Europe, UK and the US are all currently mired in a Balance Sheet Recession (BSR). A term for the current “rare disease” the global economy is suffering from coined by Richard Koo in his seminal book “The Holy Grail of Macroeconomics” where he provides a blueprint for our current malaise and provides what I think is the most comprehensive solution to date. This is my attempt to use his template, laid out in the book, to look at our world today. I am not an economist, for that I am grateful, but if I’m wrong on anything please do correct me!
The length of time it takes for the various countries to emerge from their BSR will depend on the policy responses enacted in each economic zone. One precedent is provided by the Great Depression where it took 30 years, from 1929 to 1959 before interest rates returned to their average level of the 1920s. These are once in a generation events and we have never had one affecting such a large bloc of Global GDP simultaneously.
“Recessions are typically characterized by inventory cycles — 80% of the decline in GDP is typically due to the de-stocking in the manufacturing sector. Traditional policy stimulus almost always works to absorb the excess by stimulating domestic demand. Depressions often are marked by balance sheet compression and deleveraging: debt elimination, asset liquidation and rising savings rates. When the credit expansion reaches bubble proportions, the distance to the mean is longer and deeper.” David Rosenberg
What is a Balance Sheet Recession?
“To understand the Great Depression was the Holy Grail of Macroeconomics” Ben Bernanke
A Balance Sheet Recession comes to pass when a plunge in asset prices damages private sector balance sheets so badly as to bring about a shift in the mindset and priorities of the asset owners; from profit maximisation to debt minimisation; and from forward looking to backward looking. When the value of assets like equities and real estate falls but the loans used to purchase them remain, borrowers find themselves with a negative net worth and in a struggle to survive.
As with the asset bubbles that precede them, Balance Sheet Recessions are rare and prolonged events. When they do happen, they render useless the standard economic policy responses taught in universities and practiced by Investment Bankers and Central Bankers globally.
In Japan, as today in the US, UK and Europe, we have a situation where many corporate and personal balance sheets are underwater but “core operations” for most companies and families remain reasonably robust – profits are healthy and cash flow/incomes are solid. In this situation, any rational actor will commit themselves to diligently repaying their debt and adding low risk assets to repair their balance sheet as quickly as possible.
A nationwide plunge in asset prices eviscerates the asset side of the balance sheet but leaves the liabilities intact. The entire economy experiences a “fallacy of composition” which means an action that is most appropriate for each individual becomes ruinous if everyone engages in it at once. In this example, we mean repairing balance sheets.
Koo’s example is as follows – a household earns $1,000 and spends $900, saving $100. The $900 spent becomes someone else’s income and circulates in the economy, the $100 goes to a bank where it is then lent out to individuals or corporates which would then spend or invest it, circulating it back into the economy. Therefore spending and savings both continue to circulate – keeping the $1,000 “in play”. If there are no willing borrowers for the $100 then the banks will lower the interest rate they charge until the demand is created.
But in Japan and in the Great Depression, and to some extent now, there is no demand for the $100 despite interest rates at 300 year lows.
The $100 just sits in the bank being neither borrowed nor spent. Only $900 is spent in the economy and the next household receives only that $900 of which it saves 10% to the bank, which again cannot lend that $90 because there is no loan demand so it stays as reserves. The next household receives only $810 in income and so on. This is a deflationary spiral which would serve only to exacerbate falls in asset prices making balance sheets worse rather than better.
Add to this simple model the additional problem of corporates also in balance sheet repair mode and you have an idea of the problem faced. The economy loses demand equivalent to the sum of net household savings and net corporate debt repayment each year.
This is exactly what happened in the Great Depression taking Gross National Product down by almost 50% in 4 years.
According to Koo, the only solution for this problem is for sustained fiscal policy support via direct government borrowing and spending on real projects to keep the economy afloat whilst private sector balance sheets are fully repaired.
How do we know we are in a Balance Sheet Recession?
- Private Sector is Paying Down Debt
- Monetary Policy is Impotent
- Quantitative Easing Doesn’t Work
- Silent and Invisible
- Debt Rejection Syndrome
1. Private Sector is Paying Down Debt
Now, as in Japan, it was argued by many that the banking sector was primarily responsible for the recession. It is believed that a struggling banking sector is choking off the flow of money to the economy – we see this in politicians jawboning about “forcing banks to lend to businesses so they can invest” and so on.
For a company in need of funds the closest substitute to a bank loan is corporate bond issuance. Any company that wants to borrow but can’t because the “banks won’t lend” should, in theory, be able to issue bonds on the market. So do the numbers bear out this idea that firms have been going to the market for funding? Not really….Good data was hard for me to find as much of it is polluted by huge government issuance and therefore doesn’t reflect private sector demand – but this is what I got.
Global bond issuance totalled $1.8 trillion in the first quarter of 2011, down 4% on the same period in the previous year.
Issuance by non-financial corporations in 2010 overtook that by financial institutions for the first time since financial sector issuance started to grow in the early 1990s. The $925bn issued by non-financial institutions in 2010 was down from $1,080bn in the previous year. Issuance from financial institutions declined more quickly during the year from $1,487bn to $576bn. All shrinking.
This says to me that corporate demand is at best tepid, especially relative to the bumper years in the mid 2000s. What makes this even more remarkable is that this is the face of ZIRP! These companies can borrow for costs so low they couldn’t have dreamt of them just a few years ago, and yet they still can’t be coerced.
It should be noted that even though the balance sheet recession started in 1989, it wasn’t until 1994/5 that the actual borrowing numbers turned negative – therefore the marginally positive numbers we seeing in the BIS numbers are in keeping with the Japanese roadmap.
Another interesting point made by Koo regarding Japan was that if the zombie banks were the problem, then surely the foreign banks who were willing to lend would have been able to swoop in and hoover up market share. They didn’t. This could be extended to today’s recession where we havn’t seen the “healthier” banks like Standard Chartered and HSBC stealing massive share of the personal and corporate lending markets. Maybe the problem isn’t banks not wanting to lend after all!
Neoclassical theory always assumes that the private sector is attempting to maximise profits. Koo’s theory instead imagines that there are certain circumstances, when their balance sheets are so badly damaged by a decline in asset values, private sector companies will respond by giving primacy to debt minimization.
The standard response from most economists to this recession has been to call for more and more monetary easing in the form of Quantiative Easing and lower and lower interest rates. What this diagnosis completely omits to do is consider whether there is in fact any demand for funds from the private sector.
A recession as prolonged and pronounced as the one we are currently in can only be compared with Japan since 1989 and the Great Depression. Unfortunately, the sample size is small because this “condition” is extremely rare.
Japanese companies have spent the last 15 years paying down debt at a time when interest rates are at zero. From the perspective of an IMF economist, Treasury Policy advisor or a investment bank economist, this makes no sense. As loan rates fall, demand for loans is not increasing. This is madness!
If you are profit maximising, as the private sector is always assumed to be, then the only reason you would pay down debt at zero interest rates is if you have no possibility of making a positive return on your investments – if that’s the case, are you a going concern?
What this persistent paying down of debt in the face of their education and economist’s expectations demonstrates is that the private sector no longer has “profit maximisation” as its main goal – now the goal is debt minimisation. It’s a massive, secular swing in mindset.
Loans to private businesses in Europe grew at just a 1.7% rate in November, a plunge from October’s 2.7% and missing expectations of 2.6% by a wide margin. Corporate credit is being turned off. This has happened even as the ECB’s balance sheet has risen from EUR 1.9 trillion to EUR 2.7 trillion in 6 months is truly remarkable.
Reuters said “Loans to private sector firms in the euro zone fell in November while growth in lending to households slowed, European Central Bank data showed on Thursday, adding to the case for an interest rate cut. The drop in funding to companies increased fears that the region faces a looming credit crunch, an issue of growing concern for the ECB as the worsening sovereign crisis makes firms and households increasingly wary about taking on debt, weighing on the economic outlook.
In an attempt to kick-start loan activity, the 17-country bloc’s central bank conducted last week its first-ever three-year funding operation, which saw banks take up almost half a trillion Euros.”
2. Monetary Policy is Impotent
Governments are supposed to manage economies with monetary and fiscal policy but one of the key characteristics of these rare balance sheet recessions is that monetary policy becomes useless. The Bank of Japan kept interest rates at near zero from 1995 to 2005 but yet the economy did not recover and stock markets did not rally.
The reason for this is one of the key assumptions of monetary policy is not applicable in a balance sheet recession. The assumption that the private sector always has willing borrowers that will respond to a change in the price of credit. Lower interest rates and the number of borrowers will increase and economic activity will pick up. When there are no borrowers the bank is powerless.
As explained above, if the mechanism of recycling savings back into the economy is broken then the government must do something to stop the vicious cycle. The government must do the opposite of the private sector, it must borrow and spend/invest the savings that the private sector is no long demanding to use as loans (the $100 in our example.).
Japan has avoided depression like conditions because the government has, on the whole, borrowed and spent what the private sector would not have. When the private sector is paying down debt, only public sector borrowing and spending can prevent a contraction.
When firms and households are minimizing debt the government is the only net borrower left in the economy and therefore the money supply will contract unless fiscal policy is expansionary.
3. Quantitative Easing Doesn’t Work
Because today’s economists are all trained to think the same way, to assume private sector profit maximisation, they assume that if interest rates are low enough then they will borrow and invest. This clearly isn’t happening. In today’s world we keep hearing that corporate balance sheets are awash with cash (no-one ever mentions the liabilities on the other side.) but this is a reflection of fear and uncertainty on the part of company management – they are not investing and they are certainly not borrowing to invest.
“Imagine a patient who takes a drug prescribed by her doctor but does not react as the doctor expected, and more importantly does not get better. When she reports back, he tells her to double the dosage, but this does not help either. So he orders her to take four times, eight times, and finally a hundred times the original dosage. All to no avail. Any normal human being would come to the conclusion that the original diagnosis was wrong and the patients suffered from a different disease.” Page 74
4. Silent & Invisible
No-one wants to talk about a BSR. Those with the closest knowledge of the situation are incentivised to keep quiet about it. Corporate CEOs and indebted households do not want to draw attention to their underwater balance sheets because this might make their situation worse as investors or creditors attempt to call in loans and bring a slow burning situation to a resolution.
On the other side, banks do not want to draw attention to their decimated loan books, their technically insolvent borrowers or mortgages that are in negative equity. If the payments are being met and the borrowers remain cash flow positive then both parties can “mark to make believe” and “extend & pretend”. Of course ZIRP helps ease this process too.
5. Debt Rejection Syndrome
The generation that survived the Depression has a reputation for a life time of debt repudiation. Those who have been indebted and then suffered through years of hard work to repair their balance sheets are left with a revulsion of debt even after their balance sheets have been returned to health. I believe it will take a great deal of time before the Anglo Saxon economies become as comfortable with debt, especially debt used for consumption, as they were in the last few years.
How do we fix The Balance Sheet Recession and why?
“That’s all it takes, really. Pressure, and time.” Red in Shawshank Redemption
Time, low interest rates and not having to mark assets to market help, but the economy needs more support than these things which are usually enough to restore a cyclical recession to growth.
Japan’s Great Recession has given us a roadmap for how a post bubble economy can have a prolonged workout phase and render most policy tools ineffective.
Japanese GDP stayed above bubble peak levels despite plunging corporate demand and a loss of national wealth of around 85% on asset and equity prices.
Here we have to imagine the counter-factual, which is never easy. The fact that GDP grew in the face of such precipitous asset declines may be viewed as a success. Koo says
“In a Hollywood world, the hero is the one who saves hundreds of lives after the crisis has erupted and thousands have died.
But if a wise individual recognizes the danger in advance and successfully acts to avert the calamity, there is no story, no hero and no movie…..Japan successfully avoided economic apocalypse for fifteen years. But from the perspective of the media, which has never grasped the essence of the problem, the government spent 140 trillion yen and nothing happened. So they twisted the story to imply the government wasted the money.”
So Koo is saying it was only because the government engaged in fiscal stimulus to the extent that it did that stopped a collapse in Japan’s GDP and in its standard of living. Imagine if the S&P 500 or FTSE 100 fell 80% from its current level over the next 15 years and the average home price was circa $20,000 – do you think we’d have had positive GDP growth!?
If this is the case, and the Japanese government more or less did a great job, then does that mean that a Japanese scenario is close to our best case scenario too? A scary thought indeed.
“A balance sheet recession is characterised by a deflationary gap equal to household savings plus net corporate debt repayment.” page 67
The United States Sectoral Balances
Now the United Kingdom
In the simplest of terms, the green line, the Government, needs to spend enough/ run a large enough deficit, to offset the surpluses being run by the Corporates (blue line) and the Households (red line). If they do not offset, then the economy will contract.
The problem is a chronic shortage of demand which Government needs to fill for GDP to be sustained at its current level. From this perspective, tax cuts are less effective than direct spending via New Deal-esque projects, because tax cuts are going to be partially saved by the newly conservative private sector. Robert Shiller of Yale has been advocating these “make work” schemes for some time now as a solution to structural unemployment and skill-wastage amongst much of the under utilised labour force in the US.
This theory sits very uncomfortably with me as a right leaning conservative. Koo even goes as far as to suggest that what the money is spent on is less important than the fact that it is being spent! There is no shortage of need however in the developed world. Roads, Schools, technology infrastructure, high speed rail etc could all be upgraded and would enhance our potential productive ability. How about some spending on making the US Energy Independent so they can stop going to war in the Middle East?
Fiscal Policy – The Success of the New Deal
The chart below shows the impact that the New Deal had on the United States when enacted in 1933. Fiscal expenditure increased by 125% which caused a sharp increase in economic activity which brought the unemployment rate crashing down and increased tax revenues. Remarkably, due to the pick up in economic activity, the increased government spending did not increase the budget deficit.
Bizarrely, the economic consensus is that the New Deal did not succeed and that government spending made an insignificant contribution to the recovery from 1933 to 1936 (its interesting in 1937 the minute expenditures were reigned in a little U/E went up, industrial output fell 33% and equity markets fell 50%).
As Koo points out “It is estimated 25 million people were employed directly or indirectly by these (New Deal) projects. To argue that they had no impact on the US GNP seems preposterous.”page 116.
The Confidence Multiplier
Shiller & Akerlof unveiled this concept in their book Animal Spirits.
“We speak of the basic problem as having to do with what we call a “confidence multiplier”, which refers to a sort of social epidemic behaviour. The conventional Keynesian multiplier is supposed to amplify a stimulus package through multiple rounds of expenditure when consumers or businesses automatically spend their extra income. The confidence multiplier works through the effects of the stimulus, and of subsequent rounds of expenditure, on confidence. The latter is more uncertain and context dependent.
These other considerations highlight the difficulties that governments will have in changing this wait-and-see behaviour (current poor sentiment/debt minimisation), and suggest different concerns about just how to structure a stimulus package. Different kinds of stimulus have different effects on confidence, depending on how they are viewed and interpreted by the public. The focus has to get off of “what fraction of this stimulus will be spent” to “how does this stimulus affect confidence”.
Clearly confidence is historically low and therefore the positive feedback loop that economic confidence engenders is weak. I think much of this lack of confidence stems from a lack of certainty – over jobs, housing, tax codes, policy, everything. No-one wants to play if the rules of the game will be changed half way. Provide certainty and we have a base for confidence. I believe a “New Deal” type fiscal package, commitments to sustained low rates and probably some tax code reform including incentives for corporates to repatriate offshore funds would all go a long way to providing certainty and fostering confidence.
How to Finance Hundreds of Billions of Fiscal Stimulus?
The bond vigilantes have probably stopped reading by now and my membership at ZeroHedge has no doubt been rescinded. The US, UK and Europe are low savings nations relative to where the US was in the 30’s and Japan in the 90’s. However, the answer is actually right in front of us. Because the Private Sector is deleveraging the net household savings and corporate debt repayments are not being re-lent to the private sector, they can easily be used to mop up new issuance of bonds from the governments. The government can borrow the $100 left over from our earlier example and spend it instead of the private sector.
Furthermore, the banking sector is also mired in a BSR with capital constraints, they will happily buy government bonds and earn a small spread because it lowers the risk of their balance sheet and requires little capital set aside against it. This has been happening for 18 years in Japan and 3 years in the US, UK and Germany.
Koo adds a further insight….
“The low yields on government debt are also the market’s way of telling the government that if there is anything to be done with taxpayer’s money, now is the time to do it…The market is imploring governments to undertake such projects NOW for the sake of both the economy and taxpayers.” Page 267
Why can’t we have inflation?
Quantitative Easing improves the liquidity sloshing around the banking system, it does not improve the solvency of the institutions.
Look at the chart below showing the effect of Fed QE on the Monetary Base.
This is the inflationary risk and it is huge. However, if there are no borrowers then this “money” sits in the banks as excess reserves and poses no inflationary threat. As long as there are no borrowers, no amount of QE will generate inflation. Unless private sector behaviour and preferences switch back to profit maximisation there will be no inflation.
The banks have no use for these funds, as they cannot lend it to the private sector, and so they must buy bonds issued by the central bank as they are the only willing borrower.
Koo postulates the only inflation the central banks can generate is the obviously undesirable hyperinflation, not moderate inflation.
“Although a central bank can always generate hyperinflation by acting so as to lose the public’s trust, its ability to induce modest inflation depends on whether private businesses are in profit maximisation mode or not.” Page 137
Again, we come back to the chart above, without borrowers of the excess reserves, there can be no credit growth and no inflation.
“The failure of the Bank of Japan’s five year experiment with QE to generate either inflation or growth in the money supply is proof that trust in the central bank remains intact. As long as it does, nothing will happen to inflation, because people have no reason to abandon the correct and responsible course of paying down debt.” Page 137
QE Related Price Boosts
Investors become much more focused on dividends and DCF as a guage of value after a bubble collapse. It seems unlikely that they will view price rises brought about by central bank asset purchases as anything more than transient unless they are certain the price is backed by future cash flows. This means there is not likely to be any inflationary consequences to these asset price increases.
“Central Bank purchases of government debt invariably imply an injection of reserves into the banking system. Even though additional reserves will have no inflationary consequences as long as there is no demand for funds from the private sector, once demand returns, the central bank will face the risk of a massive credit expansion based on excess reserves already present in the system.” Page 138
Central Bank purchases of debt do not create inflation. The resumption of borrowing/spending/investing by a private sector borrowing from a banking sector awash with liquidity does.
“Money is distilled work” Little House on the Prairie
Helicopter Money is a cure that is significantly worse than the disease. Because fiat money is no longer backed by gold and instead only by faith in central banks it must be treated carefully. When Bernanke threatens to drop money out of Helicopters he only thinks of the demand side of the equation, people would pick up the money and go spend it. However, he overlooks the fact that any rational shopkeeper upon seeing this would automatically close their stores as they have no way of knowing the value of the money they are receiving. The economy would collapse to barter.
The Differences between today and Japan/Great Depression?
Cultural Differences have nothing to do with the BSR – “The Japanese have a different mentality” is not a relevant argument. It is the nationwide (or global in 2008) collapse in asset prices that wrecks individual and corporate balance sheets that trigger these rare and prolonged slumps.
The US and Japan could export their way out of theirs – we no longer have this luxury. The economic bloc’s currently experiencing the global balance sheet recession are the largest consumers in the world and are too big to viably export their way out of trouble.
Both The Depression and Japan’s Recession were at a time where they were demographically much better placed to recover than the developed world currently is.
We are conducting a live experiment on the patient currently – the US seems to be taking something more akin to Koo’s recommended path, promising austerity tomorrow but remaining accommodative today (extension of unemployment benefits, tax cuts etc). Elsewhere the UK and Europe are going the route of the hard money, Austrian economists and enacting austerity, or at least making plans to enact austerity imminently.
Interestingly, since the two political paths started to diverge, when the Coalition won the election in the UK we can see that the US has started to decouple from its two peers and some are arguing that it will enjoy growth next year as the other two totter on the edge of a recession.
If that is the case, then it’s 1-0 to the Balance Sheet Recession diagnosis.
Read the book!