What To Do About a Balance Sheet Recession?

Since the beginning of what has come to be termed “The Great Recession” in December 2007, we’ve been looking for analogies to understand the hole into which our economy has fallen. “The Great Recession” itself is a reference to the Great Depression of the 1930s. Others have compared the most recent recession to the twin recessions of the early 1980s, frequently with unfavorable views of federal government response to the recent downturn. Others have looked farther afield to the persistent doldrums that struck the Japanese economy in 1990 and continues to the present.

The comparison of the recent downturn to the Great Depression of the 1930s is particularly inapt. The Great Depression saw a decline in GDP of 25% or more in the United States, was worldwide, and saw sharp declines in production, wholesale prices, and foreign trade. Contrariwise the Great Recession has none of those characteristics. Increases in unemployment between the two economic downturns are, however, quite comparable. [Update: this is an error. I am grateful to Steve Verdon for pointing out that at no time has present unemployment neared Depression Era levels, however measured, cf. this comment. I had incorrectly compared Depression Era U3 unemployment with present-day U6.]

Comparison with the Fed-induced recession of the 1980s is even farther off the mark. Unemployment increased sharply but recovered even more sharply. It was sharp, harsh, and over relatively quickly, a classic V-shaped recession in which growth rebounded almost as fast as the NBER could declare that a recession was in progress.

Over the period of the last several years the term “balance sheet recession” has come increasingly into vogue until not only is it the prevailing wisdom that the recession of 2007-2009 was in fact a “balance sheet recession” but any attempt to call that into doubt is met with considerable derision. “Balance sheet recession” derives from economic Richard Koo’s 2003 book, Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications. The timeliness of Dr. Koo’s work has given him near-oracular status on this subject. Under the circumstances and, particularly, considering the increasing likelihood of further declines or, at the very least, persistent unacceptably slow growth for the foreseeable future, I think it’s reasonable to consider the evidence that we are, in fact, experiencing the after-effects of a balance sheet recession, examine the relationship of our own economic woes to Japan’s, consider the implications of a balance sheet recession, and assess its implications for policy.

The graphic above is from the St. Louis Reserve’s FRED system and illustrates the growth in household debt from 1950 to the present. The graphic below, from the San Francisco Fed, juxtaposes U. S. household debt to income and Japanese nonfinancial corporate sector debt to GDP over 10-year periods before and after the leverage-ratio peaks. I have been unable to locate the data on actual post-war Japanese nonfinancial corporate sector debt. I think it would be very interesting.

The first graph is astonishing to me for how perfect an example of exponential growth it presents. Growth proceeds virtually at a fixed rate up to the point at which it becomes asymptotic, then declines sharply. Anything that cannot be sustained will not, indeed. In the second graph the Japanese experience presents nearly as many contrasts with our own as similarities. Yes, the graph goes up, then down. There the similarities end. Unlike the smooth exponential growth expressed in the U. S. instance, the growth in Japanese debt to GDP is more irregular and exhibits a very different pattern. Whatever is happening here differs from Japan rather dramatically.

Even if the analogy holds, I don’t think we should take much solace from it. Twenty years later Japan continues to be burdened with slow growth. The Japanese have tried Keynesian stimulus, massive infrastructure projects, and quantitative easing much as we have. None of these have reawakened growth in Japan.

Consider, too, the downturn in household debt here. Nearly all of that decline is due to foreclosures. Real retail sales have recovered by nearly three quarters while; real disposable personal income has continued unimpeded throughout the downturn. If there is balance sheet rebuilding here, I’m not seeing it.

Additionally, how far would household balance sheets need to recover? I have seen a return to 1990s levels bandied about: we haven’t even begun such a process. And why is that the right level? Why not the 1970s? The straight line curve-fitting of the 1970s is even better than that of the 1980s and 1990s and to my eye both look like partial segments of what is obviously an exponential growth curve.

Thirty five years ago 54.4% of our economy was based on personal consumption. Now 77.3% is. To return to 1990s levels let alone 1970s levels over anything but the very long term would constitute economic collapse. I conjecture that a considerable portion of that excess consumer spending is healthcare spending.

If we have, indeed, experienced a balance sheet recession what is the appropriate policy response? The Japanese experience isn’t helpful in that regard. Debt forgiveness? (something I’ve mentioned here before) More and faster foreclosures? We are a very different society than the extremely homogeneous and consensus-driven Japan. I don’t think we can stand 20 years of slow or no growth household balance sheet rebuilding peaceably. Can stand ten?

I think there’s another interpretation that I think should be considered: we have reached the end of a 70 year period during which a debt-financed model of economic activity has been pursued. It did not prove sustainable and it is not being sustained.

20 comments… add one
  • steve Link

    Not sure there is a lot of difference between the end of a debt financed era and a balance sheet recession. Also not sure that there is much of a solution. I think that we will need to work through our housing and commercial real estate inventory. Let’s hope we dont destroy our seed corn with austerity measures that give false hopes for economic recovery.


  • Drew Link

    As I’ve pointed out many, many times…………

    Its an allocation of resources issue; and political subsidy. You can bet on government as an engine of growth, or the private sector.

    You can bet on a government model of income redistribution (always, oh, always, in the name of “compassion”) or you can acknowledge that such an efforts should be very limited (and relying heavily on private charity)……..and understand basic concepts of welfare economics……..and the political dynamic to create a large, dependent, perpetual vote getting class…….which is cruel, and what we have done.

    I could go on.

    And so, to maintain lifestyle the taxpaying and declining, relative to the government transfer/tax relieved/govt employee payment recipient sector, has relied on debt. As has the government, because they realized long ago that the tax goose was in intensive care. Well, the game is over. As I noted some essays ago, Doug over at OTB chided me about the notion that a sovereign actually had “debt capacity.” Doug may be a good lawyer……..don’t hire him for a corporate finance assignment. Just sayin’

    So its chickens coming home to roost. Welfare state…..rent seeking……regulatory capture and on and on. Government driven. 40 – 50 years in the making. And for the life of me I do not understand what is “compassionate” about structural policies that give us 1%- 2% GDP growth and 10% – 15% unemployment as far as the eye can see…………….while subsidizing Wall Street or Big Health Care or Big Education. Did I hear some BS about compassion…….or was that campaign donations? My hearing may be failing.

    So I come back to: do you want to bet on government, or the private sector? An Edsel, or a Ford Mustang?

    The nation is going to have to choose. I’m hoping the left, and a number of commenters here, ain’t gonna like it at all……

  • I’ve been tested very good at English but not so good at mathematics. But isn’t our problem being overtaken by a larger and cheaper labor force?

    Unless we become isolationist, isn’t it a given?

    Japan’s prospects look fairly cheery until the Koreans and Chinese came online.

  • Seems like we are in “HC SVNT DRACONES” territory.

  • sam Link

    Here is Richard Koo on the problem

    Interview: Richard C. Koo, Nomura Research Institute

    Your book respectively your “Balance Sheet Recession” concept has been the talk of the town in 2009, as the global economy was in the middle of a severe contraction. Stimulus packages around the world however prevented the global economy to slip into a depression. Some economist and politicians are now asking to scale down the stimulus, as if a recovery may have started. Do you agree?

    Not until private sector deleveraging is over. At present, private sectors in the US, UK, Spain, Portugal, and Italy are still deleveraging. This means these countries should not try to reduce fiscal stimulus. Any attempt to cut deficit in these countries is likely to result in a weaker economy and a larger deficit as seen in Japan in 1997.

    The other source of stimulus is “quantitative easing”. What is your take on this?

    Useless [ans] until private sector deleveraging is over. When private sector is deleveraging, money multiplier is negative at margin. No monetary stimulus will work in such an environment where people are trying to reduce debt, even with zero interest rates, in order to repair their damaged balance sheets.

    The argument it is that in an environment of severe contraction, as firms and households deleverage, fiscal stimulus is required (government spending), but not monetary stimulus (QE). If this is true, then the recent strum and drang in DC over deficit reduction at this time is misplaced. Basically, I guess, if nobody else is spending money — because folks are attempting to redress the imbalance between assets and liabilities by paying off debt — then the government has to.

  • sam Link

    ah,damn, the moderation queue. And the last, beginning, “The argument” is my gloss on Koo’s interview.

  • Icepick Link
  • Sam Link

    What To Do About a Balance Sheet Recession

    Stop being so scared of inflation.

    Greg Mankiw:

    That is, the Fed could announce that, hereafter, it would aim for a price level that rises 2 percent a year. And it would promise to pursue policies to get back to the target price path if shocks to the economy ever pushed the actual price level away from it

    Scott Sumner:

    There’s nothing in modern macro theory that would suggest NGDP falling 11% below trend would depress growth, is there?

  • The problem that I see with the prescription is that there are few signs that households have started deleveraging or, at the very least, that old habits die hard and deleveraging is proceeding so slowly it could take 10 or 20 years to complete the process.

  • Icepick Link

    Sam, those of us on small incomes will get crushed by inflation. We’re already seeing that this year. Because wage inflation isn’t happening anytime soon with real unemployment at these levels.

  • Icepick Link

    So I come back to: do you want to bet on government, or the private sector? An Edsel, or a Ford Mustang?

    I will point out that both the Edsel and the Ford Mustang (and for that matter, the Gremlin and the Pinto), are all products of private enterprise. Perhaps you should have compared the Ford Mustang to a Yugo.

    Drew may be a good PE finance BSD……..don’t hire him for a writing job. Just sayin’.

  • Icepick Link

    Corrected: Speaking of personal consumption….

  • Increases in unemployment between the two economic downturns are, however, quite comparable.

    Uhhhmmm…WTF? Seriously?

    Peak unemployment during the Great Depression: 20%
    Peak unemployment during the Great Recession: 10%.

    Looking at the increases:

    Prior to the Great Depression unemployment was 5% or so. Prior to the Great Recession it was 4-5% or so.

    Yeah…comparable…or not.

    I think there’s another interpretation that I think should be considered: we have reached the end of a 70 year period during which a debt-financed model of economic activity has been pursued. It did not prove sustainable and it is not being sustained.

    I don’t why this has to be the case at all. If an economy uses debt, but does so in a way that is reasonable what is wrong with that? In other words, take your debt numbers and calculate a debt/GDP ratio and see what you get. Sure debt is exponential, but so is GDP.

    If the ratio is increasing over time then there may very well be a problem. In that case it isn’t debt in and of itself, but that perhaps households are taking on too much debt.

  • You’re right on unemployment, Steve. I was basing the observation on a recollection of a comparison of present U6 unemployment at about 18% to unemployment in the Great Depression of around 20% but it seems my recollection is wrong.

    If an economy uses debt, but does so in a way that is reasonable what is wrong with that? In other words, take your debt numbers and calculate a debt/GDP ratio and see what you get. Sure debt is exponential, but so is GDP.

    I think that, based on the actual numbers, that it’s a workable hypothesis that there’s a barrier to either GDP or debt going asymptotic. I’m open to other suggestions. If your suggestion is correct, how is a balance sheet recession possible if GDP continues to rise?

  • Icepick Link

    Looking at the revised Personal Income and Outlays numbers from the BEA shows something fun. Personal Income Excluding Current Transfer Receipts (2005 chained dollars) is still down over 4% from 2007. Big downward revisions in this report as well. Having trouble finding the monthly numbers from 2007 in this report, so there’s a good chance the number is off by even more than that from the recent peak. (CR reported the number was down 5.1%.) Nasty, nasty stuff.

    In other recovery news yet another friend got laid off yesterday, this time from one of the giant tech companies that is sitting on tens of billions of dollars. (Cisco) He doesn’t seem to have taken it personally, as the company is laying off thousands of people.

    Endless Recovery Summer II.

  • Icepick Link

    And ISM Non-Manufacturing is down, although still over 50. The employment component is also still over 50. Still not a good report. More for Pimco’s and Blackrock’s “stall speed” argument. (Need it be mentioned that Pimco and Blackrock stand to benefit most from more action by the Fed, which is what they’re calling for?

    So two more signs of economic weakeness today, but much better than the lousy reports from the last couple of weeks or so. Maybe the BLS report Friday will show +35k to +50k, which in the current environment will look like the pot of gold at the end of the rainbow.

  • Icepick Link

    Wow, we’re in market meltdown again. Started the day slightly positive and now everything is tanking. The funny part is that the Debt Deal turns out to have been completely irrelevant, just as predicted by so many people.

  • Icepick Link

    Berlusconi is going to give a pep talk later today. Outstanding. That ought to give the markets a fresh jolt of energy to the downside!

  • I don’t think the debt deal was irrelevant. I think that the market had already discounted default and had thought that more would actually get accomplished than the much ado about very little, accompanied by hyperbolic jeremiad, than occurred.

  • If your suggestion is correct, how is a balance sheet recession possible if GDP continues to rise?

    If your debt rises faster than your GDP. That is if debt/GDP stays constant at say 60% you might never have a problem. But if there is some critical value, say 100%, then if you have a sudden surge in the growth of debt a country could find itself in serious problems.

    I’m not saying this is the case, just tossing out a possible idea. I don’t think debt in and of itself is bad, but if debt growth gets out of whack then who knows. Just food for thought.

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