Global Balance Sheet Recession
Analysis By - Keith Rankin
The world economy is at present at a significantly greater risk of a 1930s' style collapse than at any time since the Great Depression of that era. While I'm optimistic enough to believe that it won't happen this or next year, despite the heightened risk, I am more sure than ever that an economic disaster greater than that of the 1930s will happen at some time over the next two decades.
We have had, since 2008, a phenomenon that has recently come to be known as a global "balance sheet recession". Broadly we - meaning the governments and central banks of the world - followed appropriate monetary and especially fiscal policies for a couple of years, preventing the collapse that many feared in September and October 2008. Fiscal policies, in particular, meant substantial deficit-funded government spending.
Those policies were extremely successful when contrasted with the feared 'counterfactual' of another great depression. Yet, because world economic growth has been and continues to be lower than it was in the mid-2000s, many people have come to regard post-2008 fiscal policies as a failure.
So, intellectually, we have a 'battle of the counterfactuals'; two contesting (yet unstated) views about what would have happened in the absence of the 2009 fiscal stimulus programs undertaken by the governments of the worlds largest economies. One view is that we averted a great depression. The second view is that we would have had a world economic slowdown in 2009-2010 no worse than those of the early 1980s and early 1990s, and a return to expansion by 2011.
On the basis of the first view, the fiscal stimuli saved the world economy from disaster. On the basis of the second counterfactual view, the fiscal stimuli were largely ineffective, and may be stifling the expansion that believers believed would have started by now.
Compelling research about Japan's long (1991-2005) recession, by Taiwanese/Japanese economist Richard Koo, reveals that Japan experienced what Koo called a "balance sheet recession" (see, for example, www.entrepreneur.com/tradejournals/article/191646706.html). Further, he showed that Japan stumbled on the policy solution - deficit government spending for the duration.
Koo has also shown (in a 2009 book) that the Great Depression, which began in most countries from 1926 to 1931, and ended between 1933 and 1940, was also a balance sheet recession. Koo focussed on the US balance sheet recession which lasted from 1929 to the end of 1939. Only for a few years in the mid-1930s did the US run an appropriate Federal Government spending programme (New Deal).
A balance sheet recession can be defined thus: "An extended period of zero or negative growth, characterised by private sector financial surpluses, driven especially by the requirement of businesses to repay debt in the wake of substantial decreases in asset prices."
In a normal recession, monetary policies that reduce interest rates to very low levels are sufficient to stimulate sufficient new private sector borrowing and spending. In a balance sheet recession, firms will not take on new debt even if interest rates are zero. Their overriding aim is to get the excess debt off their balance sheets.
A balance sheet recession arises when many businesses and households suffer huge downward valuations of their assets (following a burst property and/or sharemarket bubble), finding themselves technically insolvent. (Many such firms and households had borrowed from banks to buy property and other assets at inflated prices.)
With ongoing cash inflow, however, firms and households can repair their balance sheets by using earnings (sales or wages) to repay debt and rebuild their assets. The balance sheet recession will last as long as it takes for firms in particular to repair their balance sheets.
With the private sector becoming a substantial net saver, the spending that provides the cash flow that's required to pay down the debts must come from outside a country's private sector. Japan's cash flow in the 1990s was maintained by both export sales and high levels of government borrowing (funded from increased household savings, and reduced business and household debt) and spending.
In a global balance sheet recession, the only outlet for private sector surpluses is government deficits. Globally, total private lending must equal total public borrowing. (There's no such thing as partisan arithmetic!) If governments refuse to borrow and spend under these conditions, then firms cannot make the sales they need to save them from liquidation. And households cannot achieve the savings they desire, because firms not selling goods and services must make their employees redundant.
In countries such as the United States and the United Kingdom, non-financial businesses have not been net borrowers for nearly a decade. Yet, in the orthodox view of the financial system, the market economy depends on an ongoing process of households lending to firms. In the mid-2000s in these countries, growth occurred solely because households borrowed and spent while firms (often with borrowed funds) built up portfolios of speculative assets (especially overpriced real estate). Today many firms in these countries must substantially reduce their indebtedness to survive. Many other firms are sitting on huge piles of cash that they refuse to spend.
The Economist of 19 May 2011 (economist.com/node/18713516) reported: "British firms in aggregate have been spending less than they earn for most of the past decade. Saving has increased since the financial crisis struck: at the end of last year the corporate funds left after capital spending, tax, interest and dividends reached 6.2% of GDP (see chart). This embrace of the German habit of excessive thrift has hurt the economy. Companies are meant to be repositories of peoples' savings, but instead have been huge savers themselves."
Liberals (in the US meaning of the word) point out that businesses will not spend on new plant and equipment (the correct meaning of the word "investment") unless they achieve sufficiently high sales to make such investment profitable. That means governments must borrow and spend the funds that the private sector is desperately trying to lend (through intermediaries such as banks) to governments. The constraint to growth is the absence of what economists call "aggregate demand".
Conservatives on the other hand believe that businesses will spend their huge piles of cash, and borrow a whole lot more, if only taxes and wages (business costs) were reduced, and workers produce more goods for every dollar paid to them. Further, they believe that it is productive (and therefore good) for businesses to invest in (ie purchase) such things as espresso coffee machines, but unproductive (and therefore bad) to sell cups of coffee, to consumers, in a café. It is common sense to all but economic conservatives that firms will not invest in coffee machines unless there is a demand by consumers for café coffee.
In 2011, the world economy is being propped up by spending, mainly facilitated by governments, in China, India, Brazil, Australia and a few other countries. These countries cannot continue to borrow and spend indefinitely, to save the rest of us from our misguided thrift. Australians are already spending substantially less. From China we now hear stories of the probable future insolvency of its huge local government and publicly-owned-enterprises sectors (eg economist.com/node/18775343). Further, China has a property bubble that must eventually burst.
In New Zealand we now have an exchange rate that is killing off much of our tradable sector, as revealed by very low levels of imported plant and equipment, despite a favourable exchange rate for imports. Dairy farmers are focussed on repaying debt. New Zealand will suffer much as the US and UK will, if our government adopts similar austerity measures. In the Great Depression it was the countries with overvalued currencies that suffered the most.
The global economic crisis ultimately can only be resolved through a process of "rebalancing" or "deleveraging". This means that those persons and countries which can spend must spend, by buying goods and services from those indebted firms and countries that must sell goods and services to bring their debt down to manageable levels.
From the 1990s the global economy experienced a substantial leveraging process, in which those in debt incurred annual deficits (buying more than they sold, adding to their debts), while those already in credit saved more. While the creditors' annual surpluses (selling more than they bought) added each year to their financial wealth, the debtors' annual deficits added to their material wealth. (While money flowed to those persons and countries running surpluses, goods and services flowed to those persons and countries running deficits.)
A deleveraging global economy is one in which it is the debtors who run surpluses, and the creditors who run deficits. It's time for the Belgian dentists and Japanese housewives to spend. The required global deleveraging has barely begun, and it's looking increasingly likely that nothing less than an economic catastrophe (or worse) will achieve the required rebalancing through massive write-offs or global inflation. (The two biggest rebalancing events in the 20th century were World Wars 1 and 2.) The collapse of spending in the US has the potential to be an important trigger of such a catastrophe.
For any economy to be stable, if some people are saver/lenders, then others must be borrowers. (Banks are only 'middle-men'. If you save by lending to a bank, then the bank must lend to some other party who is willing to pay you interest.) Likewise, if some sectors are net lenders, others must be net borrowers. It is mathematically impossible for governments to balance their budgets when every other sector is attempting to save or repay debt.
It behoves governments to recognise when their country – or the world as a whole – is facing a balance sheet recession. The remedy for this acute condition is for governments to borrow from those who wish to save but have only the public sector to lend to. In a balance sheet recession, governments are required to act as "borrowers of last resort", as Richard Koo puts it.
Government borrowing as last resort is equivalent to placing sick economies into remission. Over the longer term, only deleveraging represents a cure. Debtors, including governments, must run surpluses during a deleveraging phase. Debtors can only run surpluses, however, if creditors willingly run deficits. (For Greece to run a surplus, Germany must run a deficit. Germans need to break their habit of "excessive thrift"; they must learn to buy goods from Greece, rather than sell goods to Greece.) That's the real challenge of deleverage; getting those with savings to spend their savings.
The economic problems that the world faces are problems of arithmetic rather than of ideology or wickedness. Left-wing arithmetic is the same as right-wing arithmetic. We face a global balance sheet recession. Let's address it dispassionately.
Keith Rankin teaches Economics in Unitec's Department of Accounting and Finance.