Go to ... Page 1 | Page 2 | Page 3 | Page 4 | Page 5 |

The Sit­u­a­tion

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?

1. Pri­vate Sec­tor is Pay­ing Down Debt
2. Mon­e­tary Pol­icy is Impotent
3. Quan­ti­ta­tive Eas­ing Doesn’t Work
4. Silent and Invisible
5. 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.

Go to ... Page 1 | Page 2 | Page 3 | Page 4 | Page 5 |

Read more from the author/contributor here.

Comments

Comments are closed.