Balance Sheet Recession Basics – Not Your Father’s Economic Cycle _ ValueWalk

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The Situation

Europe, UK and the US are all currently mired in a Balance Sheet Recess ion (BSR). A term for the current

rare disease the global economy is suffering from coined by Richard Koo in his sem inal book The Holy

Grail of Macroeconomics where he provides a blueprint for our current malais e 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 econom ist, for that I am grateful, but if Im 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

respons es enacted in each econom ic 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 simultaneous ly.

What is a Balance Sheet Recession?

To understand the Great Depression was the Holy Grail of MacroeconomicsBen Bernanke

A Balance Sheet Recession comes to pass when a plunge in asset prices damages private sector balance

sheets s o badly as to bring about a shift in the mindset and priorities of the ass et 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 s truggle to survive.

As with the ass et bubbles that precede them, Balance Sheet Recess ions are rare and prolonged events.

When they do happen, they render useless the standard economic policy respons es 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 s ituation where many corporate and pers onal

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, an rational actor will commit

themselves to diligentl repaing their debt and adding low risk assets to repair their balance sheet as

quickl as possible.

A nationwide plunge in as set prices eviscerates the asset side of the balance sheet but leaves the liabili ties

intact. The entire economy experiences a fallacy of compositionwhich means an action that is m ost

appropriate for each individual becomes ruinous if everyone engages in it at once. In this example, we mean

repairing balance sheets.

Koos example is as follows a household earns $1,000 and spends $900, saving $100. The $900 spent

becomes someone elses 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 econom y.

Therefore spending and savings both continue to circulate keeping the $1,000 in p lay. If there are no willing

borrowers for the $100 then the banks wi ll lower the interest rate they charge until the demand is created.

But in Japan and in the Great Depression, and to som e extent now, there is no dem and for the $100 despite

interest rates at 300 year lows.

The $100 just s its in the bank being neither borrowed nor spent. Only $900 is spent in the economy and the

next household receives on ly that $900 of which i t saves 10% to the bank, which again cannot lend that $90

because there is no loan demand s o 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 ass et prices making

balance sheets worse rather than better.

Add to this sim ple model the additional problem of corporates also in balance sheet repair m ode and you

have an idea of the problem faced. The econom loses demand equivalent to the sum of net household

savings and net corporate debt repament each ear.

This is exactly what happened in the Great Depress ion taking Gross National Product down by almos t 50% in

4 years.

According to Koo, the only solution for this problem is for sustained fiscal policy support via direct government

borrowing and s pending 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 Doesnt Work


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4. Silent and Invisible

5. Debt Rejection Syndrome

1. Private Sector is Paing Down Debt

Now, as in Japan, it was argued by many that the banking sector was primaril y respons ible 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 jawbon ing about forcing banks to lend to business es s o they can invest and so on.

For a company in need of funds the closes t subs titute to a bank loan is corporate bond issuance. Any

company that wants to borrow but cant because the banks wont lend s hould, 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 m uch of it is polluted by huge government

iss uance and therefore doesnt reflect private sector demand but this is what I got.

Global bond iss uance 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 ins titutions for the first time since

financial sector issuance started to grow in the early 1990s. The $925bn iss ued by non-financial ins titutions in

2010 was down from $1,080bn in the previous year. Iss uance from financial institutions declined m ore 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 s o low they couldnt have dreamt of them jus t a few years ago, and yet they still cant be coerced.

It should be noted that even though the balance sheet recession started in 1989, it wasnt 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.


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Another interesting point made by Koo regarding Japan was that if the zombie banks were the problem, then

surely the foreign banks who were wi lling to lend would have been able to swoop in and hoover up market

share. They didnt. This could be extended to todays recession where we havnt seen the healthier banks

like Standard Chartered and HSBC stealing m ass ive share of the personal and corporate lending m arkets.

Maybe the problem isnt banks not wanting to lend after all!

Neoclass ical theory always assumes that the private sector is attempting to maximis e profits. Koos theory

instead im agines that there are certain circums tances, when their balance sheets are so badly damaged by a

decline in as set values, private sector companies will res pond by giving primacy to debt minim ization.

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 recess ion 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 s ize is small because this condition isextremely rare.

Japanese companies have spent the last 15 years paying down debt at a time when interest rates a re at zero.

From the pers pective of an IMF economis t, Treasury Policy advisor or a investmen t bank economist, this

makes no s ense. As loan rates fall, demand for loans is not increasing. This is madness!

If you are profit maximis ing, as the private sector is always ass umed to be, then the only reason you would pay

down debt at zero interest rates is if you have no poss ibility of making a pos itive return on your investments if

thats the case, are you a going concern?

What this persis tent paying down of debt in the face of their education and economis ts expectations

demons trates is that the private sector no longer has profit maximisation as its ma in goal now the goal is

debt minimisation. Its a m assive, secular swing in mindset.

Loans to private businesses in Europe grew at just a 1.7% rate in November, a plunge from Octobers 2.7%

and missing expectations of 2.6% by a wide margin. Corporate credit is being turned off. This has happened

even as the ECBs balance s heet has risen from EUR 1.9 trillion to EUR 2.7 trillion in 6 m onths is truly

remarkable.

Reuters s aid 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 blocs central b ank conducted last week its first-ever

three-year funding operation, which saw banks take up almost half a trillion Euros.


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2. Monetary Policy is Impotent

Governments are suppos ed 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 useles s. The Bank of

Japan kept interest rates at near zero from 1995 to 2005 but yet the economy did not recover and s tock

markets did not rally.

The reason for this is one of the key ass umptions 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 powerles s.

As explained above, if the mechanism of recycling savings back into the economy is broken then the

government m ust do s omething to stop the vicious cycle. The government m ust 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 s pending can prevent a contraction.

When firms and hous eholds are m inimizing debt the government is the only net borrower left in the economy

and therefore the money supply will contract unless fiscal poli cy is expansionary.

3. Quantitative Easing Doesnt Work

Because todays economis ts are all trained to think the sam e way, to assume private sector profit

maximisation, they ass ume that if interest rates are low enough then they will borrow and invest. This clearly

isnt happening. In todays world we keep hearing that corporate balance sheets are awas h 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 managem ent they are not investing and they are certainly not borrowing to invest.

Imag ine a patient who takes a drug prescribed b y her doctor but does not react as the doctor expected, and

more im portantly does not get better. When she reports back, he tells her to doub le 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 hum an 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 closes t knowledge of the situation are incentivised to keep

quiet about it. Corporate CEOs and indebted households do no t 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 m ortgages that are in negative equity. If the payments are being m et and the borrowers rem ain

cash flow pos itive then both parties can mark to m ake believe and extend & pretend. Of course ZIRP helps

ease this process too.

5. Debt Rejection Syndrome

The generation that survived the Depress ion has a reputation for a life time of debt repudiation. Those who

have been indebted and then s uffered through years of hard work to repair their balance sheets are left with arevulsion of debt even after their balance s heets 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?

Thats all it takes, really. Pressure, and time.Red in Shawshank Redemption

Time, low interest rates and not having to mark ass ets to market help, but the economy needs more s upport

than these things which are usual ly enough to restore a cyclical recess ion to growth.

Japans 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.


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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 suchprecipitous ass et 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 m ovie..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 governm ent spent 140

trillion yen and nothing happened. So they twisted the story to imply the governm ent wasted the money.

So Koo is s aying it was only because the government engaged in fiscal s timulus to the extent that it did that

stopped a collaps e in Japans GDP and in its s tandard 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 wed

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 clos e 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 Unied Sae Secoal Balance


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No the United Kingdom

In the simp lest 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 les s effective than direct spending via New Deal-es que

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 som e 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 hatthe 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 s peed rail

etc could all be upgraded and would enhance our potential productive ability. How about som e 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 Uni ted States when enacted in 1933. Fiscal


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eedie iceaed b 125% hich caed a ha iceae i ecic acii hich bgh he

ee ae cahig d ad iceaed a eee. Re aab, de he ic i ecic

acii, he iceaed gee edig did iceae he bdge defici.

Biae, he ecic ce i ha he Ne Dea did cceed ad ha gee edig ade

a i igifica cibi he ece f 1933 1936 (i ieeig i 1937 he ie eedie

ee eiged i a ie U/E e , idia fe 33% ad ei ae fe 50%).

A K i 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.age 116.

The Confidence Mliplier

Shie & Aef eied hi cce i hei b Aia Sii .

We speak of the b asic problem as having to do with what we call a confidence multiplier, which refers to a

sort of social epidem ic behaviour. The conventional Keynesian multiplier is supposed to amplify a stimulus

package through multiple rounds of expenditure when consumers or b usinesses automatically spend their

extra income. The confidence multiplie r works through the effects of the stimulus, and of sub sequent rounds of

expenditure, on confidence. The latter is more uncertain and context dependent.

These other considerations highlight the di fficulties that governments will have in changing this wait-and-see

behaviour(ce eie/deb iiiai), and suggest different concerns about just how to

structure a stimulus pack age. Different kinds of stimulus have different effects on confidence, depending on

how they are viewed and interpreted b y the pub lic. The focus has to get off of what fraction of this stimulus will

be spent to how does this stimulus affect confidence.


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Clearly confidence is historically low and therefore the pos itive feedback loop that economic confidence

engenders i s weak. I think much of this lack of confidence stem s from a lack of certainty over jobs, hous ing,

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 bas e for confidence. I believe a New Deal type fiscal package, commitments to

sus tained 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 mem bership at ZeroHedge has no doubt

been rescinded. The US, UK and Europe are low s avings nations relative to where the US was in the 30s and

Japan in the 90s . 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 iss uance 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 als o 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 deb t are also the m arkets way of telling the governm ent that if there is anything

to be done with taxpayers money, now is the time to do itThe market is im ploring governments to undertake

such projects NOW for the sake of both the econom y and taxpayers.Page 267

Why cant we have inflation?

Quantitative Easing improves the liquidi ty slos hing around the banking s ystem, it does not improve the

solvency of the institutions.

Look at the chart below showing the effect of Fed QE on the Monetary Base.


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This is the inflationary risk and it is huge. However, if there are no borrowers then this money sits in the

banks as excess res erves and pos es no inflationary threat. As long as there are no borrowers, no amount of

QE will generate inflation. Unless private sector behaviour and preferences s witch 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 b y acting so as to lose the pub lics 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 Japans five year experiment with QE to generate either inflation or growth in the

money supply i s proof that trust in the central b ank rem ains 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 becom e much m ore focused on dividends and DCF as a guage of value after a bubble collaps e. It

seem s unli kely 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 as set price increases .

Central Bank purchases of government deb t invariably im ply an injection of reserves into the banking

system. Even though addi tional reserves will have no inflationary consequences as long as there i s 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 aprivate sector borrowing from a banking sector awash with liquidity does.

Helicopter Mone

Money is distilled work Little House on the Prairie

Helicopter Money is a cure that is s ignificantly worse than the dis ease. Because fiat m oney is no longer

backed by gold and ins tead only by faith in central banks i t mus t be treated carefully. When Bernanke

threatens to drop money out of Helicopters he only thinks of the demand s ide of the equation, people would

pick up the money and go spend it. However, he overlooks the fact that any rational shopkeeper upon s eeing

this would automatically close their s tores as they have no way of knowing the value of the money they are

receiving. The economy would collaps e to barter.


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luewalk com/ /balance sheet recession basics not your fathers econo

The Differences between toda and Japan/Great Depression?

Cultural Differences have nothing to do with the BSR The Japanese have a different mentalityis not a

relevant argument. It is the nationwide (or global in 2008) collapse in as set 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 blocs

currently experiencing the global balance sheet recession are the larges t consumers in the world and are too

big to viably export their way out of trouble.

Both The Depress ion and Japans Recession were at a time where they were demographicall y much better

placed to recover than the developed world currently is.

We are conducting a live experiment on the patient currently the US seem s to be taking something m ore

akin to Koos recommended path, promising austerity tomorrow but remaining accom modative today

(extension of unemployment benefits, tax cuts e tc). 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 pol itical paths s tarted to diverge, when the Coali tion won the election in the UK we

can see that the US has started to decouple from its two peers and som e are arguing that it will enjoy growth

next year as the other two totter on the edge of a recess ion.

If that is the case, then its 1-0 to the Balance Sheet Recess ion diagnos is.

Read the book!

http://www.paecon.net/PAEReview/issue58/Koo58.pdf

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Balance Sheet Recession Basics – Not Your Father’s Economic Cycle _ ValueWalk