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A Primer On Balance Sheet Recessions
Lately, much of the economic debate has been force-shifted by the economic pundits to observations of a financial rebound framed merely as a consequence of a manufacturing recession, when the core of the issue is and continues to revolve in a balance sheet recession context. As the later has a unique set of deflationary threats over and above the usual framing of the output gap as perceived by Ben Bernanke et al, who keep trying to convince US consumers that the 2008-2009 period is nothing to write home about, we would like to present a research piece by Nomura's Richard Koo, who does an admirable job of recapitulating just why America and China are set to recreate the Japanese experiment of several "lost decades" and still running. What we can expect, if America does not change its course: at least three years of lost GDP, if not much more.
As Koo frames them, the key features of a balance sheet recession are the following:
- A balance sheet recession emerges after the bursting of a nationwide asset price bubble that leaves a large number of private-sector balance sheets with more liabilities than assets.
- In order to repair their balance sheets, private sector moves away from profit maximization to debt minimization.
- With the private sector de-leveraging, even at zero interest rates, newly generated savings and debt repayments enter the banking system but cannot leave the system due to the lack of borrowers.
- The sum of savings and debt repayments end up becoming the leakage to the income stream.
- The deflationary gap created by the above leakage will continue to push the economy toward a contractionary equilibrium until the private sector is too impoverished to save any money (=depression).
- In this type of recession, the economy will not enter self-sustaining growth until private sector balance sheets are repaired.
Keep this presentation in mind as you consider the $1 trillion+ and rapidly rising excess reserves with Fed Banks: that is the single biggest threat to Bernanke's reflation approach. No matter how much money the Fed Chairman keeps on pumping into the system, the new "frugal" normal as defined by Rosenberg, will force consumers to stay away from any and all incremental borrowing for an indefinitely extended amount of time.
The one critical take home message is that GDP growth in a balance sheet recession/depression is indicative of absolutely nothing except government largess, and future massive funding needs.
And here is the terrifying quantification of the lost 17 years in Japan: 1.5 quadrillion yen, or 3 years worth of Japan GDP!
All this and much more in the attached presentation:
For those interested in more, here is a recent video conference with David Koo discussing the economic outlook.
h/t CreditTrader
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Excellent, Tyler. This is the best explanation of what is going on globally. It builds on Irving Fisher's theory (1933) of the Great Depression. Fisher correctly diagnosed the mechanism but he though that the solution was "reflating" the economy, which it's clear it doesn't work under this scenario.
http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf
The issue is that you and the piece above assume that a CB will behave traditionally by only purchasing government securities as the means to stem deflationary expectations (as is the case with Japan and the Fed doing everything wrong the 30s).
The key is to understand what Ben's helicopter argument actually means in practice (turns out it's not actually dropping bales of cash into city streets from a helicopter, but it's not far off either): the CB simply bids up whatever kinds of asset classes it sees fit to stem deflationary expectations (as they arise).
Read the following (skip the math) and see if you still feel as confident that a traditional debt deflation scenario will play out with the Fed 2.0 behind the wheel:
http://ideas.repec.org/p/imf/imfwpa/03-64.html
Note the various citations to Bernanke in the piece--these guys are all in very similar schools of thought.
The best part is that once you understand their mentality, you realize that they have all the tools they need. What they really lack is the legal authority to place bids any asset class (resulting in ultimate asset price support), so I wouldn't be surprised to see the Fed trade transparency in return for the power to buy any asset class (if the Fed audit support grows strong enough to pose a threat).
Remember that deflation spirals because of expectations that prices will fall without limit, so if a CB employs practices discussed in the linked piece, the spiral can be broken.
And what makes this outlook a mind fuck is that all the Hugh Hendrys out there are right about the scale of debt deflation in the hopper, but they underestimate the Fed 2.0, completely dismissing its long-term ability to inject trillions (yes, a 't') into the system without it ending up as bank reserves, given enough time. So with this in mind, one can even argue that rising gold prices actually help the Fed out (in the short/medium term) because it helps stem deflationary expectations.
---
FD: long gold, long silver (for the above reasoning that the Fed 2.0 will use all means necessary to support asset prices to offset debt deflation in the coming quarters/years)
That models the price index not balance sheet contractions. Read Fisher and Koo again, you are missing the main concept. Furthermore,
1. The Fed is not facing a closed economy but the most globalized economy since the early 1900s'. All major blocks are in the same situation, unprecedented, and the weakest point is the EU. One major EU bank fails and it would be like 10xLehman. All this is beyond the Fed. In fact the USD-Yuan devaluation against the EUR is increasing the pressure on Europe, wrong spot at the wrong time.
2. You underestimate the assets size in the economy. US assets are about 13xGDP. Now combine that with the other major blocks and you'll soon realize that there is no entity big enough to stop the avalanche. Case in point is US housing, only one component, in full deflation. It will de down 40-50% by the time it reaches equilibrium. The housing price contraction in other countries will be larger.
http://rutledgecapital.com/2009/05/24/total-assets-of-the-us-economy-188...
http://www.youtube.com/watch?v=BRW1IJ7Un3s
http://1.bp.blogspot.com/_Et4TQ-a0gGU/Sg7WE-vBCII/AAAAAAAACEM/FQKqA_G5XO...
This article says it all. And the thing about lost GDP, is that it promotes more stimulus packages and deficit spending. Which leads me to believe that 3 years of lost GDP is simply a point where data runs out due to time constraints of the present -- the chart above gives no indication that it will not be more than 3 years lost GDP, which I suspect it will.
until the private sector is too impoverished to save any money (=depression).
wow.
Tisk tisk Tyler. Way to easy to understand.
Where are the big brained economists frantically waving their hands, sweat pouring from their furrowed brows, specks of white foam forming in the corners of their mouths as they spout gibberish and nonsense, all the while assuring us that if only we were as smart as they are, we pea brained peons would understand?
This pea brained peon understands that when I burn more wood than I chop down, my wood pile gets smaller. Stoking the fire doesn't help matters. The way out is simple. Let's get off our asses and start working again. Economists are dolts if they can't grasp this.
That declining wood pile is a lagging economic indicator and not a harbinger of future conditions. They would say precisely because your wood pile is declining, you will go out and either purchase more wood or cut your own wood. Either way, you're being more productive and increasing the economic worth of the country. You are improving our GDP. Thank you.
Of course, all the forests have been cut down, we are breaking up the furniture to burn this winter and it's looking to be the coldest in 100 years. Most economist never stop to consider that we live in a finite world. Their models require endless supplies of "resources" in order to work. We can never run out of anything because at worse everything has an alternative source. Of course, endless credit stimulates endless consumption.
Insanity by any definition. But as long as their numbers balance, all is right with the world.
Is it me or is it getting cold in here?
Don't forget that the current leadership is in the process of making sure that you greedy bastards that chop wood need to share with the parasites who don't work, by force if necessary. And if you grow your own forest you're gonna get doubly whacked.
So you are saying that using false financial system models and treating them like they are real things has psychological impacts on people?
Fat Larry Summers learned a long time ago...
As a protege of Too Connected to Fail (TCTF)...
Robert "What Me Worry About Insider Trading at CIti" Rubin...
That consumer confidence since the 1990s has a strong correlation to the DJIA and S&P. The Sheeple follow it like a football score. Up we are winning, I the sheeple have confidence. The ramp up recapitalizes the insolvent banks and has the side effect of fooling the public.
Devaluing the dollar, destroying the purchasing power of the shepple and ripping of savers who earned by legitimate work and contribution to GDP? Ahhh, colateral damage. They will get over it, if they ever see it or figure it out.
That is a classic Fat Larry win win and change Mr.Change can believe in...
So if Japan can kick the can for 15+ years and remain an ongoing concern, why can't we?
Easy.
The US is the world reserve currency. If you kick the can for that long you will be replaced as your currency loses vigor, health, and flesh.
By "we" I assume you mean USA.
It has been the policy of the USA since the early 1980's. Just kick the can down the road.
Only now the road has come to an end. (Think of it as interest rates at ZERO being the end of the road).
Next up is QE which represents the USA's new policy.
EXTEND and PRETEND.
Now gaze into your crystal ball and see what the future holds
Thank you kindly. If I understand correctly, we've run out of rope sooner than Japan because 1) we went to ZIRP faster; 2) we are the world's reserve currency, 3) we have no mfg and/or export base, and 4) we have no personal savings. So we don't get a 15 year grace period before some kind of hard stop/disruptive reset.
A back of envelope calculation that I got from B school was that in most modern economies, all tangible assets that comprise the nation's equity after depreciation etc was 4 times GDP. Now if a nation is at 366% to 380% indebted in terms of high water mark GDP before EVEN going into a depression, no way to emerge without a negative net national worth.
For all the mirages of built-up wealth (cars, mansions, few factories, technology, design), the numbers say we are poorer than when those few daring souls first touched foot on the American continents. Only intellectual capital is superior, but morally the USA is much, much inferior.
You can't seriously believe that American wealth is a mirage?
The real mirage isn't the _stuff_, the real mirage is the _numbers_. They lie. Debt is only crushing and net worth only negative if the debt is actually going to be repaid. What you need to realize is that it probably isn't. That holds true for Japan and the USA.
The stuff won't just vanish, but the numbers sure will. I would adjust my portfolio accordingly.
No we will continue paying for depreciating assets with impaired-to-negative cash flows with amortizing payments which include an interest rate in excess of the natural rate of growth.
That is the definition of an upside down balance sheet and economy.
Only by debauching the currency, and running the various risks of unintended consequences thereby, will the crushing austerity imposed by this high debt ratio be able to be borne.
Without the assistance of debasement, the dominoing bankruptcies would further shred delicate balance sheets and exacerbate a deep depression.
Probably 50% of the above ground finished durable goods should NOT have been created.
Weak hands MUST deliver into strong hands. But there are SO few untainted strong hands.
"Probably 50% of the above ground finished durable goods should NOT have been created."
Watch for a lot of recalls on products. Better believe there is a government funded program for companies that have to recall products. The cpsc.gov is in overdrive right now.
I think you missed the gist of my point. It's clear that we're debasing the currency. You seem to think that we'll be able to dig our way out of the debt hole, and I disagree. I think that we're headed for default and/or currency crisis.
As a strong hand myself (on a micro scale), I'd actually like to see a deflationary depression. It would allow me to use my savings to wrest control of productive assets from the irresponsible and the overextended.
However, we both know that is not going to happen. I believe the winning move is to borrow as much US currency as you can get for US assets (max out the debt-to-equity on the house, etc), and to park my wealth overseas where it won't be subjected to the Fed's ritual abuse.
Anyway, you seem to think the US has the means and the will to delever. I think we are past the point of no return and headed for a currency crisis.
Just.a.... you speak jubilee, but who will be celebrating?
Sends a repo man to just.a.guy to explain real mirages.
I guess I am a bit of a contrarian here, I agree with the analysis but disagree with the prescription. Japan has had both a continued monetary and fiscal stimulus during the last two decades. The monetary stimulus has done more or less nothing (remember also that Japan has 3x more currency in circulation = monetary policy less efficient).
The fiscal stimulus however, has meant that Japan now has enormous highways, ports and other public works projects, that are completely useless. They have government employees that stand and blow in whistles when the light turns green (note : there is still a green light! he just does it to have a job!). What Japan did, like the US will do, is refuse to let banks and big corporations fail. They will leave the inefficient zombie giants in business - which costs a lot of money. The end result is something like the Japanese government debt that will reach about 250% of GDP within a few years (default most likely in the end when the demographic curve slams the economy into pieces and inflation finally sets in due to production shortfall).
Savings shortfall during boom years + government overspending during bust years = 3x annual GDP. There are two options for getting out of a "deflationary trap" :
1 (Slow and expensive) What he said
2 (Fast and furious) Let the giants banks and corporations collapse, the money supply collapse and prices drop through the floor. Had the US federal government and Federal reserve done this, you would now have recovery. The reason this didn't happen is that the federal government would have had to contract like all other sectors. Also, Goldman sachs didn't want to go bust, the FDIC promised they had everyones back and Paul Krugman found a microphone.
That's my take, for what it's worth....
"Fast and furious" is just the way it is supposed to be working in the real capitalist system, you just do not interfere with natural flow of things and let the insolvent entities go bankrupt. Unfortunately, it didn't happen and all these zombie entities will be carried forward at everyone else's expense.
Koo's prescription is equity injections, which on a large scale could be done from a kind of sovereign fund , somewhere in Treasury, with Congressional oversight. The problem with all policy instruments right now is that they only involve debt and there is too much debt in the system.
http://farm4.static.flickr.com/3549/3382546343_997fe867de_o.jpg
I thought it was just me! I also thought the diagnosis was spot on but the solution sounded a whole lot like "Hey, if you want a couple lost decades here's how you do it." And while there simply are no good options at this point, the "lost decade(s)" approach has been tried and failed, already, with an economy that unlike ours entered said period as net savers and exporters (whereas we are net spenders and importers, both big time).
That said, since the "fast and furious" approach will certainly upset the governmental and oligarchical apple carts the chances such will be allowed to happen over Obama's, Chopper Ben's and Goldman's dead bodies are probably slim to none with "slim" on the next train out of town. So, welcome to "The Lost Generation", folks! Woo hoo!
There is a huge difference between Japan in 1990 and the United States in 2008. Between 1960 and 1990, the Japanese savings rate averaged about 15%, which allowed the Japanese to fund the deficits domestically. The Japanese once considered it patriotic to help fund the huge deficits, but savings rates have dropped to the point where even Japan may have to raise interest rates to finance future shortfalls.
US creditors (China, Japan, Germany) don't feel it is their patriotic duty to continue backstopping the Federal Government's staggering deficits, and to believe foreigners will continue to purchase US Treasurys ad infinitum is folly.
Please correct me if I'm wrong. I see 5 major differences between Japan (then) and US (now)
1. Japan had positive balance of trade, not deficits.
2. Japan relied on their own citizens to lend, not foreign governments.
3. Japan's central bank did not actively buy securities, their easing stopped at (near) 0% rates.
4. The Yen was not widely held outside Japan, whereas there are a trillions of dollars/denominated assets outside the US.
5. Nominal debt/deficit is several times larger for the US than Japan.
IMO - these factors seem to point to a more acute currency crises in the US than in Japan, as all the above impact the Dollar more strongly than they did the Yen.
The Bank of Japan had a pretty open policy of purchasing equity securities in the open market during their ZIRP, in stark contrast to our opaque friends at the Federal Reserve.
Some other factors:
The japanese labor market is much less elastic than the US labor market. In Japan the average number of companies worked for in a lifetime is around three to five, while in the US it is about six times more.
Japan raised rates briefly in response to the bubble bursting, while US lowered them dramatically.
Japan does not have a starving military complex hungry for constant war.
There are more differences, but I believe the trade surplus/deficit difference to be the main one: All this jibber-jabber about numbers balancing out and paper moving around and whatnot (finance in short) only serves one purpose: to have more imports than exports. We have to think that people are ultimately worried about the real world implications instead of pixels moving around. So while in Japan, they were in a losing position from the start of the bubble bursting in that they had to work towards a trade deficit, in the US it is already firmly in place. All that has to be done now is to maintain it. Given the size of this deficit, this is not such an easy task, and will require large compromises, which is what Benny Boy is doing right now. He is conceding US purchasing power for the survival of the financial system and continuation of a deficit.
USA entered depression with near negative savings rate. Japan not.
Japan had domestic slump but international companies had significant presence in other nations capturing revenue streams from countercyclical behavior there. Booming economies gobbled exports from a Japan that manufactured high quality goods.
The world is in a synchronized downcycle here. We cannot export to another planet. Exporting out of depression is much less likely now.
We may have to export war to destroy manufacturing and production capacity like last time.
If you compare the Japanese R.E. bubble to the U.S. bubble the Japanese bubble was 3X as extreme... maybe even more if you compare the index above to the Cash-Shiller index.
Does it not cross Richard Koo's mind that at some point the Japanese government will have to de-leverage as well?
In regard to repairing the s&l crisis, Koo states "and cost to taxpayers was nothing!". He then goes on to describe FAT spread whereby banks exploit ignorant depositor by paying very low interest (probably negative when compared to inflation) while charging high rates to borrowers.
While not costing taxpayers from bailouts, nevertheless bailouts were performed and the costs were borne by the productive economy in the disguised form of loss of interest earnings by a conspiratorial, non-free market banking system run by oligarchic bureaucrats.
BTW, Japan may STILL go bankrupt as they used the public balance sheet very liberally trying to solve the private balance sheet impairments.
What benefit if private companies are able to emerge when the nation and its credit rating are destroyed?
Tired of those who shift weights about a lever and pivot and say thereby we have "gained" a mechanical advantage. It is just redistribution to favoured parts of an economy.
And unfortunately after a season of such gaming, all the weight have been distributed to the ultimate ends of each side of the lever and the pivot is fixed. Any further shifting is detrimental.
"In order to repair their balance sheets, private sector moves away from profit maximization to debt minimization."
Ummm, when was this due to begin?
Released November 20th, 2009:
"Company debt sales top annual record already
With more than a month to go until 2009 ends, companies have already sold more debt this year than in any previous year..."
Doesn't seem to be a very accurate assessment so far?
I didn't watch the video till the end but I don't think he answers 2 questions:
1) Who is going to finance goverment spending ?
2) How is goverment going to pay out it's debt ?
He makes a compelling argument for maintaining GDP at zero by increasing government stimulus to replace the collapse of private economic activity. A great academic intellectual exercize. HOWEVER, this is not workable when the GDP is at an artificially high level to begin with. Our level of GDP today is at a false high. It is a result of consuming more than we produce. We must allow GDP to fall to get in line with our actual level of production. Stimulating the economy to maintain the current false level of economic activity just continues the facade of a false standard of living and like compounding interest rates just compounds the problems as time marches on.
This admin/Dearest Leader has no clue. All those off the wall stimulus suggestions to distribute the money directly to us just might have worked. Now, there is zip demand. Oh, there are people still eating out at various venues, still shopping at some subsistence level, yes there is still some action-but there is no velocity of money. Banks are waiting for the other shoe to drop and global trade keeps contracting or nill growing.
We need serious job creation not make work b/s. To create jobs there has to be demand, then there will be hiring. More dramatic, non-debt creation, action must be taken/thought up, ASAP!
TD please stop this talking ad! It's horribly distracting.
Thanks
Loved the bullet points, succinctly stating what we all know in our hearts.
Like the grinch that stole Christmas, human greed and a need for instant gratification brought forward future demand with huge leverage - stealing all the demand for tomorrow - all the future Christmas's. It's like cash for clunkers, it just creates more imbalances.
In addition, the most important question relates to property rights and human rights on a debt default. Should banks that have made loans out of thin air with no threat of bankruptcy (since they are backstopped) have a property claim (lien) on assets that were created with labor, materials and equity from a property buyer (saved up labor)? This is the most important question confronting us in this collapse - the banks right to property they did nothing for, just like speculative buyers of CDS wanting the companies covered to default the banks could want mass defaults to pick up real physical assets with their imaginary capital (debt).
The important corollaries to observe here are: 1) price inflation is good 2) fiat money is good, because without either of the two there would not be any economic progress, as in well-being 3) a disconnect between reality, that of the need for money, and the amount of money available, is not good. Sadly, the Holy Equilibrium (HE)is not the ideology of any CB, or anyone in politics. One concludes therefore, that in a short future HE would be precisely the new modus operandi.
Great article. We need to learn from what happened in Japan.
admin
http://invetrics.com
well very good analyses of the problem. if you follow his approach it sounds the US is doing more less everything right right now. especially when they talk of a second stimulus. he just never explained how the government does de-leverage at the end?
regarding financing the deficit. if you follow Rosenberg in his view that does not seem to be big problem as the household increase their savings rate. and if you look at mutual fund flows thats what happening at the moment. eyq get reduced and fixed income funds have massive inflows. as well as the banks as their is no demand for borrowing and higher capital ratio requirements they finance the deficit.
dude.. look at what they are recommending for their cure.
SLOW NPL - systemic.. not fast.. damn you guys cant read worth shit.
Japan and the USA economies are different. Forgive my simplicity here;
Japan = manufacturing based economy ---> Capacity utilization = Factory Utilization, with production.
USA = service based economy ---> Capacity utilization = Those Employed, with disposable income.
The USAs number one economic focus should be employment. Without employment, service based capacity utilization drops. I would say that a service based economy is fundamentally weaker than a manufacturing based economy due to the reliance on employment (consumption) and increasing wages. One may argue that a service based economy runs a greater risk of prolonged non-recovery because at a fundamental level, the consumer is highly exposed to external forces; housing, employment, medical costs, food, transportation, and so on, which can greatly effect disposable income.
Consumption is not investment, when the goods are manufactured off-shore, and thus, is not economically self sustaining.
Can the US government increase capacity utilization through stimulus alone without the contribution from personal disposable income? Where will personal disposable income go? and in what magnitudes before producing economic growth?
What if the previous real gains in disposable income came through debt (easy credit), and not some underlying strength in the economy as a whole.
Perhaps you will see no growth until debt is paid down and savings re-established. At what level of capacity utilization will prices stabilize?
Could it be, fundamentally, that a service (consumption) based economy is not viable in terms of prolonged growth, or in its ability to quickly de-leverage from debt? Perhaps this is the real failure of our government, not recognize the risks of globalization. That sometimes the lowest global price, if it subverts the diversity and strength in the nation's economy, is in the long run, more expensive.
Mark Beck
I don't understand how back scratching and picking nits off eachother, which is how I view a service economy, creates growth.
As someone so eloquently put it the other day---
We are SO beyond Phucked, that we can't even catch a bus back to Phucked.
Happy Holidays to all---Try to enjoy your friends and family and things that really matter.
Many here point out the difference between the economies of Japan and the US. I would like to add that much of Koo's thesis rested on the notion that money was sitting in banks, and the Central Bank/Government became the borrower of last resort. He mentioned bridges to nowhere and digging ditches and refilling them at government expense. He contends that fiscal spending is the way out.
But what was the BOJ spending??? It was spending increased corporate and household debt repayments, idled because nobody wanted to borrow. Does the US have that available? I think that the US defaults on mortgages and credit cards. I think that is moral anatehma in Japan - not sure. I fear that here one is considered a fool to pay it off.
Still some debt is getting repaid. Some argue that only now, the home ATM machine is finally ceasing after a sharp slowdown.
I just don't see that the US has idle savings to borrow. The government create money and borrow it from itself. That is different from borrowing real savings.
The point about Japan having a ZIRP w/o any inflation is interesting. I suppose that Japan was experiencing a flat or shrinking multiplier. We have that here. Outside of mutual fund charters/mandates, I don't see the attractiveness of buying Treasuries.
Koo also makes the point about calling loans from businesses if Japan was experiencing contraction. I agree tht calling a business loan can destroy a business. Is it possible to destroy a house by callng the loan against it??? I don't think so. However we destroy clunkers, but they seem to be paid off in full.