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Simplified explanation of the balance sheet recession
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The balance sheet recession
carljohnsson.commarkets | finance | economics
1. Debt accumulation
2. Deleveraging after the bubble pops
3. Recovery on a macro level
3 Fases of the balance sheet recession:
Fase one:
The accumulation of debt
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In this phase,
the economy is booming,
and the bull is raging…
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Money stacks up,
the need for investment
opportunities is on the rise…
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Hence,
risky investment opportunities pop
out of the ground.
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Since funds are cheap,
even monkeys understands there is only
one logical thing to do:
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A random company’s balance sheet might
evolve like this:
The firm takes on debt (25 � 125),
to finance investments (0 � 100)
Year 1
Assets 100 Equity 75
Debt 25
Total 100 Total 100
Year 2
Assets 100 Equity 75
Investments 100 Debt 125
Total 200 Total 200
Fase two:
The bubble pops
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…sending their
values down.
Speculative investments fail to
generate high returns…
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so there’s only one logical thing to do…
With investments down (100 � 25),
and debt constant (125)
equityholders take the punch (75 � 0)
Year 3
Assets 100 Equity 0
Investments 25 Debt 125
Total 125 Total 125
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Deleverage,
Ideally, the ratio of debt to equity
comes down to ‘normal’ levels.
Year 4 (ideal)
Assets 100 Equity 100
Investments 25 Debt 25
Total 125 Total 125
Paying back debt (125 � 25)
Increases equity value (0 � 100)
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The only problem is….
Deleveraging takes a long time...
In Japan, it took 15 years…www.carljohnsson.com
And deleveraging company’s don’t invest,
in factories, infrastructure et cetera…
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We also know that ‘the economy’ is
measured as
GDP = C + I + E + G
Where,
C = Consumer spending
I = Investments
E = Net exports
G = Government spending
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So when all companies are deleveraging at
the same time, this leads to a dangerous
vicious circle in which the economy rapidly
deteriorates…
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Fase three:
The recovery
How are we gonna break
through this vicious
circle doc?
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Increase government spending as long as
companies are deleveraging…
…to halt the vicious circle
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Government spending on (for instance) infrastructure or
defense results in GDP, and thus employment, income and
revenues, to remain intact…
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That way the governement can keep the
economy going…
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Résumé
The balance sheet recession:
1. Debt builds up in risky investments
2. After the bubble pops, firms
deleverage, cut back on investments,
impacting the economy badly
3. The government can step in by
increasing spending, keeping GDP
intactwww.carljohnsson.com
