'Balance sheet recession' is an innocuous name for a very big economic event. It represents a particular kind of contraction of a country's economy – or of the global economy – in which one of the most important laws of 'financial economics' is practically disabled; that is the economic law that households and businesses respond to interest rates. In addition, it is a period in which banks impose unusually tight lending criteria with respect to unsecured household and business borrowers.
Households and businesses can be understood as the parties – or participants – of 'the Economy'; that is, households and businesses are economic parties. There is one other key party – governments – which also plays an important role in the economy. So, the global economy can be thought of as a 'game' involving three parties. It is a 'game' that – if played well – has no losers; 'the Economy' should be understood as a win-win game. Introductory versions of the economic game are two party versions; households are the first party and businesses are the second party.
(We may note that, when considering single nations, the economic game is usually considered to have four parties – foreign households, businesses and governments are commonly lumped together as the fourth party. Generally, all households, taken together, make up the household sector; and voluntary organisations such as clubs can be regarded as households. Businesses taken together constitute the business sector, and all parties foreign constitute the foreign sector. The government sector includes governments at all levels; local, provincial, national. The economic 'game', in its purest form, is global; it has no foreign sector, people are people wherever they live.)
Some more definitions. Finance and economics are different – though related – disciplines. 'Financial economics' is the part of the discipline of economics which relates to borrowing and saving by the participating parties; so, it relates to the financial deficits and surpluses of households, businesses and governments. Economics is about 'the Economy'. Financial economics enables us to understand how the distribution of spending can be different from the distribution of income.
Finance – as a distinct discipline – is about the behaviour of financial markets. Thus, it's about the buying and selling of 'assets'. Finance is about, as I have called it elsewhere, 'the Casino'; my preferred term for ‘secondary financial markets’. There are secondary financial markets in shares (equities), bonds (promises, including government bonds), land (real estate), commodities (eg gold and silver), financial derivatives, cryptocurrencies such as ‘bitcoin’, and certain scarce items such as artworks.
We can understand that money circulates in both 'the Economy' (the subject of 'economics') and 'the Casino' (the subject of 'finance'). Banks are the creators of money – and are thus central to both 'finance' and 'financial economics'.
Under normal circumstances – including normal recessions – with decreasing interest rates, households and businesses respond by borrowing more and saving less; that is, they borrow more from banks and deposit less to banks. And the converse holds; with increasing interest rates, households and businesses respond by borrowing less and saving more. For reasons that are not clear, there is a convention that governments are insensitive to interest rates, under all circumstances. This convention has been sorely tested since the global financial crisis of 2008, but still appears to hold.
(Government-related financial economics is called 'fiscal policy'; economists can distinguish between 'autonomous fiscal policy' and 'induced fiscal policy'. 'Induced fiscal policy' represents government responses to the 'monetary policy' actions of the Reserve Bank. The unwritten and unnecessary convention is that all fiscal policy is 'autonomous'.)
During a balance sheet recession, this normal link between banks and the Economy becomes disabled. Lending to households and business does not increase – as it should – when interest rates decrease. The result is that banks engage less with the Economy, and more with the Casino. The other possibility is that, rather than engaging more with the Casino, banks engage more with governments. This depends critically on governments willingness to pursue an 'induced fiscal policy'. (There is one other possibility, that the banks practically disengage from both the Economy and the Casino. In the Great Depression – in a number of countries, especially the United States – that meant huge numbers of bank failures through the early stages of that calamity.)
A balance sheet recession happens when a preponderance of otherwise viable businesses (and, commonly, households too) find themselves with so much debt on their books that they become technically insolvent. This situation obliges businesses and households to prioritise the repayment of debt over ongoing investment. These parties become sufficiently debt averse – to both old and new debt – that even very low interest rates cannot persuade them to behave otherwise. Further, banks become reluctant to lend to these businesses and households at usual interest rate margins. It means that money ceases to flow through the Economy via these usual business and household channels. The economy grinds to a halt.
Understanding the Great Depression as a Balance Sheet Recession, and Governments' Responses
The Great Depression of the 1930s remains "a riddle wrapped in a mystery inside an enigma" to plagiarise Winston Churchill's description of Russia. While almost everybody has heard of the Great Depression, almost nobody knows what actually happened, what its causes were, or how the world recovered from it. This is not only the case with the general public; it's also true of academic economists and historians. Economists who know quite a lot about what happened will tend to explain it in terms of the philosophical assumptions they bring to their profession. And many academics – especially American academics – tend to focus on its national dimension, rather than seeing it as a truly global event.
Nevertheless, almost all accounts of the Depression note that mistaken fiscal policies – especially reluctances around government spending – converted what might have been a once in a decade economic event into the economic event of the twentieth century.
Government borrowing was technically more difficult in the early 20th century than it is today; it was a world in which central banking was new. Before the establishment of the Reserve Bank of New Zealand, the New Zealand government had to borrow from the London money market. While the government still borrowed from London and other financial centres in later years, especially at times when exports were insufficient to pay for imports, the presence of the Reserve Bank fundamentally improved the government's financial autonomy.
The term 'balance sheet recession' was only invented in the twentyfirst century – it was not a concept that was understood in the 1930s. Not that it is well understood today. New thinking takes time.
There were other important differences between the Great Depression and the post-1980s economic contractions. The Depression was characterised by quite severe deflation – falling prices – which meant that interest rates close to zero nevertheless represented expensive borrowing. The contrast with more recent events is that borrowing has become very cheap.
The first big new idea that came out of the Great Depression was the 'debt-deflation' death spiral. Falling prices would inflate existing debts, and all attempts to pay back money would reinforce the forces that were causing deflation, further inflating existing debts. Thus, the policy imperative in the 1930s was to reverse deflation; to raise prices, to 'reflate' the economy. The main policy lever to do this was monetary policy, based on the widespread belief that there was an intimate and predicable relationship between the money supply and the level of prices. It didn't work. While new monetary reserves can only enter the economy through borrowing, households and businesses were debt-averse; it didn't matter what the interest rate was.
A secondary monetary policy lever – only able to be applied at the national level – was currency devaluation. The policy did work, though it aggravated problems for countries which didn't devalue their currencies; it was regarded as a 'beggar thy neighbour' policy. New Zealand strongly benefited from two devaluations of the pound – that of the British pound against the American dollar in 1931, and that in 1933 of the New Zealand pound against the British pound.
The policy that did work in all countries – when it was eventually applied – was new government borrowing and spending. The creation of new money had been a necessary but not sufficient pre-condition for economic recovery. The sufficient condition was the mass spending by government of that new money.
There were three major reasons why this required policy was too little and too late, for the world as a whole. First was the gold standard system of fixed exchange rates that applied in the world of the late 1920s and early 1930s; governments of countries that were losing gold were expected to enact pro-depression policies in order to force price deflation. France and the United States in particular behaved as gold hoarders, holding more money at the expense of other countries, and wanting to save rather than spend their gold reserves. A second reason was that price deflation made government borrowing potentially very expensive; just as inflation eroded personal and government debts in the 1970s and 1980s, deflation in the 1930s would aggravate debt.
A third reason was the lack of economic knowledge. The discipline of economics did not have its intellectual revolution until 1936. It was John Maynard Keynes who showed the importance of activist government borrowing during an economic contraction, and allowing debt repayment to take place of its own accord, allowing the recovery to generate the required tax revenue. Applying such counter-cyclical fiscal policy, Budget surpluses in post-recession high growth economies would constrain inflationary pressures that might arise.
Keynes' findings did not come as a sudden surprise in 1936. There had been plenty of chatter on the subject before that year; indeed Keynes himself wrote much – his collected writings are a massive tome. And Keynes already had a reputation, with several books already well known. People noticed what he wrote. As his thinking developed after 1931, his insights were well available to governments looking for fresh thinking about the unfolding economic crisis.
New Zealand did better than most to get out of the Depression, after a slow – indeed obstinate – start. Once the problematic Minister of Finance (William Downie Stewart Jr.) resigned in opposition to the 1933 devaluation proposal, three important policy decisions happened in the years 1933 to 1937 to bring New Zealand out of the Depression. First was the devaluation of 1933, argued for by new Finance Minister Gordon Coates. The devaluation gave a big boost to the tradable sector; that's farmers and manufacturers. Second was the creation of the Reserve Bank in 1934 – enabling New Zealand to have sovereign control over its own money supply, especially once it became wholly government-owned in 1936. Third was the willingness of the First Labour Government to use Reserve Bank money to embark on a widespread and successful program of social housing development.
The central problem of the great depression was not just to create new money; the problem was to get that money into circulation into the Economy. That is the problem of the 'balance sheet recession', getting money into circulation. Instead, governments trying to balance their budgets by slashing their spending – that is, refusing to borrow to spend – proved to be the principal obstacle to recovery.
Despite the difficulties governments faced, this decision by governments at all levels to retrench – to try to balance their books at a time when households and businesses also were trying to run big surpluses –was the critical factor in making the Great Depression the disaster that it became. In that sense, then, the Depression can be characterised as 'optional', given that governments did have another option.
Japan's 1990s' Balance Sheet Recession
Japanese are financially conservative people, with a long history of saving and debt averseness. Japanese households were used to lending money to both foreign borrowers and to their own governments.
Japan changed in the late 1980s, following a major global currency realignment (the Plaza Accord) which saw a previously undervalued Yen soar to become substantially overvalued. While this created competitive adversity to Japan's world-leading manufacturing sector, it also created new opportunities for consumers, and for the development in Japan of 'the Casino'. A sharemarket bubble began in about 1986, and continued unabated after many other countries' sharemarkets crashed in 1987. Indeed the 1987 crash created new momentum in Japan, as foreigners sold out of their markets and bought into Japanese financial markets. At the height of the urban property boom, a small area in the centre of Tokyo was reputed to be worth about as much as the total land value of California.
Japanese households and businesses borrowed like crazy to play the enriched Casino; businesses borrowed massively, but to speculate on financial assets, not to expand or modernise their own businesses.
It all fell apart, inevitably. After their 1991 crash, Japanese households and businesses, en masse, found themselves holding huge amounts of debt, and near-worthless financial assets. Economy-wide, the story was much the same – private financial insolvency. All firms scrambled to repay debt; few were willing to take on new debt. Contrary to advice from western financial experts, Japan's government realised that only it could save the day. The government started to borrow, to offset (and facilitate) household and business repayments. It worked. A shallow but long-lasting period of close to zero growth – a decade and a half of it – became the new normal; the alternative was a catastrophic depression. Not only did Japan save itself by breaking all the rules of conservative public finance, it has continued to retain its position as one of the three biggest economies in the world.
Today, Japan's 250 percent (of GDP) public debt is its strength, not its weakness. It is financially strong enough to run an Olympic Games in 2021, even without crowds if that turns out to be necessary. Japan is strong today because it never tried to 'repay' its 1990s' public debt. Japan is strong because its public finances are underpinned by creditor households supporting a debtor government. By lending to their government at zero percent interest, Japanese are foregoing some consumption just as they would by paying the money as taxes. However, any particular Japanese savers may withdraw their funds if confronted with an unexpected household situation that requires use of those funds. Japan's public finance works like an efficient public insurance program.
We also note that, in Japan in the 1990s and early 2000s, businesses continued to grow with minimal business borrowing. Indeed, Japan's economy continued to export more than it imported despite this lack of traditional business investment. Japan showed the rest of the world – although the rest of the world did not see – that an advanced economy could remain productive and competitive without relying on the traditional capitalist dynamic of household saving and business borrowing. Rather than being utilised by local businesses, Japan's household savings were absorbed by governments and by foreigners. Interest rates in Japan have been around zero for decades.
The 2008 Global Financial Crisis and ensuing Recession
The years from 2000 to 2008 were characterised in much of the capitalist world by increased household deficits and unanticipated business surpluses; the reverse of the presumed norm. Governments sat back, not realising that it was households rather than businesses which were spending on credit, pumping money into the Economy and into the Casino. Further, businesses were 'investing' their saved profits into the Casino, trying to generate speculative returns, much as Japanese businesses were in the late 1980s.
Much as occurred in Japan 17 years earlier, the 2008 crash happened in the United States and elsewhere; massive numbers of businesses and households became technically insolvent. There was no deflation this time, though interest rates – which dropped substantially from 2007 levels – continued to exceed inflation rates. Households and businesses generally became debt averse, though businesses were not indebted to the same extent that their counterparts in Japan had been.
The problems that delayed the recovery from the Great Depression were not there. Exchange rates were flexible – and behaved predictably, in the sense that money returned home from the many exotic destinations it had been sent to. The exchange rates of the bigger and richer economies went up, and the other exchange rates went down. It was cheap for governments to borrow in 2009, because there was minimal deflation to cope with. Debt deflation had not had time to take hold, thanks to a very rapid and global Keynesian response – called the 'fiscal stimulus'. Policymakers had learned some useful lessons from the Depression.
The bigger story after 2009 turned out to be the second wave of the Global Financial Crisis; mainly the crisis in the European Union (EU). The EU prematurely abandoned its fiscal stimulus, by introducing public 'austerity' and 'fiscal consolidation'. Unlike what happened in Japan, the European governments tried to 'pay back' the money. While the consequences were tragic for Southern Europe, the austerity policies also generated much political extremism all over Europe in the 2010s. The consequences of European austerity were offset – fortunately for the capitalist world – by widespread spending and borrowing in the emerging tier of capitalist economies: the likes of India, Russia, Brazil, Turkey, Indonesia, South Africa, and especially China. Most particularly, it was China's expansionary policies that saved the world from experiencing a balance sheet recession to rival that of the 1930s.
The European Union 'got away' with its austerity pro-depressionary policy by running a decade of foreign-sector deficits; that is, other countries borrowed to accommodate Europe's excess saving. There is no guarantee that the rest of the world will be as accommodating next time; indeed, a lack of 'rest of the world' accommodation in the 1930s ensured that there would be a global Great Depression. A part of the accommodation to Europe's austerity in the 2010s was a substantial amount of private sector (household and business) deficit spending by New Zealanders; and it was that private deficit spending in New Zealand that enabled the New Zealand government to run Budget surpluses after 2015. In financial accounting, 'deficit' is NOT a dirty word; it's simply a negative number.
In the 2010s, New Zealand pursued an austerity-lite approach, benefitting from a rising terms of trade (meaning export revenues grew rapidly on account of higher prices, while import prices fell). By taking advantage of a lucky recovery – a recovery spurred by Chinese and Australian spending – New Zealand missed the opportunity to address its structural inequalities, in favour of pointlessly getting public debt down to 20% of gross domestic product (GDP). Further, New Zealand's apparent success depended critically on New Zealand households and businesses eager to run deficits – to borrow and spend. As might have been expected, much of that private borrowing was spent in the Casino rather than in the Economy. Hence New Zealand's inflated real estate market that peaked in 2017, and appears to have taken off again in 2020.
The Balance Sheet of the Reserve Bank of New Zealand
Where does the money come from for governments to run ongoing expansionary fiscal policies; that is, spending at all levels of government financed by a mix of taxes and borrowing?
The abovementioned chart shows the size of the Reserve Bank's balance sheet since 2002. Because of double-entry bookkeeping, this is both the assets and the liabilities of the Reserve Bank. The sizes shown represent the base of New Zealand's money supply. New Zealand's total money supply is essentially the combined balance sheets of all the country's banks. The assets of banks are their loans. It means that New Zealand's money is technically a debt to the banks, and ultimately to the Reserve Bank. The liabilities of banks are their deposits, and their capital (which is their shareholders' equity). The economic citizens of New Zealand are the shareholders of the Reserve Bank.
When the Reserve Bank increases the size of its balance sheet by adding to both sides, it simultaneously adds to its loans and to its capital. Thus, there is an increase in the amount of 'money' that the citizens of New Zealand owe to the citizens of New Zealand.
What then happens is that the Reserve Bank attempts to 'inject' that new money into the economy by either (a) lending it to its usual depositors (ie the banks or the government) or (b) by 'buying bonds' in the secondary marketplace (ie in the Casino). In the former case (a), on the liabilities side of its balance sheet, the newly created 'capital' becomes a 'deposit' of the borrower; and that borrower is free to spend or relend that money. In the latter case (b), the Reserve Bank takes over an existing debt (eg a company or government 'bond') as an asset, and the money paid to purchase that bond appears in its balance sheet as a deposit liability.
Under normal circumstances the combined balance sheet of the banking system should expand at the rate of 'nominal economic growth'; that's the 'real' economic growth rate (typically three percent in a year) plus the inflation rate (typically one percent in a year). Thus, over the ten years from 2010 to 2019, we would expect the 'size' of the banks' combined balance sheet to have increased by an average four percent per year. Over a period of decades, we would expect the same average for the Reserve Bank's balance sheet (ie the balance sheet depicted on the chart referred to); though there tends to be periods where most of that monetary growth is on the commercial banks' balance sheets, and other (usually shorter) periods when most of the growth is on the Reserve Bank's balance sheet.
The chart shows basically a flat RB balance sheet from 2002 to 2006, then a catchup from 2006 to 2009, and then another flat period from 2009 to 2019. Finally, the chart shows a substantial jump in 2020. (We also need to note that the chart is somewhat distorting, because it uses an 'arithmetic' rather than a 'logarithmic' scale of values. See my recent set of Covid19 charts that shows how different charts can look, depending on which scale is chosen. This RB chart understates the changes in the 2000s' decade – values more than doubled from 2006 to 2009 – and exaggerates the 2020 increase, which represents a doubling of the size of the RB balance sheet.)
What is most important to note here is that the money created and lent in the 2006 to 2009 period has not been 'paid back', and never should be. Repayment to the Reserve Bank of that money – in say the late 2010s – would have represented a collapse of the RB balance sheet back to early 2006 levels; an economic disaster.
So, in terms of public finance, what happened in the late 2000s is that the RB purchased lots of commercial and government 'bonds' (ie debt assets) from the Casino, and – from 2008 to 2014 – the Government funded its deficits by selling newly issued bonds to the Casino. The Casino acted as a 'middleman'; an intermediary. The Government borrowed from the Casino, and the Reserve Bank lent to the Casino. The net – and perhaps unnecessarily convoluted – effect was that the Government borrowed new money, indirectly, from the Reserve Bank. The money created by the Reserve Bank went – in part – into circulation into the Economy, through the 'vector' of government deficit spending. (The rest of the money created on the Reserve Bank's balance sheet either entered the Economy through private deficit spending, or entered the Casino as loans used to purchase existing assets such as city real estate.)
In the second half of the 2010s, the Government ran Budget surpluses, meaning it 'paid back' some of its debt. It repaid debt to the Casino, but the Casino did not repay the Casino's creditor, the Reserve Bank. Rather the Casino relent the money that the Government repaid; the Casino relent that money to household and business borrowers, and much of that relent money circulated within the Casino rather than within the Economy.
The net effect, was that the Government paid back money that it did not need to pay back; it repaid money that could have been spent on social housing or on teachers' salaries or on the healthcare system. And the repaid money did little more than further stimulate the Casino, helping to push up the prices of financial assets.
The repaying of that Government debt represented a case of 'double jeopardy'; it meant the loss of the many good things that the Government could have spent the money on, and it meant that the prices of financial assets – including residential property – became even more inflated than they otherwise would have become. The flipside of the government's austerity-lite policy was the housing crisis of 2013 to 2017.
To repeat, the Government debt incurred around the time of the Global Financial Crisis of 2008 was never repaid to its ultimate creditor, the Reserve Bank. Rather it was repaid to the 'money markets' (the Casino) who relent it to private borrowers. There is no evidence whatsoever that the private borrowers spent that money in 'better' ways than the government could have spent it.
Covid19: The Economy versus the Casino
So, what will become of our present balance-sheet recession, the Covid Global Recession (GCR?)? First, this has the potential to become a global balance sheet recession comparable in severity to the Great Depression. And second, most of the chatter – coming from the media, government spokespeople, mainstream political parties, and most economists who feature in the media – is the capitalist world talking itself into a funk about 'having to pay the money back' and 'intergenerational equity'. Somehow – the confused reasoning goes – future generations will become better off if, in the 2020s, governments opt for 'depression' (paying back debt incurred in an emergency) rather than 'investment' in people's lives.
This is frightening chatter, which suggests that we have learned nothing at all from the previous balance sheet recessions which I have cited above. Further, it suggests a naivete about public finance that is substantially worse than that displayed during the Great Depression. In the Great Depression there were real and genuine excuses why governments failed to borrow and spend; at least at that time governments did eventually act, albeit too little and too late.
The Great Depression was a 'voluntary depression', in that governments largely chose not to borrow and spend when the only way out of this global event was for governments to borrow and spend.
Most of the chatter that I am hearing tells me that we are heading towards a global environment in which an insolvent private sector – households and businesses – will be desperately trying to run financial surpluses, while governments will be actively trying to minimise their financial deficits. The West cannot reasonably look to China to bail it out this time. This chatter is a recipe for a global depression – an optional or voluntary global depression – that could last many years.
At least in the Great Depression, the Casino had become largely dysfunctional. This time looks like being different. Much of the huge amounts of money being created in the world's central banks (such as the RBNZ) are getting into the Casino, and circulating there, because governments are far too cautious to utilise the money that the central banks have created. Much of the money that the Government should be injecting into the Economy will instead circulate in the Casino. Further, premature repayment of government debt just pushes even more money into the Casino.
We are already seeing a 'surprising' lift in asset prices; house prices in New Zealand, share prices in other countries such as the United States. It's a result of central banks creating the money that the 2020s' economy needs, but the governments of the world rebuffing the central banks, forcing money that could do much good into the Casino where it can do much harm. This would be double jeopardy – given a choice of 'good' versus 'harm' – the governments and the people who elect them seem more intent than ever to choose 'harm'.
There is one note of optimism, however. In the wake of yesterday's PREFU – pre-election financial update – today I heard three people mention the term 'modern monetary theory' (economists Shamubeel Eaqub and Ganesh Nana; and journalist Corin Dann). (See my Money: Where Does it Come From, Where Does it Go?.) I have never before heard the words 'modern monetary theory' on Radio New Zealand. Further, such relatively enlightened economists – though still subject to professional constraints – are stating to admit that public debt is largely money that we owe ourselves, and that the repayment of such debt is not a necessary thing. (We must note that the non-repayment of debt is not the same as debt default; it's much more that certain types of debt may be perpetually 'rolled-over'.) These economists are calling for 'conversations' about public finance to take place – conversations that I have been trying to facilitate.
Centuries of Government Deficits
In 2009, the New Zealand government was talking about a coming 'decade of deficits' as a consequence of the Global Financial Crisis. This was generally interpreted as 'a bad thing', even though Japan had showed the rest of the world that government deficits should not have been thought about in this problematic way. Certainly, most of the world's governments – though not New Zealand's – got their decade of deficits; an inevitable self-defeating outcome of unusually high levels of financial caution. The 2010s' decade became a period of high levels of savings, on the part of the world's households and businesses; and high levels of debt aversion on the part of governments. It is not possible for governments to avoid running deficits when households and businesses both insist on running surpluses.
By definition, for governments – or any other parties – to incur debt means to run financial deficits, and to pay back debt means to run financial surpluses; generally many years of government surpluses. While government surpluses may have been common in a few oil-rich countries, there has probably never been a year – let alone a sequence of years – in which the global government sector has 'paid back debt'. Government debt is a critical component of the global financial balance sheet. Government debt is a critical component of human 'civilisation'.
For the coming century to be economically successful, we as a species need to learn to embrace appropriate government financial deficits; as 'governments doing their job'. While government debt needs to be contractually serviced – it should never be 'paid back' if, by so doing, it either has an adverse impact on the circulation of money or helps to fuel the financial Casino, raising the prices of financial assets above their fundamental levels. (The fundamental price of residential land, is the price that renters of that land can reasonably be expected to pay.)
So yes, we should be looking to another century of deficits of the worlds' governments, as a good thing. Government deficits – despite our unthinking aversion to them – were the central recipe to the advanced state of economic development that took place throughout the world in the twentieth century.
Instead of all our talk of 'governments paying back the money' that they must borrow, we should be debating how money should be allocated, and ensuring that we have equitable tax and benefit systems that properly stabilise economic perturbations large and small.
John Maynard Keynes wanted governments to run deficits in difficult times and surpluses in good times. Japan has showed that governments should be running large deficits in bad times, and small deficits in good times. Such deficits do not stifle households and businesses. While government deficits will always have a cyclical aspect, we need to accept government debt as a structural component of sustainable democratic capitalism. What Japan has learned to do with its public finances does work; and it neither leads to unsustainable economic growth nor to the crowding out of genuine private sector economic activity.
Radio New Zealand interviews mentioned (both 17 Sep 2020):