Why The World Is Headed For A Balance Sheet Recession
In my post Koo, White, Soros and Akerloff videos from inaugural INET conference I highlighted four speeches from the recent George Soros-sponsored pow-wow. I have already written up a post based on the one by William White in "The origins of the next crisis."
This post serves to give you some colour on another of those speeches, the one by Richard Koo and his balance sheet recession.
Koo believes the US, Europe and China are headed for a period of incredibly weak consumer spending not unlike what Japan has been through. Let me say a few words about this balance sheet recession theme, private sector deleveraging, and the related sovereign debt crises. Then, at the bottom, I have embedded a recent paper of his which has a bunch of graphs that explain what Japan has been through as a cautionary tale for the global economy.
I have described Koo’s thesis this way:
Nomura’s Chief Economist Richard Koo wrote a book last year called “The Holy Grail of Macroeconomics” which introduced the concept of a balance sheet recession, which explains economic behaviour in the United States during the Great Depression and Japan during its Lost Decade. He explains the factor connecting those two episodes was a consistent desire of economic agents (in this case, businesses) to reduce debt even in the face of massive monetary accommodation.
When debt levels are enormous, as they are right now in the United States, an economic downturn becomes existential for a great many forcing people to reduce debt. Recession lowers asset prices (think houses and shares) while the debt used to buy those assets remains. Because the debt levels are so high, suddenly everyone is over-indebted. Many are technically insolvent, their assets now worth less than their debts. And the three D’s come into play: a downturn leads to debt deflation, deleveraging, and ultimately depression. The D-Process is what truly separates depression from recession and why I have said we are living through a depression with a small ‘d’ right now.
Now, what US policymakers are trying to do is to both increase asset prices and consumption in order to short circuit the D-Process i.e. prevent the debt deflation that results from deleveraging and asset and price deflation. Almost all measures taken to date are attempts to prop up asset prices (artificially I believe).
The mortgage modification programs are but one example. Here is what economist Arnold Kling says about them in his prepared testimony before Congress:
Perhaps one goal of the mortgage modification program is to keep homes off the market that otherwise might be subject to foreclosure and sale. The idea might be to keep home prices higher than they would be if foreclosures were to proceed. This attempt to maintain artificially high prices for houses also will create arbitrary winners and losers.
Suppose that mortgage modifications succeed in temporarily boosting home prices. That is, suppose that in a neighborhood where the price of homes would be $180,000 if foreclosures took place, the mortgage modifications allow prices to be maintained at $200,000. What that means is that people who sell homes now will do better than they would otherwise, while people who buy homes now will do worse. Somebody who buys a house at $200,000 has much less chance of enjoying appreciation than someone who pays $180,000.
Maintaining home prices by preventing foreclosures does not create wealth. Instead it simply takes away wealth from those who at the moment are seeking to buy and gives that wealth to those who are seeking to sell. How do we know that today’s sellers are more deserving than today’s buyers?
–What I’m Saying – Arnold Kling, EconLog
This is a market distortion that not only creates winners and losers, but also has macro implicationsregarding the allocation of productive resources within the economy. Read Why the housing market is about to turn to see the perceived benefit to homebuilders for example. Left unsaid here is what sectors are not receiving capital as a result of this implicit subsidy for the housing market.
But all of this is an outgrowth of a wish to avoid a balance sheet recession and the dynamics I spoke of in "The origin of the next crisis", what Ray Dalio calls the D-Process. He says:
The D-process is a disease of sorts that is going to run its course.
When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?
The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the ’90s, that occurred in Latin America in the ’80s, and that occurred in the Great Depression in the ’30s.
Basically what happens is that after a period of time, economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.
Long story, short, we are in for a debt restructuring across Europe, and in America and China because of the accumulation of debt and malinvestment. Policy makers are reverting to the same old game of asset price inflation to stave this off, what William White has called short-termism.
For his part, Dalio calls the D-process a debt restructuring not unlike what GM has gone through:
This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.
We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes — the cash flows that are being produced to service them — or we are going to have to raise incomes by printing a lot of money.
It isn’t complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.
This has mostly to do with the private sector. But, there is a relationship to the public sector here. In China, remember, that China’s local municipalities have been speculating on land and property during the stimulus-induced property bubble. The municipalities have a lot of debt associated with this. Listen to Jim Chanos’ conversation with Charlie Rose to get a sense of the debt land mines there.
Also, you should notice that printing money is not an option in Greece or Portugal or anywhere in the Eurozone. This and the fact that Greece has the largest public sector external debt to GDP in the entire world means they have a hard road to hoe. See this Wikipedia list of countries by public debt for aggregate amounts. Zimbabwe tops the list. The first developed country, Japan is in second place. They have funded their deficits internally. So that is a cushion. In Greece’s case, the overwhelming majority of the debt is owned externally by foreigners – a problem for Greece and its foreign creditors, mostly in Europe.
Where does this leave us? It leaves us with chronically weak consumption trends acutely exacerbated by the demographic trends of an aging populace. It is no coincidence that Germany and Japan have such weak consumption growth given these countries have the highest average population ages in the world (outside of tiny Monaco).
In my view, these dynamics are particularly problematic for Europe because of the strictures imposed by the Euro, the large public sector debt-to-GDP ratios and the advance age of the populace. The Greek problem is the tip of the iceberg and the Europeans are seriously deluded if they think their troubles are over.
I said my piece on the US and why I think we are experiencing a cyclical upturn in the William White article. So I will leave you with Koo’s recent presentation which puts some numbers on what the U.S., Europe and China can learn from Japan.