type unraveling, both consumers and companies retrench big time. 12 years and a war for the US in the Depression. 16 years of deleveraging for Japan.

     3. The government must step in and replace private spending. This happened with the New Deal replacing Hoover's fiscal discipline approach in 1933 and continued through 1937, when the hawks won the political day, and the cuts in government spending dipped the US back into deep recession. In Japan, the government was very patient. The hawks intervened twice with austerity reform moves. Each time the economy quickly moved into recession.

     4. The hawks are simply wrong, and dangerously so. There is NO risk of inflation. There is also no risk that government bond rates will run away to high levels. There is, however, a HUGE risk that the hawks will not allow the necessary spending by the government to keep us moving forward.

I dearly hope we can learn from Japan. But I am not so sure.

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